Wharf Properties Limited v. Commissioner of Inland Revenue

CACV000204/1994

IN THE COURT OF APPEAL

1994, No. 204
(Civil)

Headnote

Inland Revenue Ordinance - Sections 16(1)(a) and 17(1)(c) - Deduction of interest payments incurred on loans utilized for purchase of land for development - Taxpayer's intention was to redevelop for rental income.

Held (Court of Appeal): The expenditure was of a capital nature and therefore properly disallowed as a deduction against chargeable profits under s16(1)(a).

IN THE COURT OF APPEAL

1994, No. 204

(Civil)

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Coram: Hon Litton, V-P, Godfrey and Ching, JJ.A.

Dates of hearing: 2, 3, 7 and 8 November 1995

Date of handing down of judgment: 13 December 1995

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J U D G M E N T

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Litton, V-P:

Introduction

1. This is an appeal against Patrick Chan J's judgment dated 30 September 1994 whereby he dismissed Wharf Properties Limited's appeal against the determination of the Commissioner of Inland Revenue in respect of profits tax assessments for two years of assessment: 1987/88 and 1988/89. The appeal is focused upon only one point: Whether the appellant was, in respect of those two years of assessment, entitled to deduct as an outgoing or expense the substantial interest payments made by it to banks and financial institutions for loans advanced by them, pursuant to s16(1)(a) of the Inland Revenue Ordinance. The judge, at the conclusion of his 73-page judgment, said No, because the expenditure was of a capital nature. Despite his finding that "interest is interest and cannot be capital" (p.57-G, judgment), he concluded that the interest was expenditure of a capital nature because the moneys borrowed from the banks were used to acquire a capital asset.

2. Mr Gardiner QC, counsel for the appellant, submits that in so concluding the judge has misconstrued the effect of the statutory provisions governing the deduction of expenditure, in the ascertainment of assessable profits under Part IV of the Ordinance.

Background facts

3. The appellant is a company in the Wharf group of companies of which Wharf (Holdings) Limited is the ultimate holding company. One of the companies in the group, Hong Kong Tramways Limited ("Tramways") operated the tram service on Hong Kong Island from a depot at Sharp Street, Causeway Bay. The depot was owned by three wholly-owned subsidiaries and was used by Tramways under a licence granted by them.

4. By an agreement dated 29 March 1988 the appellant bought the depot from the three subsidiaries for $3,039m. This was pursuant to an agreement made the previous year, under which an instalment of the purchase price amounting to $1,000m was paid. The entire purchase price was financed by means of short-term loans. These loans were first advanced in August 1987 when the first instalment of the purchase price was paid by the appellant. Further facilities were made available when the balance of the purchase price became payable in March 1988. The term of these loans varied from one week to one month. They were either rolled over or replaced by other short-term facilities as they matured from time to time.

5. The total interest payments made by the appellant to the banks and financial institutions in respect of moneys borrowed for the purpose of acquiring the depot were as follows: For the year ending 31/3/1988, $51,275,848; for the year ending 31/3/1989, $292,000,841. During the same periods, the appellant derived licence fees for the use of the depot by Tramways as follows: For the year ending 31/3/1988, $6,160,000; for the year ending 31/3/1989, $8,991,613.

6. The purpose for the acquisition of the depot, as found by the judge, was for redevelopment for rental income. Plans were submitted for approval to the Building Authority for a large commercial complex and when, on 20 March 1989 Tramways vacated the depot, the appellant was able to proceed with the construction phase of the redevelopment which eventually became the well-known land-mark called Times Square. However, before the redevelopment was completed, the appellant sold the property to another wholly-owned subsidiary in the Wharf group. This took place in the year 1990/91. The result was that the appellant in fact never received any rental income from the completed development Times Square.

Income earned from the depot site

7. Plainly, the purpose of the acquisition of the depot, financed by the substantial borrowings from the banks, was not to earn the licence fees paid by Tramways during the two years in question. These were negligible compared with the interest expenses incurred. Nevertheless, the Commissioner in his determination was prepared to accept that this was a "subsidiary purpose" of the company acquiring the depot and, to that extent, he allowed by way of deductions sums equivalent to the licence fees earned. The way the Commissioner put it in his determination was as follows:

"(6) The assessor has proposed to allow an equivalent amount of interest expenses as having been incurred in producing the rental income for the relevant period. Although the proposed deduction appears generous for such a subsidiary purpose, I am prepared not to disturb his proposal.

