Lo and Lo v. Commissioner of Inland Revenue

HCIA000002/1981

Section 16(1) of the Inland Revenue Ordinance (Cap. 112) - profits tax assessment - Does Part IV of the Inland Revenue Ordinance allow a taxpayer in a profits tax computation to make a deduction against a future contingent liability to its staff - Is the value of a maturing liability deductible if in a business sense it affects the relevant rear profits, as in the United Kingdom: or are presently existing liabilities only deductible as in Australia - United Kingdom practice and reasoning applied to the construction of the Hong Kong Ordinance.

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Coram: Hon. MR. Justice hunter in Court

Date: 18 March 1982

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JUDGMENT

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1. This is an appeal by case stated, under section 69 of the Inland Revenue Ordinance (Cap. 112) from a decision of the Board of Review dated 23rd. November 1981, upholding the respondent commissioner's disallowance, in a profits tax assessment, of an item entitled "Provision for staff retirement benefit $770,000" in the appellant solicitors' accounts.

2. In the case stated the Board has set out the facts it finds and the contentions advanced before it with commendable clarity. It is therefore sufficient for me to summarise. The relevant assessment was based upon the appellant's accounts for the year ended 31st December 1977.  On 3rd January 1977 the appellants, to meet competition, introduced a new standard term into the conditions of employment of all its staff. This term was: -

"5. Any member of the staff who leaves the firm's employment after not less than 1.0 years' service will be entitled to a lump sum payment calculated by multiplying the number of years (complete) employed by the firm by half of his average monthly salary for the last twelve months of his employment. Naturally this will not apply where a number of the staff is dismissed for dishonesty, serious misconduct or gross inefficiency."

I do not share the Board's doubts about consideration in relation to this improvement. Any member of staff who continued to work on the basis (inter alias of this new condition would give ample consideration to enable him to sue upon this promise on his retirement. Indeed the Commissioner did not argue to the contrary before me. I therefore think that the partners in the firm were right thereafter to regard the firm as contractually bound by this promise.

3. Some staff members retired between January and December 1977, and by reason of this provision they received in all the total sum of $93,102. This sum was included in the accounts as a deduction and was allowed by the Commissioner. At the time of the preparation of the accounts the firm also made a calculation as to the total sum that they were now '' on risk" to pay to other members of their staff by reason of this new provision. Save that the calculation related only to 23 employees, the case does not seem to me precisely to record how it was done.  I have however been told in argument that the 23 employees were those who had already completed 10 years service and had therefore, as it were, crossed the first hurdle raised by clause 5 of the letter. Those members who had served less than 10 years were ignored. The item "Provision for staff retirement benefit $770,000" was based upon this calculation.

4. The issue dividing the parties can thus simply be stated. Does Part IV of the Inland Revenue Ordinance allow a taxpayer in a profits tax computation to make a deduction against a future contingent liability to its staff of the type created by clause 5 as the appellants contend or as the commissioner contends, can a taxpayer deduct against receipts only sums actually paid under such a scheme in the year in which such payments are actually made?

5. It is at the outset convenient to consider the effect of clause 5 and why the firm wished to make this provision at all. To my mind the effect of this clause can be summarised as follows: -

I have deliberately used the phrase "every member" in sub-paragraph (i) above because I can see no difference in principle between the position of the members of staff who have served less than 10 years and those who have served more than 10 years. Each group is potentially "earning" his retirement benefit. A risk of future payment arises in respect of both groups. The risk is more remote in respect of the former group, but this seems to me to be a matter to be taken into consideration only in the calculation of the provision. It follows in my view that if the appellants are entitled to make this provision at all, they have erred on the side of caution in excluding some unknown number of staff who have served less than 10 years.

6. In these circumstances the firm says that the true cost of a member of staff (at least those who have completed 10 years' service) is the total cost of both elements. If both do not appear in the accounts then such accounts do not give a true and fair view of that year's staff costs.  This retirement lump sum is the product of years of service and should be charged to profits over those years.  To charge it only in the final year when it is paid will distort the accounts for that year in any event, and possibly gravely distort them if a number of long-serving employees should happen to retire together. The commercial correctness of this contention is not in issue. It is not disputed that if the appellants' accounts are prepared upon the basis that provision should be made which is in fact necessary, judged by ordinary accountancy and commercial standards, then the appellants' provision should appear and the profit would be reduced accordingly. 1 shall call this "the true profit". But what is contended is that on the true, construction of the Hong Kong. Ordinance the taxpayer is taxed, not on the true profit in the above sense. but upon a different statutory computation of profit which excludes this provision, and which I shall call "statutory profit''.  In an assessment of statutory profit what is permissible by way of deduction is not governed by accountancy or commercial standards but by what the law permits, and the law permits only such sums to be deducted as are paid or payable in the year of assessment.

