Hong Kong Profits Tax & Aviation Fuel Supply Company v CIR
The charging provision of profits in Hong Kong, detailed in article 14 of the Inland Revenue Ordinance (IRO), might be considered as simple by ‘outsiders,’ it is far from straightforward, as the charging provision can be open to many different interpretations. As a result, even the most straightforward cases can prove complex, and interpretation is often left to the tax advisers or lawyers and the Courts.
Is compensation of a business of an income or capital nature?
Aviation Fuel Supply Company v CIR (HCIA 6/2009) was such case, and one of the discussions therein was whether the ‘compensation for surrender of business’ was of an income or a capital nature. This distinction of treatment is important, as according to article 14 of the IRO, profits arising from the sale of capital assets are excluded from the charging section (NB: there is no explicit authority that all receipts of a capital nature are exempt, although in practice the Inland Revenue seems to extend the capital assets sale exemption to a range of other receipts of a capital nature).
The facts of this case are quite comprehensive but can be simplified as follows: The Aviation Fuel Supply Company (‘AFSC’) concluded a Franchise Agreement with the Airport Authority in the late nineties. Pursuant to this Franchise Agreement, the AFSC financed, designed, constructed and commissioned a fuel service facility (‘Facility’).
In addition, there was a Lease Agreement between the AFSC and the Airport Authority regarding the area on which the Facility was built and an Operating Agreement between AFSC’s nominee and the Airport Authority regarding the operational responsibility for the Facility.
On the 23rd of October 2002, the Airport Authority notified the AFSC of its election under the Franchise Agreement to ‘accelerate AFCS’s recovery of the Facility costs’ and as a result of that, the Lease Agreement was terminated, the Operating Agreement continued and the AFCS received an amount of US$ 456,929,590. The IRO argued that this amount had to be considered as chargeable income under article 14 of the IRO (or alternatively as deemed income under article 15A of the IRO).
The AFCS argued thereinafter that the amount was of a capital nature and therefore exempt under 14 of the IRO (or alternatively that an exemption under 15A paragraph three could be claimed), as they were of the opinion that they were running the facility themselves.
Court Ruling on the Capital Nature
On the 8th of July, 2011, the Court of First Instance ruled however in favor of the AFCS, taking amongst others, the following points into consideration:
• Documentation showed that the operators of the Facility would be given the opportunity by the Airport Authority to operate with a goal to make profits, and that any operator would develop the Facility for their own benefit. This view can be supported by the so-called Build-Operate-Transfer model that was adopted by the Airport Authority in relation to the franchising of aviation logistics services;
• As the ‘regular’ payments for providing the Facility were paid by the Airport Authority to the AFCS’s nominee, but not to the AFCS itself, these payments cannot be considered as a payment by the Airport Authority to the AFCS directly in exchange for services rendered;
• Related documents also showed that the AFSC was allowed by the Airport Authority to claim depreciation allowances in respect to the Facility, which it only could do as an owner of such a Facility;
• The payments received by the AFSC (which were considered by the Court as not being derived from the AFSC’s business) were to be regarded as “payments made in order to bring about a termination of AFSC’s business…it is well established that payments to bring about the determination or destruction of a business are to be regarded as capital in nature.” In addition, the purpose of the payment by the Airport Authority was to prevent AFSC from earning further ‘regular payments’ in the future;
• The risk of not receiving sufficient ‘regular payments’ to earn a profit shifted from the AFCS to the Airport Authority and “such a movement of risk tends to suggest that the sum paid which brings it about is capital in nature”; and
• The length of the right to the unexpired portion of the Franchise Agreement and Lease Agreement, which was taken over by the Airport Authority for a fee, was nearly 15 years. This in itself tends to suggest that this fee was of a capital nature.
Court Case Takeaway
The Court, while considering whether or not a particular item of receipt or expenditure was of a capital or income nature, made a reference to Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634, where Dixon J. said that the answer to such questions “depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured employed or exhausted in the process.”
Please note that the Inland Revenue submitted a notice of appeal against this case on the 5th of August 2011 (CACV 150/2011) but a decision is not expected until November next year.