(7) The remainder of the interest expenses which related to the dominant purpose of redevelopment is therefore not deductible under s17(1)(c), for being of a capital nature."

8. Another way of treating that income, totalling $15,151,613 in the two years, might have been, as Mr Barlow, counsel for the Commissioner suggests, to regard it as a purely incidental income, not arising from the carrying on of any trade profession or business - in which case it would fall outside the charging section in Part IV. Be that as it may, that was not how the Commissioner approached the matter, and nothing turns on this point in this appeal.

9. The result of the Commissioner's treatment was that, for the year of assessment 1987/88, the amount of interest expense disallowed was $45,115,848 and for the year of assessment 1988/89, it was $283,009,228.

10. The judge, pursuant to the procedure for dealing with tax appeals under s67 of the Inland Revenue Ordinance, upheld the Commissioner's determination. Hence the appeal to this court.

Part IV Inland Revenue Ordinance

11. Essentially, this appeal turns on the proper construction of two provisions in Part IV of the Ordinance dealing with profits tax as follows:

Section 16(1)(a) which reads:

"16. Ascertainment of chargeable profits

(1) In ascertaining the profits in respect of which a person is chargeable to tax under this Part for any year of assessment there shall be deducted all outgoings and expenses to the extent to which they are incurred during the basis period for that year of assessment by such person in the production of profits in respect of which he is chargeable to tax under this Part for any period, including -

(a) where the conditions set out in subsection (2) are satisfied, sums payable by such person by way of interest upon any money borrowed by him for the purpose of producing such profits, and sums payable by such person by way of legal fees, procuration fees, stamp duties and other expenses in connection with such borrowing;"

Section 17(1)(c) which reads:

"17. Deductions not allowed

(1) For the purpose of ascertaining profits in respect of which a person is chargeable to tax under this Part no deduction shall be allowed in respect of -

(a) domestic or private expenses, including the cost of travelling between residence and place of business;

(b) any disbursements or expenses not being money expended for the purpose of producing such profits;

(c) any expenditure of a capital nature or any loss or withdrawal of capital;

....".

The statutory scheme

12. Profits tax is charged under s14 of the Ordinance on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits: This is defined in section 2 to mean the profits in respect of which he is chargeable to tax as calculated in accordance with the provisions of Part IV.

13. Section 16 then deals with the ascertainment of chargeable profits. Sub-section (1) says that, in ascertaining those profits, all outgoings and expenses, to the extent to which they are incurred in the production of chargeable profits for any period, shall be deducted. It has not been suggested before us that the words "outgoing" and "expense" in s16(1) are used in any unusual sense. Prima facie, they include every expense incurred whether it be of a "capital" or "revenue" nature. The only qualification is that the expense must be incurred in the production of chargeable profits.

14. Here, we are dealing with the deduction of interest payments which come under s16(1)(a), in regard to which a deeper analysis will be necessary later on in this judgment.

15. But, moving on to consider s17(1)(c), one sees that for the purpose of ascertaining chargeable profits no deduction shall be allowed in respect of any expenditure of a capital nature.

16. This, in effect, is the statutory frame-work, cut down to its bare bones, within which this appeal must be decided.

"Expenditure of a capital nature"

17. The expression "expenditure of a capital nature" in s17(1)(c) covers the whole range of "outgoings and expenses" referred to in s16(1). This case is concerned with only one type of expenditure: the interest paid by the appellant to the banks for short-term loans during the two years in question totalling $327,347,847. Section 17(1)(c) requires the court to determine the "nature" of that interest; for expenditure of a capital nature cannot be deducted. Is the interest paid to the banks capital or revenue in nature?

18. The judge said (at p43-F, judgment):

"Interest itself is of course not capital. It is also not an instalment or part payment of a large sum."

