Commissioner of Inland Revenue v. Li & Fung Ltd

HCIA000003/1979

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Coram: Garcia, J. in Court

Date of Judgment: 10 September 1980

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JUDGMENT

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1. This is an appeal by the Commissioner of Inland Revenue against the decision of the Board of Review allowing the appeal of the respondent company whereby it was held that losses arising out of the conversion of the latter's trading receipts from United States dollars into Hong Kong currency were deductible for the purposes of profits tax assessed under the Inland Revenue Ordinance, Cap. 112. In the case stated by the Board of Review for the purpose of this appeal the facts agreed by the parties and those found by the Board of Review are that the respondent company was incorporated in Hong Kong on the 28th day of December 1937 and carries on business as exporters and general merchants. Amongst its trading activities was the export of goods such as textiles, toys, plastics and rattan ware manufactured in Hong Kong, and to a lesser extent, fire-crackers manufactured in Macau. The respondent company paid the suppliers of these goods in Hong Kong dollars. The respondent company has customers for such goods in the United States of America and when shipments were made to them in that country payment for such shipments was made by means of bills expressed in United States currency drawn in the company's favour. Prior to 12th February 1973 the proceeds of such bills on maturity were accumulated in banks in the United States on 7-day deposit on call and these accumulated funds were eventually remitted back with the interest thereon to Hong Kong, at what the company calls "an opportune time", that is, when better rates of exchange between the U.S. dollar and the Hong Kong dollar could be obtained, particularly where large amounts of United States currency were involved. A subsidiary reason but a minor one advanced by the company for accumulating funds in the United States was that it required a small amount of United States currency to discharge its liabilities in that country. At the relevant date the balances of the company's bank accounts in the United States consisted of proceeds from the sales of its goods to customers in that country together with the bank interest earned thereon. The company's accounts are made up to the end of December in each year. Some time in December 1972 when it was finalising its accounts, the company became aware of the impending devaluation of the United States dollar, as a result of which its cash and bank balances, trade debits and credits expressed in United States dollars were revalued in its accounts for the year ended 31st December 1972. The revaluation of those assets and liabilities was carried out at an exchange rate of US$1 = HK$5.10 from US$1 = HK$5.68. This exercise resulted in a net loss of HK$333,296,76 in the company's Hong Kong dollar assets, made up as follows:-

2. A provision for loss arising on devaluation of the U.S. dollar in the sum of HK$333,296.76 was therefore created by debiting this amount to the company's Profit and Loss Account for the year ended 31st December 1972 and the amount of the provision was deducted from the various asset accounts in the Balance Sheet as at that date. There was therefore a prospective net loss in the company's assets of HK$333,296.76.

3. On the 12th February 1973, the U.S. dollar was devalued by 10% in terms of gold, and following such devaluation, the central rate of the H.K. dollar and the U.S. dollar was adjusted to HK$5.085 to US$1, from an exchange rate of HK$5.65 to US$1. The company made up its profits tax return for the year of assessment 1974/75, and this return showed an assessable profit of HK$4,199,281, after making a number of adjustments to the net profit for the year ended 31st December 1973 as shown in its accounts. Among the adjustments which are relevant to this appeal are the following two items:-

4. On the 19th June 1975 the assessor raised on the respondent company a profits tax assessment for the year of assessment 1974/75 an amount of $6,493,497 computed as follows:-

The assessor took the view that such part of the loss as related to cash and bank balances arising from the devaluation was not allowable, and therefore disallowed the amount of $327,750 in assessing the company's profits. The company objected to the assessment and the issue before the Board was whether the claimed loss is a capital loss which is not deductible, or a trading loss which is deductible for profits tax purposes. The majority of the Board held that the U.S. dollar balances being proceeds from the sale of goods and therefore income from trading did not lose their identity as trading income by being retained in the United States of America. The Board further held that the objective of the company was to remit the U.S. dollar funds back to Hong Kong at an opportune time so that in placing the funds on 7-day deposit on call to earn interest pending remittance back to Hong Kong did not turn the trading income into capital investment. The minority view held by one member of the Board was that the retention of the proceeds of sale in U.S. dollar and the placing of them on deposit altered the nature of the funds from trading income to an investment so that the loss claimed is a capital loss. The appeal was therefore allowed and the assessment reduced by the deduction of the losses which arose on the conversion of the U.S. dollar, in the amounts of HK$327,750 and HK$41,584.

