Wharf Properties Ltd v. Commissioner of Inland Revenue
Read the full judgment text of HCIA 2/1993 on BabelCite. This HCIA judgment.
1. This is an appeal by the appellant against the determination of the Commissioner of Inland Revenue.
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Inland Revenue Appeal No.2 of 1993
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Appeal from Determination of Commission of Inland Revenue direct to the High Court under s.65 of Inland Revenue Ordinance, Cap 112 without hearing by Board of Review Property Company purchased property from associated company within the Group for redevelopment and long term investment – entire purchase price borrowed from banks and financial institutions on short term loans – vacant possession not available until 20 months later – large amount of interest paid on those loans – only small rental income received during this period – policy stated in accounts on capitalisation of interests on loans – expenses on preliminary work on project capitalised in the accounts but interests paid on loans expended as an item of expenditure in the profit/loss accounts instead of capitalisation – Company claimed deduction of interest paid as an expense under s.16(1)(a) and s.17(1)(c) of Ordinance – Commissioner disallowed this Interpretation and application of s.16(1)(a) – whether loan and interest for the production of chargeable profit Interpretation and application of s.17(1)(c) – whether interests were expenditure of capital nature – tests to be applied and factors for consideration – whether U.K. or Australian or Commonwealth authorities preferred – C.I.R. v Tai On Machinery Works Ltd (1969) HKTC 411 followed – Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes (1985) 85 A.T.C. 4432 not followed Interest in question within s.16(1)(a) being incurred for the production of chargeable profit – but excluded by s.17(1)(c) being expenditure of capital nature Appeal dismissed IN THE SUPREME COURT OF HONG KONG (Appellate Jurisdiction) Inland Revenue Appeal No.2 of 1993 -------------- BETWEEN
------------- Coram : Hon Patrick Chan J. in Court Dates of hearing : 9th – 13th, 16th, 23rd – 26th May, 1994 Date of delivery of judgment : 30th September 1994 ---------------------- J U D G M E N T ---------------------- 1. This is an appeal by the appellant against the determination of the Commissioner of Inland Revenue. 2. The appellant was assessed to Profits Tax as follows:
3. On 14th April 1993, the appellant lodged an appeal against this determination. With the consent of the Commissioner, the appeal was transferred to the High Court under s.67 of the Inland Revenue Ordinance Cap. 112 without a hearing before the Board of Review. Before me, the parties submitted a Statement of Agreed Facts and called a number of witnesses pursuant to s.67(5) of the Ordinance. The Agreed Facts 4. The Statement of Agreed Facts went to some 10 pages with altogether 30 appendices. I shall try to summarise the salient agreed facts as follows. (1) events relating to the acquisition of the Depot 5. The appellant was incorporated in 1974 as Harbour City Limited. From the time it commenced business, it had been a wholly owned subsidiary of Wharf (Holdings) Limited. Since 1982, the appellant had been carrying on the business of property ownership and letting. In 1983, it changed its name to Wharf Properties Limited. 6. Hong Kong Tramways Limited ("Tramways") was also a wholly-owned subsidiary of Wharf (Holdings) Limited. It used to operate its tram service from a depot located at Sharp Street in Causeway Bay ("the Depot"). The Depot was however owned by its 3 wholly-owned subsidiary companies and was used by Tramways under a licence granted by these subsidiaries. The licence was subject to a monthly fee which was increased to $770,000 per month in 1984. It was terminable by 3 months notice. 7. In 1972, Tramways, its 3 wholly-owned subsidiaries which were the owners of the Depot and Realty Development Corporation Limited (which was then a subsidiary of the Wheelock Group of companies) entered into an agreement for the redevelopment of the Depot into a residential block on top of the tram depot. In 1984, Tramways began negotiating with the Government for approval of the relocation of its depot. The agreement to have a joint development of the Depot was cancelled on 3rd August 1987. It was also agreed that Tramways would be permitted to occupy the Depot until 31st March 1989. 8. By an agreement made on the same date, 3rd August 1987, the appellant agreed to purchase the Depot from the 3 subsidiaries of Tramways for a sum equivalent to the market value to be assessed by a property valuer appointed mutually by the parties but not less than $2,300,000,000. The valuation was to be made either within 15 days from the Town Planning Board's approval of the master layout plans for the redevelopment of the Depot or on 15th March 1989, whichever would be the earlier. 9. The appellant paid an initial deposit of $1,000,000,000 on 3rd August 1987 and agreed to pay a further sum of $1,300,000,000 within 15 days of the valuation of the Depot and the remaining balance, if any, within 90 days thereafter. 10. This purchase was approved by the board of directors of the appellant at a meeting held on 3rd August 1987. The minutes of that meeting recorded inter alia as follows:
