Commissioner of Inland Revenue v. Montana Lands Ltd

HCIA000003/1967

IN THE SUPREME COURT OF HONG KONG

APPELLATE JURISDICTION

INLAND REVENUE APPEAL NO.3 OF 1967

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Coram: Mills-Owens, J.

Date of Judgment: 13 January 1968

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JUDGMENT

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1. This is an appeal from a decision of the Board of Review, brought by the Commissioner of Inland Revenue by way of case stated under s.69 of the Inland Revenue Ordinance (Cap.112). The taxpayer respondent is Montana Lands Ltd., i.e. a company incorporated in Hong Kong. The case concerns the profits of its trade or business, namely the construction of flats in multi-storied buildings and the disposal of those flats by way of sale. The whole question is whether, in the case of such of the flats as have been disposed of on deferred terms, instalments of purchase-price not yet accrued due are liable to be brought into account for taxation before their actual receipt.

2. The case stated contains (inter alia) a statement of the following agreed facts -

*see Note on Balance Sheet - Appendix 'B'."

3. According to the Balance Sheet (Appendix 'B'), the figure of $2,766,096 mentioned in para 2(p) and para 3 of the case stated represents the proportion of the cost of flats sold on an instalment basis which relates to instalments receivable after the 31st March, 1965.

4. The accountants' letter Appendix 'D' gives the following explanation -

"As requested we now explain fact 16(B) relating to the 'estimated gross profit on instalments due after the balancing date (31st March, 1965) but not brought into account'.

= 48.23% (representing the gross profit ratio of cost of sales)

5. The figure of $712,324, 'unearned interest', mentioned at the end of para.2 of the case stated, and deducted in para 3 thereof, is explained by the Board in its Decision (page 2) in the following manner -

"Normally, when flats are sold on instalment terms, the total purchase price eventually payable by the buyer would be more than what he would have to pay if the transaction is completed by a lump sum payment in full. The difference between the face value and the actual value appears to have been regarded by the Commissions as interest and he has in his determination allowed a deduction for this interest factor by using an interest rate of 1.2% per month which we really need not concern ourselves with as it has been indicated to us that it represents a notional figure agreed between the parties so that if the present Appeal should be dismissed, the matter would not have to be argued out at length again to the inconvenience of all concerned."

6. There is attached to the case stated a specimen of the Agreement signed by the purchaser on purchasing a flat on deferred terms. It is, in fact, a copy of the Agreement signed in a particular case, but it is agreed to be representative of the contracts usually made in such cases. In the particular case the purchase price was $50,560 and the contract was for the assignment of an undivided one-four hundred and thirty-fifth share of and in the building and site together with the right to exclusive occupation of the shop or flat No.11 on the 9th floor and together with certain easements. Payment was to be made as follows -

7. Completion was to take place when the occupation permit came to be issued by the appropriate authority, all instalments being duly paid. In default of payment of any instalment (time being of the essence) the deposit and all instalments already paid were to be absolutely forfeited, and the company might rescind and resell, and recover from the purchaser any deficiency in price and the expenses attending such re-sale. The company reserved a limited right to alter the building plans, and was to be entitled to make arrangements for the management of the building and its common services on behalf of the common owners, subject to contribution to the expenses thereof by the common owners, and subject to the right of the common owners to replace the company as 'manager' after a period.

8. Provision was made for mutual covenants to be entered into by the purchasers, designed to secure the amenities of the building. Under clause 19, the company reserved the right to adjust the share of the purchaser of and in the premises, provided that any such adjustment should not affect his right to exclusive occupation and enjoyment of the said flat or shop No.11 on the 9th floor. Presumably this was in case the company exercised its right to alter the building plans and consequent construction, possibly thereby increasing or decreasing the number of flats ultimately built. By clause 20, if the occupation permit should be issued before the final instalment fell due the purchaser might enter into occupation, provided all instalments accrued due had been paid, but only as a licensee under a licence subject to determination on default in payment of any future instalments, and subject to bearing the outgoings. Under clause 21, the company was to be entitled, notwithstanding anything thereinbefore contained, to mortgage the whole building and site; the mortgage to have priority to the Agreement, provided that the sale under the Agreement was to be free from incumbrances and completion was to take place accordingly. Presumably this was to be a means whereby the company might obtain finance during the course of building, but on terms that the mortgagee would concur in the assignment of any flat or shops sold and duly paid for. No doubt such concurrence would be on terms of payment to the mortgagee of the whole or part of the purchase-money. By clause 24 the company bound itself to procure a mortgage for the purchaser upon the issue of the occupation permit for the balance of the purchase-price, repayable on the same terms as agreed between the company and the purchaser. As the case is presented this clause is not material; in any event it must be dependent on completion, one would suppose.