5. The questions now posed in this appeal are:-

Before the Board, the respondent relied on the case of Imperial Tobacco Co. (of Great Britain and Ireland) Ltd v. Kelly, and Imperial Tobacco Co. (of Great Britain and Northern Ireland), Ltd v. Commissioner of Inland Revenue 25 Tax Case 292, and in particular to the judgment of MacNaghten, J. at page 297:-

"The price paid for dollars bought for no other purpose than to pay for tobacco leaf to be used in manufacture by the company is obviously a trade expense which should be included as a debit in the computation of the annual profits of the trade and it would seem to follow that, if in any year the company bought more dollars than were actually required and had to sell the surplus, the price received by the company in any such sale should be credited in the accounts of the trade, with the result that if the surplus dollars were sold at a loss the assessable profits of the trade would, to the extent of that loss, be diminished, and if they were sold at a profit the assessable profits would likewise be increased."

6. In that case the company had to sell to the British Government U.S. dollars purchased by it in 1939, the Treasury requiring it to sell it all surplus dollars on September 30, 1939. This the company did at a profit of $646,000. The company contended that this sum was not a trading profit but merely an appreciation of a temporary investment in foreign currency. The Crown argued that this purchase by the company was not an investment of idle capital, but part of the company's trade of tobacco manufacturers. It was held by MacNaghten, J. that the profit made by the appellant on the compulsory sale of its surplus dollars must be included in the computation of the profits of its trade under the Income Tax Act 1918, Schedule D, Case I.

7. On appeal the decision of MacNaghten, J. was affirmed, the Court holding that the sale of the company's dollars to the Treasury was a revenue profit and must be included in their profits for the purpose of assessment to income tax.

8. In his judgment, Lord Greene, M.R. said:-

9. The company bought a total of US$45,000,000 between January and August 1939 and by September 9, 1939 when the Treasury required it to sell the dollars so acquired $25,755,000 was surplus to its requirements, that is, the balance had been used for the purchase of tobacco leaf and even with such accumulation of dollars over that period of time, the dollars were held not to have been impressed with the character of a capital asset but from what has been said by Lord Greene M.R., in his judgment cited above those dollars remained on revenue account and therefore the profit on the sale thereof was liable to tax.

10. In the present case, the Crown concedes that exchange losses are allowable as deductions for the purpose of tax computation but contends that this principle is applicable subject to certain conditions. An example of such a condition would be where a taxpayer sells goods overseas and receives foreign currency in payment but before full payment is made the currency is devalued, the losses so incurred by the taxpayer would be a deductible allowance for tax purposes. The other example is where proceeds of sale are received in the country where the goods are sold and before such proceeds are remitted to Hong Kong, a devaluation of that currency occurs, the losses resulting from such devaluation would qualify as a deductible allowance if such proceeds are remitted back to Hong Kong within a day or two of their receipt. There is no authority for the latter proposition and I would think that there is no place for the element of time in the transformation of the nature of funds from revenue to capital. How long, for instance, should that time be - in modern commercial practice, remittances could be made and received the same day - should therefore the fastest means be used for the transmission of such proceeds before there is no transformation? In my opinion, time is not of the essence but what is important is the origin of those proceeds and the use to which it is intended that these proceeds be put by the taxpayer once they are received.

11. However, another argument which flows from the submission made by the Crown that there was an element of speculation in the depositing of the U.S. dollar proceeds in U.S. banks, is that in order for such losses to qualify as a deductible allowance under the Ordinance, there should not be any intermediate dealing with them between the time of receipt in the United States and the time of their remittance back to Hong Kong. It has been submitted that this was the case here because the proceeds had been deposited on 7-day call in U.S. banks in order to attract more favourable rates of exchange. The authority cited for this proposition is the case of Commissioner of Inland Revenue v. Brown Bros Ltd 20 S.A.T.C. 55.

