Commissioner of Inland Revenue v. Douglas Henry Howe

HCIA000001/1977

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Coram: Cons, J.

Date of Judgment: 28th July 1977

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JUDGMENT

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1. These proceedings are by way of a case stated under section 69 of the Inland Revenue Ordinance, Cap. 112, and any section that I refer to generally hereafter will be a section of that Ordinance.

2. The taxpayer is an author. He writes what appear to be English language textbooks suitable for pupils in Eastern and Far Eastern countries. Until 1965 his place of business was Malaya. From there he marketed his works exclusively through the Oxford University Press, which I shall call simply "OUP". Payment was made to him by way of royalty agreements. In 1965 he transferred to Hong Kong but continued to work through OUP as before.

3. For the first few years after the transfer the taxpayer had no assessable profits arising in or derived from this Colony. He did not therefore become liable to the profits tax imposed by section 14. Later naturally his financial position vis-a-vis this Colony changed and he became subject to profits tax for the years 1969/70 and 1970/71. Tax for those years was assessed on the basis of royalties received from OUP less expenses.

4. In May of 1970 the OUP offered to the taxpayer the post of E.L.T. Advisor to their East Asian Branch. E.L.T. probably stands for English Language Training or something similar. The appointment was to be for three years in the first instance subject to six months' notice on either side. The duties of the post were, amongst other things, to advise the branch generally on E.L.T. publishing and to write E.L.T. books and courses according to a priority list to be mutually agreed upon between OUP and the taxpayer. No payment for the writing of those books or courses was to be made specifically under the contract. These would be the subject of individual royalty agreements as usual. For the post itself there was to be an annual retainer expressed in Pounds Sterling. The taxpayer accepted that offer and took up the post as from the 1st August 1970. He still holds it.

5. In the following financial year, that is, on the 27th July 1971 the taxpayer incorporated a private company in Panama under the name of the Guided English Corporation, which I shall call simply GEC. At the same time he entered into a contract of employment with GEC. One of the terms was that the taxpayer should "devote his activity in writing books to earning royalties for GEC". In return he received a salary of $12,000 per annum. His royalties at that time were not far short of $160,000 per annum.

6. In or just before October of the same year the taxpayer made another agreement with GEC. This one was to assign to GEC the benefit of all the royalties to which he was currently entitled on the 27th July, that is the date on which he entered the company's employment. The deed itself was executed very much later but that is not material. In the deed the consideration for the assignment was expressed to be $1. The value placed upon it for stamp duty purposes was $1,210,000.

7. Since he made these two agreements the taxpayer has not engaged in any literary work on his own account. All his writing has been for GEC. It has been marketed through OUP as it was before, but all royalty agreements have been in the name of GEC. Now by virtue of section 18 profits are assessed for the purpose of profits tax on a "preceding year" basis. So for the financial year 1971/72 - the year with which I am now concerned - the taxpayer was assessed upon the royalties he had received during the year ending 31st March 1971, less allowable expenses. He objected, as he was entitled to, under section 64. The Commissioner considered the objection but upheld the assessment. The taxpayer then appealed to the Board of Review. This comes under section 66. Their decision was substantially in his favour but he remains dissatisfied on two questions. Both parties therefore bring the matter before this court.

8. The first question that has to be decided arises from section 61. That provides:

"Where an assessor is of opinion that any transaction which reduces or would reduce the amount of tax payable by any person is artificial or fictitious or that any disposition is not in fact given effect to, he may disregard any such transaction or disposition and the person concerned shall be assessable accordingly."

9. The Commissioner applied the section to both the taxpayer's contract of employment with GEC and to the assignment of his royalties. The Board reversed that decision. Counsel for the Commissioner asks me to say that the Board is wrong. For reasons that will become apparent later he does not argue that the transactions are fictitious. He says only that they are artificial.

10. I was referred to two authorities of this Colony. In the first Kum Hing Land Investment Co. Ltd. v. Commissioner of Inland Revenue⁽¹⁾ the taxpayer was a limited company with interests in land. Its Managing Director happened also to be the senior partner of a private firm which carried on a trading business, particularly with customers in Japan. The limited company sought for tax purposes to deduct from its profits a large sum of money which it had paid to the private company as "introduction commission" on the letting of one of its premises. That "introduction" was no more than this. The limited company was looking for tenants for a particular building. The private firm suggested that they might be found in Japan. The limited company sent one of its own men to Japan and he did there find a tenant. Scholes, J. had no difficulty in finding the payment of commission both artificial and fictitious. At that time no distinction had been drawn between the two. He said at p.321 that it seemed to him quite ridiculous to suggest seriously that one business company would genuinely pay another business company $300,000 for just suggesting that it should look for business in another country.