9. It will be observed that the usual form of contractual arrangement for sale on deferred terms contemplates a period of some eight years during which the purchaser will be paying off the amount of the purchase-price by monthly instalments; that completion does not take place until payment of the final instalment; and that although once the occupation permit is issued the purchaser is entitled to enter into occupation, he does so as a licensee only whose licence is dependent upon payment of future instalments as they fall due.

10. It will also be observed that the Agreement is extremely strict in its terms regarding payment; as mentioned above, it is provided that time is to be of the essence of the contract in relation to the payment of the instalments, and that on default not only is the deposit to be forfeited but also all instalments already paid. It is not made clear whether, on a resale, the company must give credit for any amounts forfeited. It may well be the case that equitable relief would be available in respect of these provisions; I am not, however, asked to decide that. The point is made on behalf of the Commissioner that these provisions, in effect, afford security to the company for unpaid or future instalments; on behalf of the company it is pointed out that falls in market value might well at any moment dissipate such security. Obviously, it depends on the circumstances in each case.

11. In giving its decision the Board said :-

"It is common ground that prior to 1964 the appellant's mode of computation was a practice accepted by the Revenue. It appears to have been the usual method used by leading firms and chartered accountants in the colony when dealing with proceeds of flats sold on instalment terms. However, in September, 1964, the Commissioner of Inland Revenue issued a Department Practice Note dealing, inter alia, with this subject and the relevant parts are contained in Clauses 18 and 19 thereof which read as follows :-

Since the publication of that directive the Inland Revenue Department has declined to accept computations on the old basis and thereafter taxpayers have been assessed in the manner that follows the Commissioner's determination in this appeal."

12. The arguments before the Board were put by the Board, in giving its decision, as follows :-

13. The Board came to the conclusion that the method of computation employed by the company is in accordance with "established accountancy principles", that it presents a balanced view of the company's affairs, that it provides for necessary adjustments, and that it presents a true commercial picture, consonant with the object of a Profit and Loss Account. The Board continued:-

"No directions are given in the Ordinance as to how profits are to be ascertained and the authorities are sufficiently well established to show that they must be arrived at on ordinary commercial principles. There is no rule which allows the Revenue to dictate the system which is to be employed in computing profits. Being, therefore, of the opinion above expressed and there being evidence that the appellant's computation is in accordance with accountancy practice this appeal will be allowed."

This paragraph indicates the sense in which the Board referred to "established accountancy principles".

14. There is, so far as I am aware, no authority precisely in point on the main question which I have to decide. In England, the availability of building society or local authority loans would render unlikely sales of property on the terms in question here. Section 16(1)(d) of the Ordinance differs from section 137 of the Income Tax Act, 1952 (formerly Rule 3 of the rules applicable to Cases I and II of Schedule D), particularly in that it can only be by inference that debts other than bad or doubtful debts are not to be excluded in computing the profit to be taxed; this inference being supported by the proviso (i). It differs also in making express provision for the deduction of debts which turn out to be bad or doubtful in the basis period although due and payable in an earlier year. This could be said to have the significance in the present case of showing that section 16(1)(d) has no application to debts which have not yet accrued due. The section refers to debts proved or estimated "to have become" bad or doubtful, which is perhaps an expression more appropriate to debts accrued due. But on the whole I do not think that any assistance is to be gained from a consideration of these differences in language.