11. On 14th October 1987 and 16th January 1988, Tramways entered into leases with the Government to construct two new depots at Whitty Street and Aldrich Bay. Meanwhile, Tramways and its 3 subsidiaries were concerned with the Government's proposed changes in the zoning of the areas in the vicinity of the Depot and the possible effects of the zoning changes on their plan to redevelop the Depot. 12. On 14th January 1988, the appellant submitted to the Town Planning Board its first formal master plan for the redevelopment of the Depot into a commercial complex to be known as the Times Square. 13. On 15th March 1988, the Depot was valued at $3,039,000,000. On 29th March 1988, the appellant entered into a formal Sale and Purchase Agreement with the 3 wholly owned subsidiaries of Tramways for the purchase of the Depot at that price. A further deposit in the sum of $1,300,000,000 was paid on 31st March 1988 and the balance of the purchase price in the sum of $739,000,000 was to be paid on 29th June 1988. The purchase was expressed to be for the purpose of redevelopment of the Depot and subject to the existing licence granted to Tramways to be used as a tram depot until the delivery of vacant possession. The sale and purchase was to be completed not later than 31st March 1989. 14. It was not disputed by the parties that the entire purchase price of $3,039,000,000 was financed by means of short term loans obtained from banks and/or financial institutions. 15. It was on 20th March 1989 that Tramways vacated the Depot and moved into its new depots. During the period when the Depot was still occupied by Tramways, that is, from 3rd August 1987 to 20th March 1989, it continued to pay licence fees to the appellant. Such fees in the sum of $6,160,000 were paid for the period between 3rd August 1987 and 31st March 1988 and of $8,991,613 for the period between 1st April 1988 and 20th March 1989 making a total of $15,151,613 as the rental (or licence) income received by the appellant during the years of 1987/88 and 1988/89. 16. On 21st March 1989, the appellant took possession of the Depot and commenced to redevelop it into a commercial complex which was later known as the Times Squares. (2) events relating to the assessments and Determination 17. On 9th December 1988, the appellant submitted its 1987/88 Profits Tax Return which was accompanied by accounts, schedules and profits tax computation for the year ended 31st March 1988. In these documents:
18. The Assessor requested information relating to the properties held for development, loans incurred and interests paid. In its reply, the appellant, in an explanation on the non-capitalisation of the interest expenditure, said that "the site was being held for rental purpose at 31/3/1988 pending vacant possession for redevelopment. Interest on loans was charged as expenses to offset the related income." Further correspondence ensued. 19. On 1st August 1989, the Assessor, not satisfied with the explanation, made an additional assessment of Profits Tax for the year 1987/88 disallowing as a deduction the interest of $51,275,848. On 14th August 1989, the appellant filed a Notice of Objection to this assessment for the following reasons:
20. On 5th October 1989, the appellant submitted its Profits Tax Return for the year 1988/89 with the relevant accounts, schedules and profits tax computation for the year ended 31st March 1989. In these documents, there were statements similar to those appearing in the accounts for the previous year, that is:
21. Again the Assessor requested for further information which was provided by the appellant. 22. On 27th September 1990, the Assessor made an additional assessment of Profits Tax for that year disallowing as a deductible expense the interest expenditure of $276,071,999. On 20th October 1990, the appellant filed another Notice of Objection to this additional assessment. 23. The Assessor then requested for further information from the appellant on the interest expenditure claimed and the appellant replied on 19th March 1991. 24. On 11th November 1991, the Assessor informed the appellant in writing that:
25. In relation to these two Notices of Objection, the Commissioner made a determination adopting the Assessor's revised additional assessments. This Determination is now the subject matter of the present appeal. The evidence (1) the appellant's intention in acquiring the Depot 26. The appellant adduced evidence to show its intention in the acquisition and redevelopment of the Depot. This came mainly from Mr. Gonzaga W.J. Li who is currently the deputy chairman and chief executive of Wharf (Holdings) Limited, the holding company of the appellant. He was the executive director of Wharf (Holdings) Limited in 1985, the deputy managing director in October 1986, the managing director in April 1988 and the deputy chairman and managing director in 1989. He was also a director of the appellant during the relevant periods. As the officer in such posts, he was responsible for development and was involved in the Depot project since 1985. 