19. If one stopped the analysis at this point, and asked again: What is the nature of that type of expenditure? The answer seems to be: It is revenue in nature. The judge came close to so concluding where, at p.67L to Q of his judgment, he said:

"For the 20 month period in question, the appellant had made various payments of interest for the loans which it had borrowed on short term basis. The size of the interest payments was of course large in itself but small when compared with the size of the loans. The interest payments were made from time to time during the relevant period. It could, in this sense, be regarded as recurrent payments. On this test or consideration, one would be more inclined to think that the interest payments in the present case have the indicia of an expenditure of a revenue nature".

The nature of expenditure by way of interest

20. It is the case for the appellant that, by whatever test one applies, interest payments are revenue in nature. For instance, Rowlatt J in Bennett v. Ogston (Inspector of Taxes) 15 TC 374 at 379 defined interest as "payment by time for the use of money"; and Farewell J in Bond v. Barrow Haematite Steel Co. [1902] 1 Ch 353 at 364 identified interest as "compensation for delay in payment". It is recurrent; by such expenditure the appellant secures the continued use of the money; it is intrinsically incapable of being treated as a capital expenditure, at any rate on short-term loans.

The appellant's case

21. In summary, Mr Gardiner QC, counsel for the appellant puts his case thus:

(i) The judge found, in the appellant's favour, that the interest payments, totalling $327,347,847 in the two years in question, were made for the purpose of acquiring an income-generating asset: that is to say, for the purpose of producing future profits chargeable to tax under Part IV. Accordingly the condition set out in s16(1)(a) - that is, "sums payable by such person by way of interest upon any money borrowed by him for the purpose of producing such profits" - has been satisfied.

(ii) It is common ground that s16(2) does not stand in the appellant's way because at least one of the conditions in subsection (2) has been satisfied.

(iii) In considering whether the expenditure is disallowed under s17(1)(c), the purpose for which the money was borrowed is irrelevant. S17(1)(c) looks simply to the nature of the expenditure, not to the underlying purpose of the loans. This is to be contrasted with the position in the United Kingdom where, for example, under s137(f) of the Income Tax Act 1952, "no sum shall be deducted in respect of ... (f) any sum employed ... as capital in the trade ...". In the United Kingdom legislation one is directed to consider the nature of the money borrowed and not the nature of the expenditure itself. Under the Hong Kong provision it is the nature of the sum itself to be deducted which is relevant. Just as rent paid by a tenant secures the use of premises, so interest paid by the borrower secures the use of money: both expenditure are revenue in nature, irrespective of the nature of the underlying asset secured by such payments.

The judge's approach

22. The judge's findings (p39, judgment) were as follows:

"In my view, the loans in the present case were borrowed in the course of the appellant's business and with a view to pay for the purchase price of the Depot. They were obtained for the purpose of acquiring the Depot. And the purpose of acquiring the Depot was for redeveloping it into a commercial complex so that future rentals could be generated after its completion. In other words, the loans were borrowed for the purpose of acquiring an income generating asset. That being the case, the interests paid on the loans were closely connected with such purpose. It follows that the interest expenses paid or incurred during the relevant basis periods were incurred by the appellant in the production of its assessable profits after the completion of the redevelopment."

23. The judge accordingly found that the conditions of s16(1)(a) were satisfied.

24. But when he came to consider s17(1)(c) he said (p43, judgment):

"Interest itself is of course not capital. It is also not an instalment or part payment of a larger capital sum. However, one cannot look at it in vacuum. One does not pay interest without a reason. It is paid in order to achieve a particular purpose. In many respects, rent and interest are similar: interest secures the use of money and rent secures the use of premises. But there is one practical difference. As for rent, however much and for however long it is paid, it cannot and will not help either directly or indirectly in the acquisition of the premises. It simply secures the use of the premises as long as it is paid during the term of the lease. The premises for which rent is paid can be used to conduct business from which income can be generated, but at the end of the lease, the premises had to be returned to the landlord. On the other hand, interest secures the use of the money which can be employed in many ways: as circulating capital for the business, to purchase machinery and plants or stock in trade, or to purchase a fixed asset such as premises. At the end of the loan period, if the money was used to purchase premises, the premises purchased will be acquired upon repayment of the loan. Hence, apart from securing the use of the money, the payment of interest plays a part, albeit indirectly, towards the acquisition of the asset or premises. This difference may be fine but it illustrates the importance of not only looking at the status and nature of the expenditure but also the reason and purpose for which, and the circumstances under which the expenditure is incurred."