12. In that case, the respondent company carried on business in South Africa as shippers and brokers and in 1946 established a subsidiary corporation in New York, carrying on a similar class of business. The whole of the capital for this corporation was provided by the company. The company acted as the agent in South Africa for the corporation obtaining from merchants in the Union orders for goods and sending such orders to the corporation, who paid the company commissions which were credited to its account with the New York corporation from 1946 to 1949. By this means financial resources exceeding £50,000 were made available to the corporation and which was used as part of the corporation's capital. In 1949, the South African Treasury put pressure on the company to repatriate the commissions due to it but due to the fact that sterling was devalued at the time the remittance was made, the company gained £16,084.

13. The Commissioner included this latter amount in the company's taxation income and on appeal it was held that by allowing its commission to remain in the hands of the New York corporation the company had in effect made a loan of those amounts to the corporation and the transmission of the amounts to South Africa constituted a repayment of those loans, which was a transaction on capital account. Consequently the fortuitous increment in the amount repaid, due to the change in exchange rates, was a receipt of a capital nature and not liable to taxation.

14. In the course of his judgment, Blackwell, J. said:-

15. Further on, the Learned Judge says:-

"Let us suppose that in this case there were regular quarterly or yearly remittances of profits earned to the company and that, exchange control permitting, these remittances were as regularly sent back to the Corporation to help swell their working capital. Who could doubt that in such circumstances the money was a loan? The case does not seem to be altered because there was not this process of double remittance and the money was, by mutual arrangement, retained in the coffers of the Corporation."

Whilst it would appear that this case was decided on its own facts, nevertheless, a general principle emerges that where there has been an intermediate dealing with revenue funds in the manner set out in the facts of the above case, the nature of those funds is altered to that of a capital investment.

16. The exactly similar position does not obtain in the present case, but on the general principles of the above cited case which is of persuasive authority only, the placement of money on deposit at call, in the manner that has been done by the respondent company, would, in my view, alter the nature of those funds from revenue to capital. Deposits at call, and such deposits in the present case, although put on 7-day call, refers to balances of sales proceeds accumulated over a period of time (of more than 7 days duration before remittance to Hong Kong), are loans to the bank in which such accounts are opened. In Hart v. Sangster (1957) 2 All E.R. 208, Lord Goddard, C.J. in his judgment states:-

"There is no difference between a deposit account and a current account so far as the relationship of banker and customer is concerned. The relationship is perfectly clear. The leading case is Foley v. Hill (1848) 2 H.L. Cases 28 mentioned in the judgment of Atkin, L.J. in Joachimson v. Swiss Bank Corpn (1921) 3 K.B. 110 at page 130. It is that of debtor and creditor: the bank borrows money from the customer under terms to repay it."

17. Regarding such deposits the Board of Review say:-

"5. The Board found that prior to 12th February 1973 the Company took a calculated risk on exchange in respect of the U.S. dollar balances kept in the U.S.A. The balances were placed on short term deposits to earn interest during the pendency of the risk."

18. There was therefore in my opinion an intermediate dealing with the proceeds of sale by the respondent company before they were remitted back to Hong Kong, and in the event, the taxpayer's expressed intention that such proceeds continue on revenue account is not evinced by the action they took regarding those funds, as found by the Board. In Income Tax Case No. 808,20 S.A.T.C. 343, where the case of Commissioner of Inland Revenue v. Brown Brothers Ltd was referred to, the appellant was a manufacturer's agent engaged in obtaining orders in South Africa for goods manufactured in the United States of America. Some time in October 1943 the appellant cabled his principals in the United States asking them to send him the commission to which he was entitled and they replied that when he undertook the agency it was agreed that he would only be paid from time to time as funds were available and they had not been able to pay him previously. As a result the amounts of commission which had been credited to the appellant were not remitted to him until the following year when South African currency was devalued against the United States dollar. The resultant profit in South African currency was held to be a revenue and not a capital accrual, and was therefore taxable. In the course of his judgment the Learned President of the Court said:-

"In the present case the appellant had rendered services for which he was entitled to be paid. He was credited in dollars with what he had earned. In his accounts at the end of the financial year in the ordinary course of accountancy he would be credited with this claim at its value in South African currency."