15. On the appeal, the case for the Commissioner was presented, as it was before the Board on the basis of analogy with the case of a trader selling goods on credit, who must bring such sales into account in the year in which the sales are affected, or the goods are delivered, notwithstanding that payment is ...(illegible) whether voluntarily or otherwise; allowance being made only in respect of such debts so arising as are proved to be bad or doubtful in the particular year (the 'basis period' as it is termed in s.16(i)(d) of the Inland Revenue Ordinance). The Commissioner relied on a series of well-known cases establishing or approving this principle. Their effect is usefully summarised in the speech of Viscount Simon in Gardner Mountain and D'Ambrumenil Ltd. v. C.I.R.⁽¹⁾ as follows:-

That case concerned the ascertainment, on the true construction of a written agreement, of the year in which certain commission was earned. Lord Porter at p.105 referred to a contention put forward by the taxpayer in the following terms:-

Lord Simonds, at pp.110-111 said:-

"          Your Lordships were, however, pressed with, first a decision of the Court of Session, Dailuaine-Talisker Distilleries, Ltd. v. Commissioners of Inland Revenue(6), and secondly, two decisions of this House, John Cronk & Sons, Ltd. v. Harrison(5), and Absalom v. Talbot(7). The Scottish case appears to me to have turned upon the construction of a contract of a very peculiar nature, and the decision may perhaps be justified by that fact. But I must, with deference to the learned Judges who took part in it, express a grave doubt as to its correctness. In the two cases before this House, to which I have referred, the question now under discussion was not raised. The issue in Harrison's case was not to what year profits, which had in fact been ascertained, should for Income Tax purposes be ascribed, i.e., when were they earned, when did they accrue or arise? On the contrary, the profits not having been ascertained, the issue was whether certain sums, which were admittedly subject to possible diminution, should be brought into charge at their face value, as the Crown contended, or, as the subject in the alternative successfully contended, should be brought into charge at their then present value. It was the latter view that prevailed in this House, though in consideration of the possibility that no valuation was possible, the rider was added to the effect that in that event only such sums should be treated as receipts of the periods in question as were actually received. I find nothing in this decision which in any way supports the plea of the Appellants in the present case. In Absalom's case(7) somewhat similar considerations arose, and again it appears to me that there is nothing in this decision which is in conflict with the authority of the Newcastle Brewery case(3) or assists the Appellants."

16. The foregoing extracts from the judgments in the Gardner Mountain case⁽¹⁾ appear to me to encompass the range of arguments addressed to me in the present case. In particular the Commissioner relies on Absalom v. Talbot⁽⁷⁾ where (to quote Luxmoore L.J. in the Court of Appeal at 26 T.C. p.181) the problem to be solved was "how ought the annual profits of a builder to be assessed for Income Tax where the method of trading consists in the purchase of land and its development as a building estate by the erection thereon of houses which are sold to purchasers of small means on the terms that a part only of the purchase price is paid on completion while practically the whole of the balance is payable by instalments spread over a number of years and secured either by promissory notes or second mortgages." It was held in the House of Lords (Lords Atkin, Thankerton and Russell of Killowen; the Lord Chancellor (Viscount Simon) and Lord Porter dissenting) that the sum receivable under the second mortgages and promissory notes should be taken into account at the time of the sale of the houses at their estimated value at that time, and not at their face value. In the Court of Appeal, Luxmcore L.J. (at 26 T.C. p. 183) said:-

Du Pareq, L.J. at p.185 said:-

"In my opinion the answer is that, since Rule 3 deals with the computation of profits and gains, the words 'any debts' must be taken to include all obligations which a trader would naturally describe as 'debts and as such would bring into the computation as assets. If this opinion is right, there can be no doubt that debts which, ex contractu, are payable in the future, fall within the description 'any debts'."

Scott L.J., in his dissenting judgment in the Court of Appeal, thought that debts (in Rule 3) ought to be construed as limited to debts which fall due for payment in the accounting period on which the assessment is based, thus excluding altogether debts not payable at all till after the end of that year and all future instalments falling due for payment thereafter.

17. In the House of Lords the majority judgment of Luxmoore and Du Parcq, L.JJ. was sustained; as I have said, by a majority. I have already referred to the comment made upon the Absalom case by Lord Simonds in the Gardner Mountain case, and I would respectfully agree that the main question in the Absalom case, at least by the time it came to be considered in the House of Lords, was whether the sums in question should be brought with account at their face value or at a valuation. In the Absalom case⁽⁷⁾ Viscount Simon thought the position to be indistinguishable in a business sense from what it would be if the purchaser in each case had paid the builder the amount secured by the mortgage and the builder had then lent the purchaser that amount on second mortgage; so analysed, he thought the transaction obviously to be one in which the amount secured by the second mortgage should be treated as coming into the profit side of the builder's accounts at the time of the sale of the house. Lord Atkin considered that there was a number of methods of calculating the profit in such cases and proceeded to discuss them he concluded that the valuation method afforded least scope for legal doubt.

