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INLAND REVENUE BOARD OF REVIEW DECISIONS Case No. D'70/90 Profits tax - claimed expenses - whether income or capital - whether application of taxable profits. Panel: Robert Wei QC (chairman), Frank Pong Fai and Andrew W a g Wei Hung- 90 Date of hearing: 30 November 1 9 . 8 Date of decision: 1 February 1 9 . 91 The taxpayer claimed that certain repayments of unsecured loan capital or transfers of shareholder's funds or reserves should be deducted in computing the assessable profits of the business. The assessor disallowed the payments because they were of a capital nature. The taxpayer appealed to the Board of Review. Held : The payments were of a capital nature and therefore not deductible. Alternatively the payments were the application of profits and not expenses incurred in earning profits. Appeal dismissed. Cases referred to: CIR v Lo & Lo (CA) [l9821 HKLR 503 CIR v Lo & Lo (PC) 2 HKTC 34 Mersey Docks and Harbour Board v Lucas 2 TC 25 Chiu Kwok Kit for the Commissioner of Inland Revenue. Taxpayer represented by a Mr Y. Decision: This is an appeal by the Taxpayer trading as X Company against the determination of the Deputy Commissioner of Inland Revenue dated 99 12 September 1 8 confirming the profits tax assessments raised on her 978 for the years of assessment 1 8 1 7 and 1 8 1 8 on the grounds that 968 certain sums claimed to be repayments of unsecured loan capital or alternatively transfers to shareholders funds/reserves should be deducted in computing the assessable profits. 2. The Taxpayer did not appear at the hearing, but was represented by a Mr Y. No witness was called. The documents produced by Mr Chiu, the Commissioner's representative, were not in dispute. The primary facts, so far as material to this decision, are as follows: INLAND REVENUE BOARD OF REVIEW DECISIONS (a) The Taxpayer commenced business in February 1985 as a sole proprietress and carried on the business until it ceased in 99 February 1 8 . In her profits tax returns, the business was described as 'trading and design service'. (b) Annual accounts were filed together with profits tax returns for the three years of assessment 1985186, 1986187 and 1 8 1 8 978. None of the balance sheets contains any item for capital as such. Instead there is an item 'Loans (unsecured) and obligations amounting to $85,108.16 in the balance sheet as at the end of the year 1985186, and $ 2 0 0 in the balance sheet 1,0 968' as at the end of the year 1 8 1 7 . On the other hand, the 968 profit and loss account for 1 8 1 7 shows a deduction of $24,422.47 described as 'Repayments of unsecured loan capital' 6,0 while that for 1987188 shows a deduction of $ 8 0 0 described as 'Repayment of capital of unsecured loans'. (c) The profits tax return for 1985186 disclosed an adjusted loss 968 of $28,329 which was accepted by the assessor. As for 1 8 1 7 978, and 1 8 1 8 the profits were assessed in the sums of $56,231 and $122,627 respectively. (d) Subsequently in her correspondence with the Commissioner of Inland Revenue, the Taxpayer revised her profit and loss 968 accounts for 1 8 / 7 and 1 8 1 8 by describing the deduction of 978 $24,422.47 and that of $68,000 as sums 'transferred to shareholders funds/reserves'. (e) The Taxpayer explained the revision in her letter to the 9 Commissioner of Inland Revenue dated 2 June 1 8 in the 99 following terms: 'Re~avmentof loan In answer to this aspect it is obvious I received the funds (loans), that is the principal from the shareholders, otherwise I could not have commenced my business. I have not treated the transfer of funds (loans) as expenses, but as a reserve fund (loan) to meet liabilities incurred in setting up my business. The funds raised therefore are or equate to a share value or shareholders fund, which was required as a reserve in order to commence my business.' (f) In her notice of appeal, the Taxpayer stated that the loans were not repaid and that the capital was not withdrawn but held in reserve. The sums reserved, she stated, were equal to the original 'principal' put into the business to enable her to commence; without this original 'principal' there could have been no production of profits. 