In the present case, the sales proceeds were received by the respondent company in the form of bills which were discounted and the money then deposited in United States banks. The company were no longer creditors of their various buyers but in fact became creditors of the banks in which such moneys were deposited.

19. The Learned President went on to say:-

"Until the debt was paid it represented a claim for services rendered - as such it was impressed with an income or revenue character. It was and remained a revenue claim and would keep this character until it was altered by some transaction of which it formed the subject. For instance if, before its value had altered, it had been invested as a loan to the debtors (as in the case of Commissioner for Inland Revenue v. Brown Brothers Limited) its character would have been altered and it would have ceased to be income and would have become capital. Any alteration in its value would then have been a capital accretion or a capital loss as the case might be ...... It seems to me that if a revenue debt expressed in a foreign currency book of a foreign debtor increases in value, and is paid at such increased rate, the enhancement is revenue. The creditor actually recovers a larger sum in revenue the whole receipt is still revenue."

20. So also would the converse be true where there are losses in exchange due to devaluation, but the principle here seems to be that if the proceeds in foreign currency are received by the taxpayer in the country of origin and they are on revenue account, then any loss or gain in exchange would still be on revenue account unless after receipt the proceeds are altered "by a transaction of which it formed the object". There was no reason in my opinion why the proceeds from the bills should not have been remitted to Hong Kong as they were received, in order to retain their revenue character, if the respondent company's intention had been such. The amount of U.S. dollars accumulated, i.e. US$565,087.49 on deposit in U.S. banks or about 3/4 of the company's profit in the year of assessment 1974/75, would indicate that they did not require those funds on revenue account for the purpose of its business for a long period of time.

21. Another case which involves the application of the abovementioned principle is Income Tax Case No. 114, 4 S.A.T.C. 64. The appellant opened a bank account in Germany converting sterling into marks for depositing into that account. Certain purchases were made in Germany and paid out of this account. The appellant also sold certain goods to Germany and the marks so received were deposited in the same bank and allowed to remain there. As a result of the rapid devaluation in the value of the German mark, the deposits became valueless in terms of sterling. The appellant claimed that such loss had been incurred in the production of his income and therefore deductible as an allowance in the determination of his taxable income.

22. It was held that the loss of the sums deposited constituted a loss of a capital nature and was therefore not deductible. In his judgment the Learned President G.J. Maritz said:-

"...... the Court had no hesitation in saying that had the loss been the result of a fluctuation in the rate of exchange, such fluctuation would have to be taken into consideration in determining the taxable income of the appellant. The rate of exchange would have to be taken into consideration when the price received for the merchandise represented by marks had to be determined in sterling. Now, had that been done at the time there might have been a slight loss, but a loss of so negligible a character that the appellant had decided that he would not further pursue the matter."

23. It is apparent from what has been said in the latter part of the judgment that upon receipt of the proceeds, they should be converted at the time of receipt and as applied to the present case, the respondent company would not have sustained any loss as a result of the devaluation of the U.S. dollar.

24. It has been said in Commonwealth Taxation Board of Review, Number Two 16 C.T.B.R.(N.S.) Case 31, that "the state of a taxpayer's bank account is essentially a matter of capital, an item for the balance sheet. The effect of the devaluation was, therefore, to reduce a liability of a capital nature rather than produce a profit of a revenue character". I think it has been sufficiently pointed out that the intermediate dealing with the proceeds of sale in U.S. dollars had the effect of altering the nature of the proceeds from revenue to capital. That a fund may change its nature from revenue to that of capital depending on the circumstances is well settled - C.I.R. v. Jebsen & Co. H.K.T.C. 1, where Sir Leslie Gibson, C.J., said:-

"In view of the agreed statement as to the purpose for which the fund was created, it is clear that it was originally a capital investment and not a trading fund. Mr McNeill suggested that a fund which started as a capital investment must always remain so, i.e. that the original purpose for which a fund was created was decisive. He relied on Imperial Tobacco Co. v. Kelly (1943) 2 All E.R. 119. We do not agree that that case goes so far. It is true that in that case the fact the fund was created as a trading fund was taken to be the governing factor, but the fund was reconverted into sterling without being applied to any purpose, and there was no evidence that there has been any change in the purpose of the fund. It had simply become impossible, by reason of certain legislation, for the company to use the fund for its original trading purpose. We see no reason why the purpose of a fund, and therefore its nature, should be incapable of changing."