27. Mr. Gonzaga Li said that as early as 1984, it was proposed that Tramways be allowed to relocate its Depot at Sharp Street to 2 other depots. One of the reasons for the relocation was to make way for the redevelopment of the Depot. This is also clear from a letter dated 7th December 1984 from Tramways to the Secretary for Transport regarding the possibility of relocation of depots. It was already indicated to the Government in that letter that Tramways was contemplating a redevelopment of the site at the Depot. The correspondence further showed that the appellant was initially involved as an agent for Tramways in seeking approval from the Town Planning Board for the proposed redevelopment. 28. In August 1987, at about the same time as negotiations with the Government to relocate the Depot were concluded, the appellant entered into the agreement for the purchase or acquisition of the Depot. Mr. Gonzaga Li said that the reasons for making use of the appellant were first, the appellant was a mature property development company and the major property holding arm of the Wharf Group; second, the proposed project at the Depot was very similar to the Harbour City project and third, all of the appellant's assets were free of mortgage and it would be easier for the appellant to borrow funds externally. 29. From the minutes of the board meeting of the appellant held on 3rd August 1987, it seems that it was the intention of the board to hold the Depot for the purpose of redevelopment and long term investment and for the benefit of the rental return from the completed development. The directors also took the view that notwithstanding the debt which the appellant would initially incur to purchase the Depot, the long term potential of the development would allow the appellant to realize a significant profit over an extended period of time from rental income and that the appellant's income from its other property investments could be used to service the interest cost of the purchase and development of the Depot until such time as rental income would be earned. 30. The appellant was so concerned with the redevelopment that it had conducted regular financial projections to estimate the gross value of the completed building, the income which would be generated therefrom after completion and the average annual yield which could be derived from the redevelopment. It had also taken steps to ensure that the development was of high quality. 31. At that stage, it was not at all certain when Tramways would vacate the Depot and when the actual redevelopment could commence. This depended on when the sites for the two new depots would be ready and when the Town Planning approval would be granted. 32. In a Circular to Directors dated 21st September 1987 in which Tramways informed its directors of the agreement to sell the Depot to the appellant, it was anticipated that construction works at the two new depots would commence shortly and the present Depot was ''planned to be relocated thereto by September 1988". In other words, it was then expected that the two new depots would be ready in about a year's time and hence, the appellant could take vacant possession of the Depot in September 1988. However, this did not materialise until 21st March 1989. 33. From the evidence adduced before me, I find that since at least 1984 if not at a much earlier time, the Wharf Group had intended to relocate the tram depot and to redevelop the Depot site. It was decided to make use of the appellant which was the property arm of the Group to acquire the Depot and to take up the redevelopment project. As far as the appellant was concerned, at the time of the purchase, it was its intention to retain the Depot for redevelopment and as a long term investment. The attraction in the Depot did not lie in the licence/rental income which could be derived from its use as a tram depot, but in its development potential. The predominant if not the Sole purpose of the whole project was to generate rental income after the redevelopment. The licence fee to be received for the use of the Depot before its redevelopment played very little or no part in the decision to acquire the Depot. This was clear from the board minutes of the appellant at the meeting held on 3rd August 1987. Indeed, it was accepted by Mr. Gonzaga Li that the appellant would still have purchased the Depot and proceeded with its redevelopment even if there were to be no licence/rental income for its use as a tram depot. If not for the delay caused by the relocation of the tram depot and the town planning approval, it was likely that the appellant would have been ready to commence the redevelopment project at an earlier stage. The licence/rental income would seem to have been irrelevant. (2) the financing of the acquisition 34. The entire purchase price for the Depot was financed by loans which were obtained by the appellant from various approved banks and financial institutions. (At the beginning of this appeal, the Commissioner raised a query on the status of one of the financial institutions. This was later dropped.) These were short term loans for periods ranging from a week to a month and were guaranteed by the parent company, Wharf (Holdings) Ltd. They were either rolled over or replaced by other short term facilities. Upon these loans, interests were paid by the appellant. During the 20 month period from 3rd August 1987 to 21st March 1989, the total amount of interest paid was $327,347,847. 