25. The judge in the passage quoted above is right in drawing the distinction between interest and rent. But does it answer the question: What is the nature of the interest expenditure within the meaning of s17(1)(c)?

Section 16(1)

26. Mr Barlow, counsel for the Commissioner, submits that inherent in the words "outgoings and expenses" in section 16(1) is the concept that they can only be outgoings and expenses of a revenue nature. Section 16 seeks to ascertain trading profits chargeable to tax under Part IV and, by section 14, receipts from the sale of capital assets are expressly excluded from the charges. As Mr Barlow puts it:

"... a precondition of deductibility is that the expenditure be incurred in producing trading profit chargeable to Hong Kong tax. Thus, expenditure on capital account is excluded from the outset."

27. As I see it, there are two major objections to this submission - a submission which Patrick Chan J in the court below also rejected:

(i) It robs the word "all" in the expression "all outgoings and expenses" of much of its meaning.

(ii) It makes s17(1)(c) totally redundant.

28. Any construction which has this result is suspect. In my judgment the judge was right to reject this submission.

Section 17(1)(c)

29. We then finally come back to s17(1)(c) and it is here that I find the arguments of counsel evenly balanced.

30. The words in s17(1)(c) are, of course, "expenditure of a capital nature". Mr Gardiner accepts that if the wording were slightly different and the disallowance related to "any expenditure for a capital purpose" the appeal must fail because the court must then look behind the expenditure and enquire into the purpose for the borrowing. But, he says, that is not how the section is worded. There is, he submits, a real distinction between (a) expenditure on providing finance to acquire the depot and (b) money spent on the actual acquisition of the depot. A similar distinction was recognised in Ben-Odeco Ltd. v. Powlson (Inspector of Taxes) [1978] 1 WLR 1093 where a capital allowance claim under the Finance Act 1971 for the construction of an oil rig was in issue. Although the loans taken out by the taxpayer were essential to finance the construction of the oil rig, and the interest charges were capitalised in the taxpayer's accounts, that was not enough: to succeed they had to show that the expenditure represented "capital expenditure on the provision of plant and machinery": the interest on the loans did not constitute such expenditure.

31. Mr Barlow for the Commissioner argues that section 17(1)(c) is, in effect, the "mirror image" of s16(1). Just as s16(1)(a) requires the court to look into the purpose of borrowing the money - it is only interest upon money "borrowed ... for the purpose of producing [chargeable] profits" which is deductible under s16(1) - so s17(1)(c) requires the court to look into the purpose of the loan. The words in section 17(1)(c) "capital nature" are wider than "capital": the nature of the expenditure by way of interest can only be determined by asking why the money was borrowed. Money as such is valueless. It is the use to which it can be put which gives it value. And once the court looks into the use of the loans in this case, the expenditure is plainly capital in nature. The money borrowed from the banks, on which the interest was paid, went to the acquisition of a capital asset which was then held by the appellant, with no prospect of chargeable income (except the licence fees for the use of the depot) until the redevelopment was completed many years later.

32. Obviously, the court would strive to construe s17(1)(c) in such a way as to ensure the effective ascertainment of chargeable profits. If the interest payments are capital in nature, by what device under the statutory scheme, Mr Gardiner asks, do they become revenue in nature and therefore deductible?

33. In Tai On Machinery Works Ltd. v. C.I.R. [1969] HKTC 411 the Commissioner's approach, accepted by McMullin J, was to treat the interest payments made during the construction period of an industrial building as capital in nature; when the building was completed and became immediately capable of producing revenue, the interest was treated as revenue in nature and hence deductible. The rationale, as stated by McMullin J at p429, was this:

"Up to the date at which the asset comes into existence as an earner of revenue every payment of interest which is made may fairly be regarded as an item paid once and for all towards the bringing of that asset into existence. Once it has achieved existence the asset is one which endures for the benefit of the business."