25. Another factor which in my view places that matter beyond doubt is that the Board of Review's finding in paragraph 5 which I have quoted earlier, that is, that the company "took a calculated risk on exchange in respect of the U.S. dollar balances kept in the U.S.A.". I think for "calculated risk" the word "Speculation" could be substituted and it is no part of the company's business operations, as distinct from investment operations, if any, to speculate with its proceeds received on revenue account, and that in so doing, the alteration of the nature of such proceeds from revenue to capital was complete.

26. On the other hand, it has been argued on behalf of the respondent that no questions of law have been raised on the appeal and since Section 69 of the Inland Revenue Ordinance, Cap. 112, states: "69(1) The decision of the Board shall be final: Provided that either the appellant or the Commissioner may make an application requiring the Board to state a case or a question of law for the opinion of the High Court"; this Court has no jurisdiction to deal with this appeal, and then even though there were grounds upon which such appeal is prosecuted nevertheless the answers which this Court could give would be similar to those given by the Board of Review.

27. Mr Litton gives as authority for this proposition: Jenkinson (H.M. Inspector of Taxes) v. Freedland 39 Tax Case 636, Currie v. Commissioners of Inland Revenue (1921) 2 K.B. 332 (cited also in the judgment of Harman, L.J. in Jenkinson v. Freedland).

28. In the former case, Harman L.J. states:

"In this case the General Commissioners decided that the isolated transaction in which the appellant had become engaged was not an adventure in the nature of trade within the meaning of Schedule D of the Income Tax Act, 1918. On the face of it, this is a conclusion of fact with which superior Courts have no jurisdiction to interfere. Nevertheless, the Learned Judge reversed the Commissioners' finding. He must have done so because he considered that this decision amounted to a question of law. Now that can only be so if the decision was so perverse that, if the Commissioners had been a Jury, they would have been told by a judge summing up the case that it was not open to them to come to any but one conclusion, namely that the transaction was an adventure in the nature of trade."

In Currie v. Commissioners of Inland Revenue (1921) 2 K.B. 332, Lord Sterndant, M.R. says:-

"The first question that has been debated before us is this: Is the question whether a man is carrying on a profession or not a matter of law or a matter of fact? I do not know that it is possible to give a positive answer to that question; it must depend upon the circumstances with which the Court is dealing. There may be circumstances in which nobody could arrive at any other conclusion than that what the man was doing was carrying on a profession; and therefore, looking at the matter from the point of view of a judge directing a jury, the judge would be bound to direct them that on the facts they could only find that he was carrying on a profession. That reduces it to a question of law. On the other hand, there may be facts on which the direction would have to be given the other way. But between those two extremes there is a very large tract of country in which the matter becomes a question of degree. And when that is the case the question is undoubtedly, in my opinion, one of fact; and if the Commissioners come to a conclusion of fact without having applied any wrong principle, then their decision is final upon the matter. In this case, Rowlatt J. took the view that the facts were so clear that the question was one of law. I cannot agree with that view."

29. Further on in Harman, L.J.'s judgment:-

"It seems to me that the Court ought to hesitate long before upsetting findings which are on the face of them pure conclusions of fact, because it will produce a state of uncertainty if, in every case, the facts have to be gone over again by a second or third tribunal to see whether they tend one way or the other."

30. This follows the case of Cooper v. Stubbs, 10 Tax Cases 29, where at page 46:-

"it is perfectly clear that the Commissioners are the masters of the facts. It is for them to find the facts. The Court - whether the Court of First Instance before which the case stated comes or the Court of Appeal - are bound by the facts which have been found by the Commissioners, and if they have rightly directed themselves at law their decision cannot be interfered with. Mr Justice Rowlatt came to the conclusion, as I understand his judgment, that the Commissioners had not rightly directed themselves in law, and he held that Mr Henry Stubbs was liable to be assessed in respect of these profits-gains ...... It has been forcibly and strenuously argued that the Commissioners, having come to the conclusion, came to that conclusion upon a question of fact, and that Mr Justice Rowlatt was not entitled to set aside their decision, and equally that this Court is disabled from so doing; but after very careful consideration I have come to the conclusion that the basis on which the Commissioners have placed their decision is not sound in law and therefore is capable of being reviewed and must be reviewed by the Court before which the Special Case comes."