11. The second authority, although it was earlier in point of time, is Rico Internationale Ltd. v. Commissioner of Inland Revenue⁽²⁾. The factual situation is very similar to the Kum Hing Case. The taxpayer was a limited company in Hong Kong. Its sales agent was an American company in New York. There was direct association between the boards of the two companies. Each had only two directors, and one was common to both companies. The Hong Kong company paid to the American company what was a very high rate of sales commission in comparison with that which it had paid to other agents, that is 14.1 per cent as against 2 per cent or ½ per cent. This caused what would otherwise have been a profitable year of business for the Hong Kong company to become a loss. The case was decided before the Full Court with reference to section 16 as a question relating to outgoings and expenses wholly or exclusively incurred in the production of profits. But I was asked to look at what was said in passing by Blair-Kerr, J. at pp.533-4:

"I agree with the learned judge in the court below that the appellants made a profit. I am in no doubt that their ultimate object was to transfer every cent of that profit to Rico Internationale Corp. I agree that it would have been open to the Assessor, and the Commissioner, in all the circumstances, to have formed the opinion that the transaction was artificial within the meaning of section 61 and to have disregarded it entirely. The Assessor, and the Commissioner, would have been entitled to look at the transaction as a whole and to have taken into consideration the appellants' ulterior object as well as considering, on the evidence which the appellants chose to produce, whether any portion of the expenditure was in fact deductible under section 16. I do not agree that, for the purpose of section 61, the Assessor must have formed the opinion that a transaction is wholly artificial, in the sense that this epithet applies to every item of the expenditure, before he is entitled to disregard it. The Assessor is entitled to look at the whole transaction in the light of all the surrounding circumstances."

12. I take it that the "appellants' ulterior object" was to avoid the payment of Hong Kong profits tax. However with every respect to that very learned judge I think it unlikely he would have made that particular comment if he could at that time have been aware of an opinion of their Lordships of the Privy Council which was given only a few months ago. This was in the case of Seramco Ltd. Superannuation Fund Trustees v. Income Tax Commissioner⁽³⁾. The appeal was from Jamaica where section 10(1) of the appropriate law is in terms almost identical to section 61. The taxpayer was again a limited company. Substantially all of its shares were held by members of a particular family. They had entered into a dividend stripping arrangement with the trustees of a superannuation fund, which as such was exempted from Jamaican income tax. The facts of the case are too dissimilar from the present for the decision as a whole to be of much assistance. However two quotations are useful on matters of principle. At p.297 their Lordships had this to say:

"The shares agreement .... falls within the subsection if, but only if, the transaction for which it purports to provide was artificial or fictitious. The fact that the share agreement provides for dividend stripping is not of itself sufficient to bring it within the subsection, which was first enacted in 1939 before this method of tax avoidance had achieved its subsequent notoriety. It is only when the method used for dividend stripping involves a transaction which can properly be described as 'artificial' or 'fictitious' that it comes within the ambit of section 10(1). Whether it can properly be so described depends upon the terms of the particular transaction that is impugned and the circumstances in which it was made and carried out."

Pausing there, it was suggested before me that the well-known dictum of Tomlin, L.J., that "Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be.": The Commissioners of Inland Revenue v. The Duke of Westminster⁽⁴⁾, no longer has application to the highly sophisticated world of accounts and tax legislation in which we now live. With every respect I feel that the paragraph I have just quoted confirms that the principle is as valid today as it was forty years ago.

13. Their Lordships then continued in order to distinguish between the terms "artificial" and "fictitious":

"'Artificial' is an adjective which is in general use in the English language. It is not a term of legal art; it is capable of bearing a variety of meanings according to the context in which it is used. In common with all three members of the Court of Appeal their Lordships reject the trustees' first contention that its use by the draftsman of the subsection is pleonastic, that is, a mere synonym for 'fictitious.' A fictitious transaction is one which those who are ostensibly the parties to it never intended should be carried out. 'Artificial' as descriptive of a transaction is, in their Lordships' view a word of wider import. Where in a provision of a statute an ordinary English word is used, it is neither necessary nor wise for a court of construction to attempt to lay down in substitution for it, some paraphrase which would be of general application to all cases arising under the provision to be construed. Judicial exegesis should be confined to what is necessary for the decision of the particular case. Their Lordships will accordingly limit themselves to an examination of the shares agreement and the circumstances in which it was made and carried out, in order to see whether that particular transaction is properly described as 'artificial' within the ordinary meaning of that word."

