Nov. 2013 (special issue) - Nice Cheer!

Brief facts 

Nice Cheer carried on a business of trading in listed securities.  During the years of assessment 1999/2000 to 2005/2006, Nice Cheer prepared its accounts in accordance with the new financial reporting and accounting standards (SSAP24 and HKAS39).  Under the new accounting standards, unrealised gains or losses arising from the changes in fair value of trading securities were credited or debited to the income statement for the relevant year.  Prior to the implementation of new accounting standards, the listed securities were valued at the lower of cost or net realizable value with the fair market value disclosed as a note to accounts.  In computing the adjusted losses or assessable profits for tax purposes, Nice Cheer treated the unrealised gains in respect of listed securities as non-taxable gains but claimed the unrealized losses as tax-deductible expenses.   The CIR was of the view that the unrealized gains in respect of listed securities held at the year end should be taxable and included in the profits tax computation.  The tax amount in dispute is approximately HK$250 million.

Arguments put forward by the CIR

The CIR contended that as the word “profits” is not defined in the Inland Revenue Ordinance (“IRO”) and as in the natural and ordinary meaning of the word “unrealized profits” is “nonetheless profits”.  The amount of assessable profits for a year of assessment is primarily a question of fact (rather than a question of law for the courts to determine).  Furthermore, seeking to rely on the decision of the CFA in the CIR v Secan Limited (“Secan Case”), which was also delivered by Lord Millet NPJ, the CIR argued that profits and losses for a year of assessment must be ascertained in accordance with ordinary principles of commercial accounting unless they are contrary to “an express statutory provision” in the IRO.  

CFA’s decision

Lord Millet NPJ delivered the decision, which was agreed by the other four judges with no further comments, and stated that while the amount of profits is a question of fact, what constitutes “profits” within the meaning of IRO and whether the disputed amount represented assessable profits are questions of law.  The word “profits” is an ordinary English word and is capable of a broad variety of meanings.  However, the question in this case was whether for the purpose of profits tax, the word “profits” in Section 14 (the basic charging section for profits tax) includes unrealised profits.  In delivering the judgment in favour of Nice Cheer, Lord Millet NPJ cited two cardinal principles of tax law:

(1) the word “profits” connotes actual or realised and not potential or anticipated profits; and

(2) neither profit nor losses may be anticipated.  

Lord Millet NPJ stated that the CIR had misread his judgment in the Secan Case.  He pointed out that what he said in Secan Case was “in conformity with the Ordinance”, not “in conformity with an express provision of the Ordinance”.  Lord Millet NPJ explained that “While the amount of that profit must be computed and ascertained in accordance with the ordinary principles of commercial accounting, these are always subject to the overriding requirement of conformity, not merely with the express words of the statute, but with the way in which they have been judicially interpreted.”

Lord Millet NPJ stated that “it is far too well established as a principle of law” that “neither profit nor loss should be anticipated” and that this can only be overturned by clear and express statutory provision.  This well-established principle cannot be overturned by the adoption of new accounting standards.  

Unrealised losses

Though the tax deduction of unrealised losses in the listed securities in this case was not in dispute, Lord Millet NPJ tried to reconcile the apparent contradictory treatment of unrealised gains and unrealised losses.  He stated that, in his opinion, a taxpayer may use an unrealised loss to diminish his liability for tax and explained that “at first sight this seems to be merely another way of anticipating unrealised losses; but it is not.  The auditors will not normally allow such a provision to be made unless they are satisfied that the diminution in value is material and likely to be permanent.  Moreover, if such a provision is made it can be challenged by the Commissioner.”  

Comments

The decision of the CFA in Secan Case established the principle that “where the taxpayer’s financial statements are correctly drawn in accordance with the ordinary principles of commercial accounting and in conformity with the Ordinance, no further modifications are required or permitted”.  

Subsequent to the Secan Case, the Inland Revenue Department (“IRD”) changed its assessing practice and tax unrealised gains in respect of listed securities being held as trading stock. The IRD also changed its assessing practice concerning the deduction of prepaid or deferred expenditure.  Prior to Secan Case, prepaid revenue expenses were considered as tax deductible even if the sum is related to more than one accounting year and is spread over and charged to income statements of those years, on the basis that the expenses have been incurred.  Under the new practice, the IRD does not allow deduction for the full amount of a prepaid expense in the year of payment if any part of the expense is deferred to a subsequent year or period.  The CIR explicitly explained their assessing practice in its Departmental Interpretation and Practice Notes (“DIPN”) Nos. 42 and 40.  

The new assessing practice concerning revaluation of listed securities was eventually considered in the courts of Hong Kong.  Judges at different court levels unanimously decided the case in favour of Nice Cheer.  Companies with unrealized gains on listed securities held for trading should now exclude such gains from its assessable profits when preparing their tax computations.  

The CFA decision reaffirmed the tax practitioners’ view that the IRD has been stretching too far on the applicability of the Secan Case.  In light of this judgment, the IRD should consider to revise its DIPN 42 and DIPN 40 to rectify its misapplication of the decision of Secan Case as stated in the judgment of CFA of this case.

As an obiter dictum, Lord Millet NPJ stated that diminution in value in trading stock which was “material and likely to be permanent”, subject to challenge by the IRD, may be considered as allowable for tax purposes.  As mark-to-market unrealised losses in respect of listed securities held as trading stock may not represent permanent diminution in value, the IRD may challenge the deductions for such losses booked in the year end.