7. Before me Counsel on both sides agreed that

"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".

"There shall be deducted all outgoings and expenses wholly and exclusively incurred".

8. In the absence of direct Hong Kong authority, both parties resorted to other jurisdictions. The appellants relied upon the United Kingdom practice, and particularly upon the decision of the House of Lords in Owen v. Southern Railway of Peru ⁽²⁾ and Inland Revenue Commissioner v. Titaghur Jute factory Co. Ltd. ⁽³⁾ as showing that theirs was a permissible provision in the United Kingdom. The Commissioner, on the other hand, relied upon the Australian practice and upon the construction put upon the word "incurred" in the Australian Court and particularly upon three decisions of the High Court of Australia, namely New Zealand Flax Investments v. Federal Commissioner of Taxation⁽⁴⁾;Federal-Commissioner of Taxation v. James Flood Pty. Ltd. ⁽⁵⁾; and Nilsen Development Laboratories v. Federal Commissioner of Taxation⁽⁶⁾. In short the contest virtually became United Kingdom v. Australia.

9. In these unusual circumstances which understandably embarrassed the Board, (case paragraph 12) I think it essential to keep clearly in mind the purposes and limitations of such an investigation. The position seems to me to be that:-

With these reservations Fund almost E & O E, I shall now attempt go set out and explain the differences between the two systems which seem go me go be relevant in the present Hong Kong context and the apparent reasons for them.

United Kingdom Practice

10. The principal relevant statute is the Income and Corporation Taxes Act 1970, and the nearest parallel is the taxing of "annual profits" under Schedule D.s. 108 e.g. under cases 1 & 2 s.109. Much of this Act is a modern re-enactment of provisions which go back to the 19th century. The legislative pattern is similar to that of the Hong Kong Ordinance, whose draftsman almost certainly had the UK precedent before him. The prohibitions equivalent to section 17 are go be found in section 130(b) - (o). The permissible deductions approximately equivalent go section 16(a) - (h) are go be found in various sections including sections 131 - 135. The opening words of section 130 and subsection (a) which operates both positively and negatively, bridge the gap and provide what I have called above the "general rule" in the following germs:-

"Subject to the provisions of the Tax Acts in computing the amount of the profits or gains go be charged under case 1 or case 2 of Schedule D, no sum shall be deducted in respect of:-

11. When these words are compared with the original ford of section 16 quoted above, it is apparent that the draftsman must have had before him the then United Kingdom equivalent of section 130, and that he chose to substitute the word "incurred" for the phrase "laid out or expended". I have to consider his legislative intent. Was he intending no change of meaning and simply using one more contemporary word instead of a phrase which had 19th century origins and perhaps connotations? Or was he intending a deliberate change of meaning and in particular adopting the meaning which had already been ascribed to the word "incurred" by the High Court of Australia? It seems to me impossible to suggest an answer to this question by a consideration of this word alone. In its context in this Hong Kong Ordinance it seems to me capable of bearing either of the meanings advanced before me, and capable of having had either construction put upon it in the other two jurisdictions in their different contexts. I am comforted here to note that in the Court of Appeal in Owen Romer IJ records a submission for the Crown at p 630 in these words:

"Deductions which may be made from the gross profits for that year are those which can fairly be regarded as expenditure which has been incurred for the purpose of earning that year's profits".

It is obvious that Counsel for the Crown was not advancing any Australian argument, but that he was simply paraphrasing what he was contending was the effect of the UK statute. Before I can answer the question whether the Hong Kong legislator was likewise paraphrasing or intending a deliberate change of meaning I have to look beyond the single word to the broader context.

12. Owen⁽²⁾ is the leading case. It concerned a company trading in Peru. By Peruvian statute it was obliged to pay certain sums to its employees on their retirement, basically calculated by taking a proportion of their last year's salary and by multiplying the number of years of service, unless some particular disabling event had occurred e.g. the servant had been dismissed for misconduct. The company made provision in its accounts for this future liability, and the issue was whether such provision was deductible in an assessment of profits. The House of Lords held that in principle the deduction was permissible, but that the actual provision made was not sufficiently precisely calculated to be allowed.