14. It is these comments that have caused counsel for the Commissioner to limit his contentions to artificiality. What then are the arrangements and the circumstances in which they were made and carried out that I must examine in order to see whether or not they are artificial? Simply they are these. By two separate agreements the taxpayer effectively transferred all his existing and future earnings as an author to a limited company. The consideration in each case was valuable in the technical sense but by no stretch of the imagination otherwise. If that were all, the agreements would have been, as counsel for the Commissioner suggests, in the words of their Lordships (p.294) quite "unrealistic from a business point of view". But there is one other circumstance to consider. The limited company which is the beneficiary of the taxpayer's apparent generosity is controlled by the taxpayer himself. That was a fact found by the Board of Review and I assume it to mean that the taxpayer holds all or substantially all of the shares therein. In this situation it does not necessarily all of the shares therein. In this situation it does not necessarily follow that the transactions are commercially unrealistic. The overall position remains the same. What the taxpayer loses on the roundabouts he makes up on the swings. Looked at purely from the aspect of gross income the transactions seem unnecessary and unproductive. But the taxpayer may well have other matters in mind. I find nothing on the face of things that makes the agreements artificial in the way that their Lordships approached the Seramco situation. To my mind they are artificial only in the sense e.g. that a limited company is artificial. It is not the product of nature, it is the outcome of man's inventive mind. I am satisfied that the Board of Review came to a correct conclusion on this question.

15. There is one other circumstance which I have not taken into consideration, that is that the limited company was incorporated in Panama. It was a factor not referred to in argument by either side and to me seems immaterial to the question that I have had to decide.

16. The second question arises from the determination by the Board that "We were not satisfied that there had been a cessation of the Taxpayer's business of authorship on his own account." That was in reference to the 27th July 1971, the date on which the taxpayer became employed by GEC.

17. The reasons given by the Board for their decision were:

18. Nothing can be substantially raised against factor (a). Counsel for the taxpayer suggested that section 51(6) is the kind of provision which, like subsection (7), is in practice more honoured in the breach than in the observance. However, the Board would be entitled to take into consideration that at the time the taxpayer was being advised by accountants of the highest reputation who would not be expected to overlook such a requirement.

19. Factor (b) is, with every respect to the Board, I think based on a misunderstanding of the present position. They say "it appears incontrovertible that the Taxpayer is receiving a salary for doing for OUP precisely the same sort of work as what he was doing before he entered into the contract of employment with GEC". To my mind that is not a correct analysis of the situation. As was noted earlier, the nature of the taxpayer's duties as E.L.T. Advisor was twofold. He had to advise OUP and travel on their behalf. He had also to write the particular books and courses that were mutually agreed. The writing aspect was not covered by the salary, or retainer, that was paid. The books and courses were paid for by individual royalty agreements. At first these were made out by OUP in the taxpayer's name. Since GEC was formed they have been made out in the name of GEC. Furthermore OUP had been aware of the taxpayer's intentions from the start. The Hong Kong Manager of OUP and the General Manager of their East Asian Branch had discussed with him beforehand "the possibility of ceasing business in his own right and forming a corporation". The same two gentlemen had become with him the first directors of his company. The only conclusion to be drawn from these facts is that by mutual understanding and agreement between the three entities, i.e. the taxpayer, OUP and GEC, the writing duties of the E.L.T. Advisor were transferred from the taxpayer to GEC. It is therefore not correct to say that the taxpayer is "doing for OUP precisely the same sort of work as what he was doing before he entered into the contract of employment with GEC". He may, as far as writing is concerned, be doing the same sort of work. But he is not doing it for OUP. He is doing it for GEC.

20. I should interpose here to say that it was argued for the taxpayer that OUP did not in any event have an enforceable claim that he should write books for them, because the contract "expected" him to write rather than "required" him. I find no merit in this argument. The same courteous wording is adopted throughout the whole contract. Its meaning is perfectly clear.

21. Then factor (c) is, again with respect to the Board, I think founded upon a misconstruction of the taxpayer's contract with GEC. The way I read that agreement it clearly precludes the taxpayer from authorship on his own account. Paragraph 3(b) says that he shall "devote his activity in writing books to earn royalties for the company under this contract". That leaves no room for doubt. He may devote his other activities, for example advising OUP, to his own benefit. His writing activity is for GEC. No point was taken that the use of the sole word "books" left the taxpayer free to produce anything not amounting to "a book" in his own right.