34. This method of treatment is, according to the Commissioner in his determination in this case, the "accepted practice in Hong Kong". And the appellant's own auditors seem to have accepted that, as a matter of proper accounting principles, the interest should, in the initial stages, be capitalised. In the notes to the accounts, under the heading "Significant Accounting Policies" they said:

"(ii) Properties held for development

Properties held for development are carried at cost including interest or valuation less such provisions considered necessary by the directors.

Interest payable on loans relating to properties held for development is capitalised up to the date of completion of development."

35. Mr Gardiner's arguments amount, in effect, to saying that the accounting profession in Hong Kong and the Inland Revenue Department itself have, for decades, misconstrued the effect of the statutory provisions for deducting interest. And it follows from his argument that Tai On Machinery Works was wrongly decided. He invites us to over-rule that decision.

36. He says, quite rightly, that professional practice, however entrenched, cannot change the law. The flaw in the Commissioner's method of treatment, Mr Gardiner argues, is that it robs the words "for any period" in s16(1) of all meaning. It suggests that, to claim a deduction under s16(1), there must be some matching receipt within the same period as that in which the expense was incurred. This is plainly not the wording of the section; and in C.I.R. v. Swire Pacific Ltd. [1979] HKTC 1145 the court so held. At p1160 Yang J said:

"... under s16(1) of the Ordinance expenditure in the course of business which is unremunerative is none-the-less a proper deduction if made with a view to producing profit. It does not require the presence of a receipt on the credit side to justify the deduction of an expense...".

37. These are strong arguments. Are they correct, in the context of the statutory scheme as a whole?

"For any period"

38. The Commissioner accepts that upon completion of the redevelopment of the depot the appellant would be entitled to deduct interest payments on its loans. Mr Barlow finds juridical support for this by, in effect, limiting the scope of the words "for any period" in s16(1): If an expenditure (interest) is not referable to the production of chargeable profits in a future period it is not deductible under s16(1); but it becomes deductible when it is so referable.

39. Using the definition of interest in Bennett v. Ogston (supra) as "payment by time for the use of money" Mr Barlow gives this example:

"A mortgage loan is borrowed by a purchaser of a (bare land) development site for a 10-year term and in years 1 and 2 the owner constructs a building thereon which he intended in years 3-10 be let out for rent. In fact, he receives a good offer in year 5 and he sells the property and repays the loan. The interest he pays in year 1 is paid for the use of the borrowed money for that year only. It is not referable to anything that happens in year 4 and year 10. Thus, the interest in year 1 is the 'hire' of the borrowed money for a period of construction (only) and because it is not 'hired' in the production of chargeable profits, it is not deductible. The 'hire' of the money in year 4 is different. During that year the money is 'hired' to enable the business (of renting out the building) to continue to have the use of the capital asset (the building) which produces the chargeable profits."

40. This example, says counsel, can be easily applied to Times Square. Physical possession of the depot site was not given to the appellant until March 1989 (approximately 20 months after the first payment of interest) and the actual construction of Times Square took some years. It follows, Mr Barlow submits, that the judge was wrong when he found that all the interest expenses were incurred "in the production of its assessable profits after the completion of the redevelopment": the expression "in any period" in s16(1) cannot be stretched so far.

41. Take this very case. The judge found that the interest payments by the appellant in 1987/88 were incurred in the production of its chargeable profits in the future. But, in fact, the appellant sold the whole development to another subsidiary in the Wharf group in 1990/91 so, as far as the appellant is concerned, it never earned chargeable profits from Times Square; there never were chargeable profits to which the interest payments could relate.

42. I find considerable force in Mr Barlow's submissions. The concept of allowing expenses necessary to earn the receipts of a trade or business is familiar to many common law jurisdictions. As stated in Halsbury's (4 Ed.) vol. 23 para 254:

"... this proposition must be applied in a reasonable way, and must not be construed so as to preclude the deduction of those expenses as a result of which receipts or profits may accrue in the future."