13. Lord Radcliffe, with whom Earl Jowitt and Lord Tucker agreed, spoke for the majority. His reasoning can I think be summarised thus:-

14. Lord Macdermott expressed what I regard as the same conclusion in slightly different words as follows:

"As a general proposition it is, I think, right to say that in computing his taxable profits for a particular year, a trader who is under a definite obligation to pay his employees for their services in that year (my Lord's emphasis) an immediate payment and also a future payment in some subsequent year, may properly deduct not only the immediate payment but the present value of the future payment provided such present value can be satisfactorily determined or fairly estimated" pps 635, 636.

Although Lord MacDermott may appear to be taking a slightly more legalistic view than Lord Radcliffe, I very much doubt if this is correct and certainly can see no difference for present purposes. It is plain from the context that by "definite obligation" he meant not something that had accrued or become an forceable in the year in question, but an obligation which taking the workforce as a whole would come home in the future as "a matter of commercial certainty" p 637. In other words in Lord MacDermott's language clause 5 before me would constitute an obligation which the prudent trader could not ignore; and in Lord Radcliffe's words it was an obligation to which regard ought properly to be had in answer to his first question. Both their Lordships would I think have gratefully adopted, as 1 do, the Lord President's apposite phrase in Titaghur⁽³⁾" maturing obligation".

15. In Titaghur,⁽³⁾ the Court of Session in Scotland simply followed and applied Owne⁽²⁾ in a case where, with the substitution of statutory liability for contractual liability under clause 5, the facts are nearly indistinguishable from those before me. Indeed the only real argument in that case was whether the company was entitled to charge in the year in question a provision for its whole workforce which provision was as retrospective as the legislation which had provoked it. The Court's answer was "yes", because that was the year in which the obligation had first arisen. If therefore the UK practice is a relevant guide the reasoning in this decision is directly applicable.

Australian Practice

16. Here the relevant statute is the Income Tax Assessment Act 1936-1974. The only section of this Act which I have had put directly before me is section 51(1) upon which the Commissioner particularly relies. This section reads as follows:-

"All losses and. outgoings to the extent to which they are incurred in gaining or producing the assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital private or domestic nature, or are incurred in relation to the gaining or production of exempt income".

I have had to take the Australian legislative pattern and the relationship of this section to the rest of the Act from the authorities cited to me. The Commissioner's argument here Is that the word ''incurred" should be given the same meaning in Hong Kong as in Australia, and that I should adopt and apply the construction put upon this word by the High Court of Australia.

17. In argument the two cases which were dissected at length were Flood ⁽⁵⁾ and Nilsen⁽⁶⁾ particularly Nilsen. In both cases the Court relied upon some dicta from the judgment of air Owen Dixon, then Dixon J. in New Zealand Flax. ⁽⁴⁾ But having since read the whole of Sir Owen's judgment, I must take it as my starting point because it seems to me to give the clearest possible explanation of the Australian practice and of its limitations.

18. The taxpayers in that case, the New Zealand Flex Co., had sold bonds to members of the public and had thereby entered into contracts with such members, the central features of which were "the furnishing by the company of a piece of land for growing New Zealand flax and of a mill for the treatment of the flax, its cultivation cutting, treatment and sale by the company, and of the yearly distribution of net proceeds among the bond holders p 200. The assessments in question related to the first two years of the company's operation, during the first of which it had incurred no expenditure and during the second very modest expenditure only. In drawing up its accounts it had brought in on the receipts side all moneys both received and receivable under its bonds; and on the outgoings side it made substantial provision for the future performance of its obligations outlined above. The Commissioner loft p the credits standing and disallowed the whole provision for future outlay. At p 201 Sir Owen said:

"It is evident that upon the assumption that the bond moneys form part of the company's revenue full and complete provision must be made there out to enable the company to fulfil its obligations to provide the land, plaint it with flax, make a mill available and so on, before it is possible to make any fair and just computation of the net profit of the company for the year in which such bond moneys are receivable" (my emphasis).