31. I think the principle is well settled but in the present case, the questions which have been posed in the case stated are in my view, having regard to the cases cited earlier, questions of law and the decisions of the Board of Review are capable of being reviewed by the Court. However, reference has been made on this question to the case of Hallstroms Pty Ltd v. Federal Commissioners of Taxation (1946) 72 C.L.R. 634, where at page 645 Dixon J. stated:-

"In reference to a question whether a payment belonged to capital or revenue Lord Greene M.R. said in Inland Revenue Commissioners v. British Salmson Aero Engines Ltd that there had been many cases where the matter of capital or income had been debated. 'There have been' he said, 'many cases that fall on the border-line. Indeed, in many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons'. Other judges have been less explicit concerning the barrenness of the attempt to find reasons and instead have described the distinction as amounting to a question of fact. If this be right, there would seem to be no firm ground for interfering with the conclusion of the Board of Review, which decision cannot be appealed from unless it involves a question of law."

32. It appears from the decision of the majority of the Board of Review in the present case, which is recorded in paragraph 7 of the case stated, that the Board members who supported that decision drew the wrong conclusions from the facts which they had found, namely, that the trading income was not altered to capital investment by such income having been placed on deposit on 7-day call in the United States, having regard to their finding in paragraph 5 that the company took a calculated risk in so depositing the trading income, and that such trading income, from the further facts found by the Board in Paragraph 3(3) of the case stated that the company "accumulated such proceeds in U.S.A. banks and eventually remitted them back to Hong Kong at an opportune time. The purpose of such accumulation was that a better exchange rate was likely with a large sum". I think the conclusion one should draw from this finding, particularly since the word "accumulation" is used, is that the company (a) did not require the accumulation for the purpose of trading whilst the money was so deposited in U.S. banks because such money was used neither in purchasing goods either in the U.S.A. or Hong Kong and (b) found such sums surplus to their requirements for trading purposes.

33. Having regard to these findings, it is my opinion that although the sums in question originated as trading income, their nature was altered to that of capital investment in the circumstances under which they were placed on deposit in U.S. banks and the principles set out in C.I.R. v. Brown Bros Ltd's case apply to those deposits.

34. Another argument which has been submitted is that in ascertaining what is capital and what is revenue, the Court should have regard to ordinary commercial accounting principles, and that in respect of the present case, the respondent company, in computing their accounts for the year of assessment 1974/75, must bring the loss in exchange to the Profit and Loss Account, and not to treat the loss as a deduction from an asset item in the Balance Sheet because to do otherwise would be a deception upon the shareholders of the company.

35. But certainly with respect the computation of accounts, and as to how each item is presented in a company's accounts is subject to legal, as well as recognized accounting principles (e.g. Tenth Schedule to the Companies Ordinance, Cap. 32). Again, with respect, the translation of a loss from an asset item in the Balance Sheet to the Profit and Loss Account does not necessarily indicate that such a loss is on revenue account, although the converse, that is, a loss on revenue account is normally shown in either the Revenue Account or Profit and Loss Account. The finding of the Board of Review (paragraph 2(4) of the case stated) certainly indicates that the loss in exchange arises from "Cash and Bank Balances US$565,087.49" an item usually set out in the Balance Sheet as an asset, except in certain instances where the trade is in foreign currency, and not as an item in the Revenue Account. I think it is inherent in this finding of the Board that the distinction between proceeds from trading and the deposit of such proceeds in the U.S. banks had been highlighted by the accumulation of such proceeds. In my judgment, the case of Imperial Tobacco Co. (of Great Britain and Ireland) Ltd v. Kelly, has no application to the present case and I would therefore answer the question in (a) affirmatively, and "no" to the question in (b), posed in this appeal.

Representation:

T. Tristram, Crown Counsel, for appellant

Henry Litton, Q.C., and Daniel Fung (Stevenson, Low & Co.) for respondent