43. Under the Hong Kong statutory code, this is achieved by the use of the words "in any period". But those words are not free-standing: they relate to the words "outgoings and expenses ... incurred ... in the production of profits in respect of which he is chargeable to tax ..." and, to an extent, are governed by those words. The interest expenses claimed as deductions in this case were incurred in the years ending 31 March 1988 and 31 March 1989. They were incurred on account of the loans borrowed from the banks for the purpose of acquiring and retaining the depot. The loans were short term loans, never for longer than periods of one month. When they matured, they were rolled over and more interest expenses were incurred. It seems to me that the appellants cannot have the benefit of the argument both ways: They emphasise the short-term nature of the loans on which the interest expenses were incurred, and yet they say in the same breath that those interest payments were referable to chargeable profits many years into the future. As a matter of construction of s16(1) this cannot be right. In my judgment in the ascertainment of chargeable profits for those years there was no warrant for looking beyond those years to see what the appellant might have done with the depot: it was, as we know, transferred to another company in the group some years later, and the appellant in fact derived no chargeable income from the property.

44. Mr Gardiner has put his submissions most persuasively and, for a time in the course of argument, I was much attracted by them. In the end I have reached the conclusion that Mr Barlow's submissions on the statutory scheme are correct. The judge may well have erred in concluding on the evidence that the purpose of borrowing the $3,039 million was to derive chargeable profits from "an income-generating asset". This seems somewhat remote and, as far as the appellant itself is concerned, this was never realized because the asset was, as I have said earlier, transferred before it became income-generating. But this is academic: If the judge was wrong in this regard, it simply means that he was doubly right in the result: the Commissioner would have succeeded on the s16(1) point as well.

45. I would upheld the judgment on the basis that, in relation to interest as an expenditure, it is not enough to simply look at the "nature" of the interest payments. To say that it secured the use of the bank's money is meaningless. As the judge said (at p43-G):

"One does not pay interest without a reason. It is paid in order to achieve a particular purpose."

46. It is, in my judgment, wholly artificial to enquire into the "nature" of an interest payment without looking into its purpose. To say: the purpose is to obtain (or retain) the loan: is not enough. This is to give s17(1)(c) too restrictive and artificial a meaning. It is necessary to go further and enquire into the purpose of the loan.

"Asset reshuffle"

47. Having regard to the conclusion reached above, it is not necessary to deal at length with Mr Barlow's alternative argument which seeks, in effect, to impeach the judge's finding of fact with regard to the appellant's intention in acquiring the depot from the wholly-owned subsidiaries. It is stated in the Respondent's Notice in these terms:

"2. The learned Judge should have concluded that the transfer of the Depot was not an arm's length transaction but merely an asset reshuffle within a group of companies; that there was no commercial necessity or purpose behind the transfer within the group; and that the purpose of reshuffling the asset and arranging loans in the way that was done was to enable the Wharf group to use the borrowed funds to make exempted interest income from the deposit off shore of group borrowings whilst simultaneously creating a claim for deduction from profits tax in Hong Kong."

48. Factually, this submission is incorrect. There was no evidence before the court that there were off-shore deposits.

49. The judge rejected this point, and found as a fact that the purpose of the loans was to acquire the depot for redevelopment. Nothing in the judge's findings are capable of sustaining Mr Barlow's argument that the sole purpose was to gain some tax advantage. This point must fail.

Conclusion

50. The conclusions I have reached are these:

(i) The words "outgoings and expenses" in the context of s16(1) are wide enough to encompass expenditure of a capital nature.

(ii) Interest paid on money borrowed for the purpose of acquiring a redevelopment site (intended ultimately to generate rental income) is expenditure of a capital nature and therefore disallowed as a deduction under s17(1)(c).

(iii) When the redevelopment is complete and is ready to generate chargeable income, or is actually generating chargeable income, any interest paid to secure that asset is expenditure of a revenue nature and is deductible if the conditions in subsection (2) of s16 are satisfied.