3 The assessor disallowed the two deductions; the Taxpayer contends that he was wrong. F INLAND REVENUE BOARD O REVIEW DECISIONS 4. The a u t h o r i t y f o r making deductions i s s e c t i o n 1 6 ( 1 ) of t h e Inland Revenue Ordinance, which was paraphrased by Leonard VP i n C I R v - Lo & Lo (CA) [l9821 HKLR 503 a t 509 a s follows: 'In order to a s c e r t a i n t h e taxable p r o f i t s you s h a l l deduct from t h e t o t a l of r e c e i p t s and sums deemed t o be r e c e i p t s all outgoings and expenses t o t h e e x t e n t t o which they a r e incurred in t h e production of such p r o f i t s . ' In t h e same case Lord Brightman observed i n t h e Privy Council ( 2 H T 34 KC a t 71) : 'Sections 16 and 17 provide exhaustively f o r deductions i n t h e sense t h a t permitted deductions a r e confined t o outgoings and expenses incurred i n t h e production of p r o f i t s i n respect of which t a x i s chargeable; t h a t such permitted deductions expressly include those s p e c i f i e d i n ( a ) t o (h) of section 16(1), and expressly exclude those i n s e c t i o n 17. ' Furthermore, i n t h e Court of Appeal it was held t h a t an expense was incurred because it was assumed; t h a t t h e f a c t t h a t t h e l i a b i l i t y was contingent did not prevent t h e expense from being 'incurred' (per Leonard V-P a t 509); t h a t t h e word 'incurred' 'includes t h e acceptance of a l i a b i l i t y a s well a s t h e meeting of t h a t l i a b i l i t y a s and when it matures' (per Cons, J A a t 511). Section 1 7 ( l ) ( c ) expressly excludes from deduction l o s s o r withdrawal of c a p i t a l and expenditure of a c a p i t a l nature. 4.1 Withdrawal of capital. and expenditure of a c a p i t a l nature I n so f a r a s t h e two claimed deductions a r e 'repayment of e c a p i t a l ' , w think they f a l l within t h e meaning of 'withdrawal of c a p i t a l ' and t h e r e f o r e a r e not deductible. I n so f a r a s they a r e sums ' t r a n s f e r r e d t o shareholders funds/reserves ' , they a r e expenditure (not including a c t u a l payment) of a c a p i t a l nature and t h e r e f o r e a l s o not deductible. Alternatively, we t a k e t h e view t h a t repayment of c a p i t a l and t r a n s f e r t o shareholders funds/reserves a r e merely instances of applying t h e p r o f i t s a f t e r they have been produced r a t h e r than outgoings o r expenses incurred i n producing them. e W find support f o r t h i s view i n Mersey Docks and Harbour Board v Lucas 2 TC 25, c i t e d by M r Chiu. I n t h a t case a harbour board w sa empowered by Act of Parliament t o levy dock dues, e t c , t o be applied i n maintaining t h e concern, and i n paying i n t e r e s t on moneys borrowed; any surplus income remaining a f t e r meeting t h e s e charges was d i r e c t e d t o be applied i n forming a sinking fund to extinguish t h e debt incurred i n t h e construction of t h e docks, It was held t h a t t h e surplus was p r o f i t assessable t o income tax. Lord Selborne LC s a i d a t page 28: F INLAND REVENUE BOARD O REVIEW DECISIONS 'The t a x is t o be charged upon t h e p r o f i t s be charged "on t h e amount of t h e produce o r value ... and it i s t o thereof". What i s "thereof"? Of t h e concern which t h e corporation c a r r i e s on. If we had nothing more than that, I should have thought t h a t we were t o consider not t h e a p p l i c a t i o n of t h e moneys which t h e Mersey Board received when they had received them, but t h e " p r o f i t s of t h e concern" i n t h e sense of t h e "produce or value" which could properly be described as " p r o f i t s of t h e concern", and that s u r e l v could be all t h e n e t ~ r o c e e d s of t h e concern a f t e r deducting t h e necessary outgoings without which those proceeds could not be earned o r received. But ... t h e ~ c tdoes not s t o p there, it goes on and says t h a t - t h i s charge i s t o apply "before paying, rendering, o r d i s t r i b u t i n g t h e produce o r t h e value e i t h e r between t h e d i f f e r e n t persons o r members of t h e corporation, company, o