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CIR v Aviation Fuel Supply Company
Hong Kong Tax alert
15 January 2015 2015 Issue No. 1
The Court of Final Appeal (CFA) has recently clarified the interpretation of the relevant provisions of the Inland Revenue Ordinance (IRO) governing the issue of balancing charges where fixed assets, in respect of which tax depreciation allowances or deductions have previously been claimed, pass from a predecessor to a successor of a business.
Equally welcome is the CFA’s vigorous defense of the right of a taxpayer to the 6-year limitation period beyond which no fresh assessment can generally be issued to the taxpayer, even though the re-assessment in question was not strictly governed by the limitation period.
As a result, in future the Commissioner of Inland Revenue (CIR) may be more inclined to issue alternative assessments from the outset so as to protect his position.
It remains to be seen whether the decision in this case may also have an impact on whether an assessor can revise a previously agreed statement of tax loss where the revision is made after the 6-year limitation period.
Tax objections and litigations by their nature often involve complicated procedural or technical issues. Where appropriate, clients should seek professional tax advice.
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Facts
In December 1995, the Airport Authority (the Authority) entered into a Franchise Agreement with Aviation Fuel Supply Company (AFSC). Under the Franchise Agreement and in return for the consideration as detailed below, AFSC undertook to finance, design, construct and commission a facility on a certain area of the Chek Lap Kok airport then under construction for the supply of fuel to aircraft (the Facility).
As part of the terms of the Franchise Agreement, the Authority also granted a land lease (the Lease) to AFSC in respect of the land upon which the Facility was located, the Lease running for 20 years from the date of the opening of the airport on 6 July 1998.
On the same day as the signing of the Franchise Agreement, the Authority separately entered into an Operating Agreement with AFSC’s nominee (the Operator) for the latter’s operation of the Facility for a term of 20 years from the opening date of the airport on 6 July 1998.
Operator Operating Agreement
Airport Authority AFSC
20-year Franchise and Lease Agreement early terminated at the end of Year 5*
Facility Payments for the remaining 15 years then payable to the Airport Authority instead of AFSC
From July 2003 onwards
Operate the facility
Fuel supply facility#
* by way of the Airport Authority paying AFSC an Accelerated Payment of approximately US$449 million # The ownership of the facility vested in the Airport Authority following the termination for the 20-year Franchise and Lease Agreement
20-year Franchise and Lease Agreement
Fuel supply facility
Operator Operating Agreement
Facility Payments for 20 years – subject to early
termination
Airport Authority AFSC
Design, finance and construct the facility
Operate the facility
From July 1998 – July 2003
Out of the income derived from operating the Facility, the Operator was to pay periodic Facility Payments to AFSC calculated to enable AFSC to recover the costs of constructing the Facility and a reasonable return on its investment.
On 7 July 2003, the Authority exercised an option contained in the Franchise Agreement and made an Accelerated Payment of approximately US$449 million (the Sum) to AFSC, the Sum being the net present value of the expected Facility Payments which AFSC would otherwise have received for the remaining term of the Lease. Upon the Authority making payment of the Sum, the Lease granted to AFSC would terminate and the Operator would thereafter pay the Facility Payments to the Authority instead of AFSC.
The following two diagrams depict the key arrangements of the case.
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In its profits tax return for the year of assessment 2003/04, AFSC treated the Sum as a non-taxable capital receipt in return for the transfer of its entire assets and business undertaking in the form of the Facility to the Authority. The Deputy CIR however determined on 11 February 2009 that that the Sum, being a payment in substitution of what would otherwise have been taxable periodic Facility Payments, was revenue in nature and therefore chargeable to tax in Hong Kong.
AFSC appealed directly to the courts against the Deputy CIR’s determination, bypassing the Board of Review.
Decisions of the Court of First Instance (CFI) and Court of Appeal (CA)
The CFI held that the Sum was capital in nature not chargeable to tax in Hong Kong1. The CIR appealed against the CFI’s decision to the CA.
On 22 October 2012, a few weeks before the hearing in the CA, the CIR amended the notice of appeal to allege that if the CFI’s decision was affirmed, the assessment should be varied to take into account that AFSC’s Facility at the airport had consisted of prescribed fixed assets, industrial buildings, plant and machinery for which tax depreciation allowances or deductions had been claimed and the disposal of which gave rise to balancing charges.
Hearing the appeal, the CA upheld the CFI’s decision that the Sum was a non-taxable capital receipt and exercised the discretion to allow the CIR to raise the new issue of balancing charges at that late stage. The CA justified the discretion by noting that it would not create procedural unfairness to AFSC, AFSC being allowed to present further evidence and materials before the CIR if the issue of balancing charges was remitted to the CIR to consider.
However, the CA considered that it could determine the issue based on the existing materials before it without the need for a remission to the CIR and further evidence from AFSC. The CA held that in the circumstances no balancing charges needed to be made under sections 39B(7) and 39D(3) of IRO as the relevant assets passed to the Authority by way of the Authority succeeding to the business of AFSC.
Accepting the lower courts’ decision on the non-taxable capital nature of the Sum, the CIR appealed to the CFA only in respect of the CA’s decision on the issue of balancing charges.