51. Whilst I have reached these conclusions purely through the construction of the relevant provisions in Part IV, I am reinforced in my view by the expert evidence entertained in the court below. The Accounting Guidelines on Capitalization of Borrowing Costs, issued by the Hong Kong Society of Accountants, contain the following:

"(a) Borrowing costs incurred as a consequence of a decision to acquire an asset are not intrinsically different from other costs which are commonly capitalised. If an asset requires a substantial period of time to bring it into the condition and location necessary for its intended use, the borrowing costs incurred during that period as a result of expenditure on the asset are a part of the cost of acquiring the asset.

(b) Failure to capitalise the borrowing costs associated with the acquisition of assets reduces earnings merely as a consequence of the acquisition of assets.

(c) Capitalisation results in a greater degree of comparability between the costs of those assets constructed or produced within the enterprise and purchased assets (the price of which takes borrowing costs into account).(Article 3 of Statement 2.205 and Article 6 of IAS)"

52. Accounting guidelines cannot alter the law. Nevertheless, a construction of the statutory provisions which in effect accords with accepted international standards of accountancy for the treatment of interest charges is, at least, some indication of the right approach.

53. I would dismiss this appeal.

Godfrey, J.A. :

54. The central issue for our decision is whether interest paid on moneys borrowed can ever be expenditure of a capital nature. At the conclusion of the argument it seemed to me that it could not, any more than interest received on moneys lent could ever be a receipt of a capital nature. But I have since had the advantage of reading in draft the judgments of Litton, V.P. and Ching, J.A. In effect they conclude, as I understand it, that in the context on which they appear here the words "expenditure of a capital nature" are apt to cover payments of interest on moneys borrowed for a capital purpose. Certainly, as Ching, J.A. points out, it would be illogical to treat interest on moneys borrowed, and expended, for a capital purpose as a deductible expense for profits tax purposes, when such moneys themselves cannot be so treated.

55. Without any great confidence, I conclude that to construe the words "expenditure of a capital nature" so narrowly as virtually to equate them with "capital expenditure" simpliciter would be wrong. The legislature must, I think, have intended the words to have a wider penumbra than this and although I remain of the view that, on a narrow or strict construction of the words, it would be correct to say that interest paid on moneys borrowed can never be expenditure of a capital nature, the context in which they appear here does require that they should be given a more generous construction. I have no doubt that it would be sensible to treat interest on moneys borrowed for a capital purpose as if the interest itself were capital expenditure : indeed, for accounting purposes, it is the proper way in which to treat it, as Litton, V.P. has demonstrated. My only doubt has been as to whether the words "expenditure of a capital nature" could properly be construed so as to produce this sensible result.

56. As I have said, I am persuaded (just) that in the context in which they appear they can and should be so construed, and so, I would dismiss this appeal.

Ching, J.A. :

57. The appellant is one of a group of companies. It carries on a large and successful business. It purchased, as a capital asset, land and buildings ("the property") which it intended to redevelop. The purchase was funded by means of short term loans upon which interest was paid. Some years later, before the redevelopment was completed, it sold the property to another company in the group. During the two years of assessment in question the appellant's business produced enormous profits but the revenue from the property fell far short of the amount of the interest payments. The question before us is whether or not those interest payments are deductible from the appellant's chargeable profits.

58. The ascertainment of chargeable profits is provided for by section 16 of the Inland Revenue Ordinance, Cap.112. Subsection (1) begins with the words,

"In ascertaining the profits in respect of which a person is chargeable to tax under this Part for any year of assessment there shall be deducted all outgoings and expenses to the extent to which they are incurred during the basic period for that year of assessment by such person in the production of profits in respect of which he is chargeable to tax under this Part for any period ....."

The subsection does not permit the deduction of all outgoings and expenses. It permits the deduction of outgoings and expenses in the production of chargeable profits. Clearly, regard must be had to the purpose of the expenditure.

59. The deductions are to be allowed against the chargeable profits "for any period". If there are no such profits then as a practical result no deductions can be made. In my view, however, the nature of expenditure is fixed at the time that it occurs and cannot depend upon whether a profit or loss is made in the same year. If there is a loss, which would include the amount of expenditure qualifying for deduction, it can be carried over to the next year. There must be many instances of expenditure which produces no profit in the same year and I am unable to see why that expenditure should not be deductible when a chargeable profit is achieved. The subsection refers to expenditure within the year but provides for deduction from profits "in respect of which he is chargeable to tax ... for any period".