r s o c i e t y engaged i n t h e concern" ... "or t o any c r e d i t o r o r o t h e r person whatever having a claim on o r o u t of t h e said profits" ... y To m mind it i s exactly t h e same thing as if t h e r e had been a d e c l a r a t i o n t h a t , a f t e r paying t h e current expenses and all o t h e r necessary outgoings, without which nothing could be earned, t h e c l e a r surplus p r o f i t s and gains of t h e undertaking should be applied i n a c e r t a i n manner, t h a t i s t h e substance of it. The mode of t h e a p p l i c a t i o n makes no d i f f e r e n c e whatever t o t h e question of what i s "profitt' and what is "gain".' Lord Blackburn s a i d a t page 33: 'There i s nothing i n t h e nature of things, t h e r e i s nothing i n t h e words of t h e Act, t o say t h a t when an income has been a c t u a l l y earned, when an a c t u a l p r o f i t upon which t h e t a x i s put has been earned and received by any person o r corporation, Her Majesty's r i g h t t o be paid t h e t a x out of it i n t h e least degree depends upon what they a r e t o do with it afterwards, unless t h e r e is an express enactment, which I t h i n k t h e r e i s i n some cases, t h a t they a r e t o apply it t o c h a r i t i e s o r o t h e r purposes. I f t h e amount t h u s received i s t o be applied a t t h e i r pleasure, they must pay t h e tax. I f it i s t o be paid over t o shareholders o r t o c r e d i t o r s , o r t o anybody else, t h e Queen is s t i l l t o have her tax. ' The words underlined by u s i n t h e above c i t e d passages show t h a t instances of a p p l i c a t i o n of p r o f i t s , such as payments t o c r e d i t o r s are not deductible whether t h e r e i s express l e g i s l a t i o n t o exclude them o r not. The United Kingdom l a w and t h e Hong Kong l a w d i f f e r i n scope i n t h a t t h e UK deductions a r e confined t o expenditure necessary t o earn t h e receipts, while i n Hong Kong they a r e expenditure 'incurred' i n t h e production of p r o f i t s , which i s considered t o be wider in scope (~rofessor Willoughby's Hong Kong Revenue Law, v01 2, 2-241). However, t h i s difference, notwithstanding t h e d i s t i n c t i o n drawn i n Mersey Docks INLAM) REVENUE BOARD OF REVIEW DECISIONS and Harbour Board v Lucas between ascertainment of profits and application of ascertained profits, is in our view equally applicable in Hong Kong. 5 For all these reasons, we are of the view that the two claimed deductions were rightly disallowed. 6. With regard to the adjusted loss of $28,329 for 1985/86, the Deputy Commissioner's determination is in the following terms: 'The Taxpayer elected to be personally assessed under part V11 of the Inland Revenue Ordinance for the year of assessment 1985186 and her loss of $28,329 should be deducted from her total income in her personal assessment for the same year. As a result, no loss was available in accordance with section lg~(1) of the Inland Revenue Ordinance for set off against the amount of her assessable profits from the business for the year of assessment 1 8 / 7 ' 968. In her notice of appeal the Taxpayer alleged that she was forced by intimidation to elect to be personally assessed and was 'bombarded' with forms requesting her to opt for personal assessment. These are serious allegations and call for the clearest evidence before they can be established. Since the Taxpayer chose not to give any evidence, the allegations fail and the election must be taken to be valid and effective. Mr Chiu while categorically denying the allegations, stated that the Taxpayer was welcome to withdraw her personal assessment if she so wished. However, Mr Y was not ready to take up the offer; he had to seek advice. Therefore, so far as this appeal is concerned, the personal assessment is in force, and there is nothing we can fault in the words of the Deputy Commissioner quoted at the beginning of this paragraph. 7 ' It follows that this appeal is dismissed and that the profits 968 tax assessments for the years of assessment 1 8 / 7 and 1 8 / 8 are 978 hereby confirmed.
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