18. At pages 191 - 2 he said:-

19. He continued:-

"          According to the Crown's contention, it makes no difference whether the price of goods is to be paid forthwith or at the end of 20 years, or by instalments over 20 years, and whether with interest or not, nor apparently is the possibility of the debtor being unable to continue the payments over the whole period a matter to be taken into account. To my mind to treat money to be paid 20 years hence as producing a profit this year equal to money in fact paid this year is to produce a completely unreal conception of yearly profit, and I venture to think quite foreign to any commercial ideas on the subject. It will be observed that the suggested rule does not even contemplate the allowance of discount. To style the obligation a trade debt, which it is, does not meet the difficulty. Nor, with great respect, is it conclusive to say that the creation of the debt is the consideration for the delivery of the goods. It is, but the question is still whether the consideration produces a profit in the year in which the purchase is made; and there are some conditions in which that proposition cannot be true, as, for instance, a promise in return for goods to render services over a period of years, or to give in exchange other commodities in a future year or years."

20. Lord Thankerton agreed with the views of Lord Atkin, in general terms.

Lord Porter, at pp.197-8 said:-

He thought that Cronk's case dealt with a different set of circumstances. He then referred (at page 199) to the case of John Emery & Sons v. Commissioners of Inland Revenue¹⁰ (also cited before me on the present appeal) in the following terms:-

"John Emery & Sons v. Commissioners of Inland Revenue, (1937) A.C. 91; 20 T.C. 213, on which the appellant also relied, did not bring in issue any question of the value of a debt. There was no personal obligation in that case only a ground annual, that is, a perpetual annuity of a fixed sum secured upon property. Such an annuity was not money but money's worth; it had an ascertainable value in cash, and was in your Lordships' view to be taken into account at that value."

21. I have referred to these authorities, I am afraid, at some length. As I see it, none of them bears directly upon the case before me, which is concerned with executory contracts, not completed transactions. The comparison made, on behalf of the Commissioner, with the case of a trader selling and delivering goods on credit is not, in my view, appropriate in the present case. In the case of a sale and delivery of goods on credit the purchaser has obtained what he contracted for; the trader has discharged his obligation; the debt has accrued due; the transaction has been concluded, except only for the postponement of actual payment. In the present case the payments have not yet accrued due and the transactions remain to be completed. The fact that a purchaser of a flat may be allowed into possession does not alter that position or make it approximate to that of a purchaser of goods to whom credit is given. The purchaser of a flat does not contract for mere possession or occupation. He contracts for a title, in the form of a registrable deed of assignment of the property agreed to be bought and sold. It is not a case of measuring or assessing profits already earned or arising, but one in which the profits are in course of realisation, over a period. The present case is to be distinguished from that of John Emery & Sons v. Commissioners of Inland Revenue⁽¹⁰⁾ where houses were sold in consideration partly of money payments and partly of ground annuals. The ground annuals were admitted to be capable of valuation or sale at any given time and thus represented money's worth immediately available in the hands of the taxpayer; it is also to be distinguished for the reason, the main reason as I hold, that there the transactions were completed. Lord Fleming (at pp.223-4 (20 T.C.)) said:-

"The appellants' counsel, in the course of his argument, said - and I assume he was right in saying - that if a house had not been sold the appellants would not have been obliged to enter its value in their accounts as an item received by them. But the point of the case, to my thinking, is just that the houses were sold and that the appellants parted completely with the right of ownership in them ....................................... Their right of ownership, in so far as it was not represented by the money price, was converted by this transaction into quite a different type of property, namely, a ground annual ............................................... It seems to me that in these circumstances it is impossible to say that the appellants' right of ownership in the houses and ground has not been 'realised or converted'."

In the House of Lords, Lord Thankerton said, at p.227:-

"The first important point to observe in this case, to my mind, is that the transactions in question were admittedly part of the ordinary trading of this particular firm; and secondly, as the learned Dean of Faculty admitted, that the transactions between the appellants as sellers of the houses and land, and the buyers of the houses and land, were completed transactions of sale."

Lord Maugham, at p.228, concurred expressly on the same basis.