60. I am therefore in agreement with Mr. Gardiner, who appeared for the appellant, that expenditure which qualifies for deduction remains deductible even if no chargeable profit has been made in the same year. The point has no practical application in the present case since the appellant's chargeable profits in the relevant period were many times the magnitude of the expenditure. The fact that the nature of the expenditure is fixed at the time it occurs is, however, relevant.

61. Subparagraph (a) of section 16(1) gives as one of the heads of deductible expenses,

"..... sums payable ..... by way of interest upon any money borrowed ..... for the purpose of producing such profits ....."

This does not in terms differentiate between interest upon loans borrowed for capital purposes and those borrowed for revenue purposes. Once more, however, it is clearly necessary to ascertain the purpose of the loan in that the interest payable is deductible only if the loan is taken for the purposes of producing chargeable profits.

62. I agree with Mr. Barlow, who appeared for the Commissioner, that section 16(1)(a) must be read with section 17(1)(c). The latter provides that for the purposes of ascertaining profits chargeable to tax no deduction is to be allowed in respect of

"any expenditure of a capital nature ....."

These words are apt to cut down the wide ambit of section 16(1)(a). Capital expenditure cannot be deducted but section 17(1)(c) goes further than that. By the words "capital nature" the prohibition is not restricted to direct capital expenditure. They are probably incapable of exact definition but in my view they cover the payment of interest on loans borrowed for a capital purpose. I am fortified in that conclusion for the reasons that follow.

63. First, I gratefully adopt the reasoning of the Judge below that money per se is of no value. Its value lies in its use. It would therefore be artificial to consider the nature of interest paid without considering the use to which the borrowed money is to be put. In addition, it has been seen that both the opening words of section 16(1) and the words in section 16(1)(a) require the expenditure and the interest to be paid or payable for the purposes of producing chargeable profits. That is to say, one looks to the purpose for which the loan is obtained and expended.

64. Secondly if, as we know, capital expenditure is not deductible it is illogical that interest on money borrowed for the purposes of capital expenditure should be deductible. I accept that a capital asset may generate chargeable profits but in my view it is wrong to say that interest paid on moneys borrowed for the purchase of a capital asset becomes a revenue expense simply because the capital asset may or will generate chargeable profits. The payment of that interest is no more a revenue expense than the payment of the purchase price itself.

65. Thirdly, money is fungible. When it is borrowed the money becomes the money of the borrower with a concomitant obligation to repay an equivalent amount. But the money borrowed for a capital purpose becomes a capital sum and the interest paid as a price for delayed repayment must therefore be expenditure of a capital nature. The analogy drawn between the payment of rent and the payment of interest is misleading.

66. Mr. Gardiner submitted to us that the decision in Tai On Machinery Works, Ltd. v. C.I.R. (1969) HKTC 411 was wrong. It is necessary to identify exactly what was decided in that case. McMullin, J., held that interest payments made in the course of the construction of a capital asset, a building, were payments of a capital nature. In view of what I have already said I am of the opinion that he was right. There was another point. The Commissioner conceded that interest payments made after the building had been constructed and became capable of earning revenue would be revenue expenditure and would therefore be deductible. McMullin, J., proceeded on that basis. In my view the concession was arguably wrong. The interest payments began as expenditure of a capital nature and it is difficult to see how it could become revenue expenditure simply because the building became capable of earning revenue.

67. Mr. Barlow raised an argument that in any event what the appellant had done amounted to a mere shuffling of assets. It is not necessary for that to be decided although if I had thought it necessary I would have been unwilling to find that that was what had occurred on the facts.

68. For the reasons I have tried to give I would dismiss this appeal.

Litton, V-P:

69. The result is that the appeal is dismissed.

70. We make an order nisi that the appellant pays the costs of the appeal.

Representation:

Mr John Gardiner, QC and Mr Stewart KM Wong (M/S Baker & McKenzie) for Appellant

Mr Barrie Barlow (AG's Chambers) for Respondent