CFA’s decision on the issue of balancing charges
While the CIR only appealed against the merits of the decision of the CA in respect of the issue of balancing charges, the CFA considered that the chief question was whether the CIR should have been allowed to raise the issue at the last minute before the hearing in the CA.
Should the CA have entertained the CIR raising the issue of balancing charges at the last minute?
The CFA noted that on hearing the appeal, the CA had the discretionary power under section 67(7) of the IRO to make any assessment which the Deputy CIR was empowered to make when he determined the assessment on 11 February 2009. On that date, the Deputy CIR could have determined the assessment on the basis that balancing charges were required to be made, even though the assessment was originally raised based on an entirely different ground that the Sum was a taxable revenue receipt. As such, the CFA considered that the CA had the jurisdiction to entertain the CIR’s submission that AFSC should be assessed on the basis of the balancing charges, albeit the issue was only first raised by the CIR on 22 October 2012, which was more than 6 years after the end of the year of assessment 2003/04.
However, the CFA ruled that in the circumstances it was not fair for the CA to do so. This is because the effect of the CA entertaining the CIR’s submission would be to deprive AFSC of the protection of the normal 6-year limitation period against what may in substance be a fresh assessment. In this regard, the CFA noted that the main purpose of the limitation period is to protect taxpayers from having to investigate transactions that have receded more than six years into the past.
While a re-assessment under section 67(7) is not strictly governed by the 6-year limitation period, the CFA is of the view that where such a re-assessment requires any further investigation of the facts, the 6-year limitation period generally needs to be observed. The issue of balancing charges in AFSC was one such case because it would involve further investigation of the facts as to what part of the Sum should be attributed to the various assets that have attracted tax depreciation allowances or deductions.
On the above basis, the CFA ruled that the CA should not have entertained the CIR’s submission that balancing charges should be made and thus dismissed the appeal accordingly.
1. Please refer to Hong Kong Tax alert – 2 January 2013 (2013 Issue No. 1) for details of the CA and CFI decisions on the issue of whether the Sum was of a capital or revenue in nature.
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CFA’s views on the merits of CA’s decision on the issue of balancing charges
As such, while strictly not necessary to do so, the CFA did express its views on the merits of the CA’s decision on the issue of balancing charges at the request of the CIR.
The CFA noted that under sections 39B(7) and 39D(3) of the IRO, balancing charges need not be made where there is a succession to a business under which the relevant plant and machinery pass from a predecessor to a successor of the business without the relevant assets being sold.
Therefore, the question for the CA was whether the Facility passed from AFSC to the Authority by way of the Authority succeeding to the business of AFSC in which under a scenario where there was no sale of the plant and machinery to the Authority. The CA appears however, to have only considered that there was a succession of the business, and then decided the issue of balancing charges in favour of AFSC on this finding of facts alone, without considering whether the succession happened without the relevant plant and machinery being sold to the Authority.
The CFA was of the view that there had clearly been a sale of the relevant plant and machinery by AFSC to the Authority in the course of the succession of the business, the Sum paid by the Authority to AFSC being in consideration for the whole of AFSC’s assets and business undertaking in the form of the Facility at the airport.
As regards AFSC’s submission that the Facility, being a fixture on the land and therefore being part of the land, did not pass to the Authority on sale but by operation of law when the Lease was terminated (the Authority holding a reversionary interest in the Lease), the CFA noted that the termination of the Lease in such circumstances nonetheless constituted a sale. The CFA added that the fact that the price for the surrender of the Lease had been agreed in advance and that it followed the exercise of an option by the Authority made no difference to the analysis of the issue.
In addition, the CFA noted a further mistake by the CA. The CA appeared to have regarded its opinion on sections 39B(7) and 39D(3) as determinative of all the CIR’s claims to balancing charges. However, these two sections only govern the issue of balancing charges in respect of plant and machinery in the specified circumstances of a succession of business. There is however no equivalent in the provisions for prescribed fixed assets or industrial buildings and structures, in respect which certain parts of the Facility ranked for deductions or tax depreciation allowances respectively.
Commentary
We welcome the CFA clarifying the interpretation of the relevant provisions of the IRO governing the issue of balancing charges where relevant fixed assets, in respect of which tax depreciation allowances or deductions have previously been claimed, pass from a predecessor to a successor of a business.
Equally welcome is the CFA’s safeguard of the right of a taxpayer to the 6-year limitation period. In this regard, it appears that in future when the CIR determines an objection, if he is to determine it on a basis different from that on which the assessment was originally made, the CIR would equally have to observe the 6-year limitation period in accordance with the principles laid down in this CFA decision. Otherwise, such determination may be open to challenge.
As such, in future the CIR may be more inclined to issue alternative assessments from the outset so as to protect his position. For example, in this case the CFA noted that it would have been possible for the CIR to have originally made alternative assessments, one treating the Sum as a taxable revenue receipt and the other claiming the balancing charges.
It remains to be seen whether the decision in this case may also have an impact on whether an assessor can revise a previously agreed statement of tax loss where the revision is made after the 6-year limitation period.
Tax objections and litigations by their nature often involve complicated procedural or technical issues. Where appropriate, clients should seek professional tax advice.
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© 2015 Ernst & Young Tax Services Limited. All Rights Reserved. APAC no. 03001397 ED None. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/china
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