He clearly would have given effect to this and applied the dictum of Lush J. which he quotes at p 206 to the effect that "expenses they will incur" ought to be set off against receipts," if the statute allowed it". But he was bound by earlier "interpretations" of the Australian statute that ''the assessment must begin by taking, under the name of assessable income, the full receipts on revenue account, and only such deductions must be made as the statute in terms allows" p.199. At p.206 he detected in the statute "instances of special businesses and transactions may be found when nothing but the net profit could be regarded as a revenue item" (again my emphasis): but he went on to point out that outside these areas the general principle of interpretation must apply and in that context the use of the word "incurred" was too narrow to bring in expenditure that was certain but future.  He concluded at p 207 as follows:

"But the reserves on account of the mill and for the purpose of cleaning, burning, draining, ploughing, cultivating, planting and for 'maintenance and general' cannot be brought within the authority of section 23(1)(a) (the predecessor of section 51(1)). The business propriety of making such an allowance may be made clear by stating the dilemma which affects the use of the funds represented by the suggested reserves. For either they should be expended in the work described by the headings mentioned, or else they should be repaid to the bond holders as damages or otherwise. Clearly the company should not retain the money or divide it between the Crown and their shareholders under the respective descriptions of income tax and dividends, whether dividends in a liquidation or in a going concern. But the Income Tax Assessment Act is not framed to give effect to such considerations".

19. When the most distinguished Australian judge within living memory feels impelled to describe the consequences of the taxing statute before him in words such as those last quoted, it seems tome that I should think very hard before acceding to the Commissioner's argument before me and concluding that the same legislative strait jacket exists also in Hong Kong. Further it seems to me plain that Sir Owen reached his decision with reluctance and under the compulsion of authority. Had his taxing Act permitted the drawing of a balance, the treatment of "net profit" as the "revenue item", and not required this two-stage approach of ascertaining first "full receipts" and then secondly and separately permissible deductions, I feel convinced that his conclusion would not have been the same.

20. In Flood,⁽⁵⁾ the High Court of Australia disallowed an attempt by a taxpayer to bring into account in year 1 that part of his employee's entitlement to holiday pay which in a commercial sense had "accrued" in that year, and held that nothing was deductible until the holiday was in fact taken in year 2. In so doing the Court applied dicta in New Zealand Flax⁽⁴⁾ and again drew attention to the two-stage requirement of the assessment under the Australian Act above described. Deductibility of expenses it said was "not a matter depending upon 'proper commercial and accountancy practice rather than jurisprudence'" p 506. It is noteworthy that three years later the practice disallowed in this decision was regarded by Lord hadcliffe in Owen⁽²⁾ as established practice in the United Kingdom, see p 641.

21. Finally in Nilsen⁽⁶⁾ the High Court followed and possibly narrowed Flood⁽⁵⁾. The burden of this decision is that no liability has been "incurred" within the Australian Act unless it has become due and payable in the year in question. This seems to me to be the effect of the judgment of Barwick CJ, ''a pecuniary obligation which has become due" p 509; of Gibbs J., "a presently existing liability" p 511, i.e. a "present liability to make a payment" p 512; and of Mason J., "the employer is bound to make the payment'' p 514. Before me the Commissioner specifically adopted the judgment of Gibbs J. as correct, and I was invited to apply to Hong Kong the test of "presently existing liability".

22. Two further points emerge from this decision:-

The Differences

23. This review of authority I think enables me to compare and contrast the two systems as follows: -

24. The reasons for these differences are I think equally apparent. In Australia the assessment process consists of two separate and distinct stages. It is therefore proper and permissible to treat each separately, and to apply different principles to each. In the United Kingdom the search is for the balance - the net profits. It seems to me to follow that "what is true of receipts is true of liabilities" per Lord Radcliffe p 642; that the same principles have necessarily to be applied to both sides of the account; and that if accounting principles are applied to revenue they must equally be applied to deduction. In the UK the process is not two-stage; rather it represents two sides of the same coin.

25. To which of these two systems is the Hong Kong Ordinance most analogous, not in form but in substance? The answer seems to me to be plain. It is the United kingdom system. It is quite clear from sections 14, 16 and 17 that what the Ordinance raises is a tax on profits and that the steps enumerated in section 16 are steps towards the ascertainment of profit. This is what the Privy Council emphasised in the Mutual Investment's ⁽¹⁾ case. This is precisely what Sir Owen Dixon said in New Zealand Flax⁽⁴⁾ that the Australian statute did not permit. If the Ordinance requires the striking of a balance because it is looking to net profit, then the reasoning in Owen⁽²⁾ precisely applies. The same principles must apply to the assessment on both sides of the   account. Further 1 think that this has already been held to be the case by the Privy Council in the Mutual Investment⁽¹⁾ decision for the, reasons above-suggested. Another way of testing the matter is to ask whether the three sentences above-quoted From the judgment of Gibbs J. in Nilsen⁽⁶⁾ apply equally to the Hong Kong Ordinance. In nay judgment the answer is "yes" to each sentence.