22. I appreciate that it is not my function to substitute my opinion for that of the Board. My duty is "to examine those facts (found by the Board) with a decent respect for the tribunal appealed from and if (I) think that the only reasonable conclusion on the facts found is inconsistent with the determination come to, to say so without more ado": Edwards (Inspector of Taxes) v. Bairstow⁽⁵⁾. I have examined the facts as they are set out, if I may say so, with great clarity in the case stated by the Board. Yet with respect to the Board the only reasonable conclusion that I can draw from them is that the taxpayer ceased to be an author on his own account as from the 27th July 1971. If the absence of notification under section 51(6) had stood alone it would have been sufficient to base an inference that the taxpayer still continued on his own thereafter. However that inference is not strong enough to stand in the face of what did actually happen.

23. Two further questions remain. They are no longer in point because of the conclusions I have just expressed. But in courtesy to the arguments put before me I should say something.

24. For the first it is necessary to return to section 61. This commences with the words "Where an assessor is of opinion that any transaction" etc. In the present instance no assessor has at any time been of that opinion. It was first formed by an Assistant Commissioner acting for the Commissioner under section 3(3) in considering the taxpayer's original objection. It was later endorsed by the Commissioner himself. Has there then been a valid application of section 61? Section 3(4) provides that: "All powers conferred upon an assessor by this Ordinance may be exercised by an assistant commissioner". It is argued that an "opinion" is not a "power". Strictly speaking that may be so. But it is equally possible to regard the formation of the opinion as an integral part of the power to disregard. However there is a less technical way to approach the question. It was first adopted some time ago by Mills-Owens, J. in Mok Tsze-fung v. The Commissioner of Inland Revenue⁽⁶⁾. At the foot of p.274 he said:

"His (i.e. Commissioner's) duty is to review and revise the assessment and this, in my view, requires him to perform an original and administrative, not an appellate and judicial, function of considering what the proper assessment should be. He acts de novo, putting himself in the place of the assessor, and forms, as it were, a second opinion in substitution for the opinion of the assessor. He determines what should be the proper assessment afresh rather than acts as a judge weighing the merits of competing cases presented to him and making a determination within the limits or confines of the contest."

At that date the Ordinance provided for an "appeal" to the Commissioner in the first instance rather than an "objection". And the Commissioner's duties on the appeal were to "review and revise the assessment" rather than to "confirm, reduce, increase or annul" it. The present wording was introduced in 1965, possibly as the result of that decision. However, the "Objects and Reasons" annexed to the appropriate bill indicate that the Legislature intended no change in the nature of the Commissioner's functions. And I agree respectfully with the opinion of Blair-Kerr, J. that it has not effected any: The Commissioner of Inland Revenue v. The Hong Kong Bottlers Ltd.⁽⁷⁾. When taken as a whole the effect of section 64(2) is to require the Commissioner to reconsider the assessment and if necessary to reassess it from the very beginning.

25. The final question may be put in the general form "Is an author writing on his own account in Hong Kong chargeable to profits tax on the full face value of his royalties received here or only upon 10 per cent thereof?" This question involves sections 15(1) (b), 21A and 18(1):

"15. (1) For the purposes of this Ordinance, the sums described in the following paragraphs shall be deemed to be receipts arising in or derived from the Colony from a trade, profession or business carried on in the Colony -

26. At the time it was put to me I thought I understood the argument made in favour of the 10 per cent rule. I must confess to some doubts in retrospect. However I think it is framed upon these lines: In the case of an author writing on his own account there are two possible methods of assessment for profits tax, that is either under sections 15(1) (b) and 21A, or under section 18(1); these methods are mutually exclusive by reason of the fact that section 18(1) applies to the "full amount" of profits while the others relate only to 10 per cent; that, as a general principle of taxation, where there are two provisions in legislation covering the same transaction the particular provision will exclude the general; therefore the 10 per cent provision prevails.

27. This argument may have validity as a general proposition in the circumstances to which it properly relates. But I am not satisfied that these include royalties paid directly to an author. These are not truly "sums received by a person for the use or right to use within the Colony a copyright". Royalty agreements are in substance sales of the copyright itself. The purchaser has of course the right to make use of that copyright within the Colony if he wishes. Indeed the amount of the purchase price will probably be directly related to his use. But in order to bring the transaction within this subsection the words "use or right to use" would have to be equated with "sale". I do not as presently advised think that that is the intention of the subsection.

28. For these reasons my answers to the questions specifically asked are as follows:-

Representation:

H. Somerville, Crown Counsel, for the appellant.

G. Horton (Johnson, Stokes and Master) for the respondent.

(1) Hong Kong Tax Cases 301

(2) [1965] H.K.L.R. 493

(3) [1977] A.C. 287

(4) [1936] A.C. 1 at p.19

(5) [1956] A.C. 14 at 39

(6) [1962] H.K.L.R. 258

(7) [1970] H.K.L.R. 581 at 591