22. The present case, as I see it, is analogous to the case of an entire contract, where, as Lord Porter said in the Gardner Mountain Case⁽¹⁾, the remuneration is not earned until the whole task is completed. Likewise here, where the profit on the transaction is merely in course of realisation until actual completion. The fact that the purchasers of flats may become entitled to possession before actual completion makes no difference in the legal position, in my view; it cannot be held to convert an anticipated or expected profit into an actual profit. I see no analogy with the case of the trader selling, and delivering goods on credit; on the contrary, here the trader is receiving payment by instalments in advance of actual 'delivery'.

23. My view of the case is, I think, also supported by the decision of the Court of Appeal in Hall & Co. Ltd. v. Commissioner of Inland Revenue⁽¹¹⁾ concerning which Rowlatt J. said (at page 772) in Holden's Case⁽²⁾:-

"But when one looks at what the Court of Appeal said in Hall's case, I think they wished to lay stress upon the fact that they were dealing with a case where the contracts had not been executed at all, because the goods had not been received from the sellers, nor, of course, had they been delivered to the buyers. That is what they were dealing with: the whole thing was in futuro. That is what the Master of the Rolls is referring to when he says that it would be wrong to carry into the accounts the figure in question; that is what Lord Justice Atkin is referring to when he mentions that the goods had not actually been delivered; and that is what Lord Justice Younger is referring to when he points out that the profits have not yet been realised - it is not that they have not been paid, but that they have not been realised - by the completion of the transaction, the execution of the contract."

24. It is difficult to be certain upon that legal basis trade debts are to be brought into account in the year in which they arise - whether it is by reason of the provisions of Rule 3 (now s.137 of the Income Tax Act, 1952) - our s.16(1)(d) - or by reason of commercial practice. Possibly, the better view is that the legislation recognises the commercial practice of bringing trade debts into account and is concerned to secure that allowance is to be made only for bad or doubtful debts. The judgments in the Absalom Case⁽⁷⁾ both in the Court of Appeal and the House of Lords support that view. As I have said, the provisions of s.16(1)(d) of the Ordinance are worded differently from the English provisions. The proviso (i) to paragraph (d) limits deductions in respect of bad or doubtful debts to "debts which were included as a trading receipt in ascertaining the profits ....... of the period within which they arose." This appears to me to mean that in Hong Kong trade debts are recognised as brought into account as a matter of commercial practice, rather than by reason of some express or implied requirement of the Ordinance. If this is correct, as I think it is, certain remarks made by Lord Atkin in the Absalom Case⁽⁷⁾ which I have already cited, become pertinent. I refer to the passage in which he said that when one leaves the realm of ordinary commercial credits and has to deal with credits extending over many years, the whole situation is changed. That appears to me to be the position here so that the Board of Review was justified in taking the view which it did, that on commercial principles future instalments were not to be brought into account in the year in question.

25. For the foregoing reasons I would answer the main question raised by the case stated, namely question (c) appearing in paragraph 6 thereof, in the negative. The other questions have not been fully argued but if my opinion is required thereon I would answer them as follows:-

26. Cost to respondent company.

13th January, 1968.

Representation:

Sheratte, Crown Counsel, for Appellant.

Litton instructed by Deacons appeared for Respondent.

(1) (1949) 29 T.C.69 at pp.93-4.

(2) 12 T.C. 768

(3) 12 T.C.927 at p.952

(4) 11 T.C. 597

(5) (1937) A.C.185 20 T.C.612

(6) (1930) S.C. 878; 15 T.C. 613

(7) (1944) A.C. 204; 26 T.C.166

(8) 15 T.C. at p.620

(9) Edward Collins & Sons, Ltd. v. Commissioners of Inland Revenue, 12 T.C. 773, at p.780.

(1) 29 T.C.69

(3) 12 T.C. 927

(5) 20 T.C. 612

(6) 15 T.C. 613 at 620

(7) 26 T.C. 166

(7) 26 T.C. 166 at p.189

(5) 20 T.C. 612.

(10) (1937) A.C. 91; 20 T.C. 213.

(10) (1937) A.C. 91; 20 T.C. 213.

(1) 29 T.C.69

(2) 12 T.C. 768

(11) 12 T.C. 382.

(7) 26 T.C. 166.

(7) 26 T. 166.