26. In the light of this survey I return to the construction of a Hong Kong Ordinance. I am unable to regard the word incurred" as having some fixed and settled meaning in all contexts, or to accept that in , section 16 it necessarily has the meaning ascribed to it by the High Court of Australia in section 51f1) of the Australian Act. In view of the judgment of Dixon J. in New Zealand Flax ⁽⁴⁾ it seems to me singularly unlikely that the legislator positively intended to adopt the Australian meaning, and much more probable that he was not intending to change the meaning of the UK precedent and was simply parapharasing. But these semantic considerations fall into insignificance in comparison with the fundamental differences between the two systems outlined above. These seemed to me to demonstrate that the Hong Kong Ordinance was United Kingdom in origin and concept, and that it properly falls to be construed in the light of United Kingdom principles.

27. There are, I think, two subsidiary considerations which point to the same conclusion. First in relation to the permitted deductions in section 16(a) the word used is "payable" not "paid". Does this word required that the item be payable in the material year as the Commissioner argues on the definition in Nilsen;⁽⁶⁾or in that year or the future as the appellants urge on the reasoning in Owen. ⁽²⁾ The matter was tested in argument against the exception "legal fees". Take this example. A trading taxpayer instructs a solicitor in relation to litigation directly relevant to his trading receipts. This litigation extends over three accounting periods. No bill is rendered and/or taxed until after the litigation is concluded. Until that event, says the Commissioner, all contingencies have not been removed and no quantified sum is clearly due and payable. This premise may well be correct. From this the Commissioner concludes that the whole sum is a permissible deduction only in the third year. T cannot agree that this distortion of the true position is made necessary by the word "payable" It seems to me simpler, more straightforward, and consistent with the use of this word, to say in year 1 that something must be payable to the solicitors and to deduct an estimated sum or provision in that year. The Owen⁽²⁾ reasoning is equally applicable and convincing.

28. Secondly it must, I think, be manifestly more convenient, more conducive to ''fairness and justice" and less productive of results like those in New Zealand Falx⁽⁴⁾ for a "true profit" calculation to govern not simply commercial results but taxation as well. I can see no merit in this distinction between true profit and statutory profit. I must emphasise here that I am speaking of proper provision against receipts and profits, not a provision or transfer to reserves generally which is quite a different matter. In these circumstances I think I can adopt and apply the principles of construction set out by Sir Garfield Barwick in Mutual Investment⁽¹⁾ at p 596B. In relation to this decision I should for completeness say that I cannot accept the Commissioner's argument as to the effect of the paragraph in that speech starting at p 598G. To my mind Sir Garfield was not there ruling out ordinary business considerations for a11 purposes; but simply excluding the taxpayer's computation there because of the inclusion amongst its receipts of dividends which were specifically excluded by statute from the category of receipts.

29. In my judgment therefore:-

30. Finally I was asked by the Commissioner to note and record his position on two further points. The first was that he still wished to challenge the Board's finding in paragraph 18 of the award. I do not see how this is open to him. Whether the firm's estimate was sufficiently precise within the principles of Owen⁽²⁾ was a question of fact for the Board. They considered it and answered it in the appellants' favour. If in so doing they left out of consideration the members of staff who had served less than 10 years, this operated against the firm not in its favour. It cannot be said, and indeed is not said, that there was no evidence before the Board upon which it could have reached this result. In these circumstances I do not myself see why this finding is not conclusive. Certainly I cannot possibly review or even criticise it on the material before me.

31. Secondly it was said that the matter had to go back to the Board if I find as I have, because the taxpayer could not deduct both the actual payments and the provision in this year. In the first year I fail to see why not. The actual deduction relates to the benefit payable in that year; the provision to benefit payable in the future. Different considerations will apply to future years when the firm l will be confined to an adjusted provision, see Lord Radcliffe in Owen ⁽²⁾ at p 641.

32. For these reasons I think that in very understandable circumstances the Board came to a wrong conclusion, and that this appeal must be allowed. For my part I would answer the Board's specific questions as follows;

(1)     (1967) A .C. 587

(2)     (1956) 36 TC 602 (Owen)

(3)     (1978) STC 166 (Titaghur)

(4)     (1938) 61 CLR 179 (New Zealand Flax)

(5)     (1953) 88 CLR 492 (Flood)

(6)     (1981) 11 ATR 505 (Nilsen)

Representation:

Robert Kotewall, instructed by Lo & Lo for appellant

Barrie Barlow, Crown Counsel for the respondent