35. Mr. Quinn Y K Law, the Financial Controller and a director of the appellant said that it was difficult for the appellant to obtain long term loans. This was because the appellant did not know at that time what sort of building it was going to put up and when construction could commence. Banks needed to know such information before granting long term loans because they were interested in the borrower's future cash flow and the time it would be able to make repayment. It would therefore be difficult to obtain long term loans on acceptable terms and at acceptable rates. 36. From its annual reports for the several years before 1987 and Mr. Gonzaga Li's evidence, it is clear that the Wharf Group was in a strong financial position and able to finance a substantial portion of its commitments over the following few years. There were large liquid funds available, if required, for its projects. The treasury functions of the parent and its subsidiaries were centralised and the funding of subsidiaries was controlled by the Parent and Group Treasury. The appellant had maintained and/or could maintain inter-company accounts with the parent company and/or its associated companies within the Wharf Group. As an example, in its 1988 accounts, it was shown that the appellant owed its parent company $700 million and in the 1989 accounts, its parent company owed it $365 million. In 1990/91, the property was sold by the appellant to one of the subsidiaries of the Wharf Group, Zenuna Ltd. and the purchase price was indeed dealt with by way of entries made in the two companies' accounts. 37. According to the minutes of the board meeting of the appellant held on 3rd August 1987, it was anticipated that external financing would be required for the purchase and redevelopment. Mr Gonzaga Li said in evidence that the purpose of borrowing the funds (and the cost in interest terms of the same) was to secure future rental income (in excess of interest cost) from the redevelopment of the Depot. 38. The evidence showed that after the appellant had obtained the loans, the money was used to pay the purchase price to the three subsidiary companies of Tramways which owned the Depot. It was admitted that the money representing the purchase price was distributed as profits by these companies to their immediate holding company, Tramways, and Tramways likewise distributed such profits to its holding company. The money was then invested overseas. 39. I think it is clear from the evidence that as a group, it was not necessary to borrow money for the acquisition of the Depot by the appellant. Although its acquisition was legally a sale and purchase, the property was in fact a transfer from one company within the Group to another and as a result, stamp duty was saved. There were inter-company accounts between the appellant and the subsidiaries and/or associated companies of the Group and the purchase price could be reflected in these accounts. The Wharf Group was also financially sound and in a position to provide for the purchase price even if it should become necessary for it to pay such a price. Even then, the funds would be moving around from one subsidiary or associated company to another within the Group. One may expect that financing would be required for the costs of the construction of the redevelopment project as distinct from the price of the property. However, I am not satisfied that from a practical point of view, there was any good reason for the appellant (as opposed to the Group) to obtain loans from outside to acquire the property from its associated companies. It seems that the object of the exercise was to enable the Group to acquire funds from banks and financial institutions through these borrowings for its own use or investments abroad. That of course was a commercial decision. (3) the timing of the purchase 40. The agreement to purchase the Depot by the appellant from the 3 subsidiaries of Tramways was executed on 3rd August 1987 although it was anticipated that the site would not be available until at least late 1988 or March 1989. Upon the signing of this agreement, part of the purchase price had to be paid and another payment was to be made at a later stage. Since it was decided to obtain loans to pay for the price, interests on these loans would start to be payable and were in fact paid since August 1987. It was suggested that there was no reason to enter into the agreement at a time when the Depot was not ready for redevelopment. 41. The property was held by the Wharf Group since well before 1972. Since at least 1984, Tramways had planned to move the tram depot from that location to some other places. The Wharf Group had contemplated the redevelopment of the Depot after such removal. The appellant was the property arm of the Group and had been dealing with the Town Planning Board as agent for Tramways since October 1986. It was understandable that the appellant was deployed to take up such project. The Depot would have to be transferred to the appellant. 42. In 1987, discussions were held on the availability of suitable sites for the new depot and negotiations were conducted with the Town Planning Board with regard to the project. It was therefore a matter of time as to when new depot sites would be available and when government approval for the project would be forthcoming. The reason for entering into the agreement for the transfer of the Depot to the appellant in August 1987 was clearly not for saving stamp duty since this would be saved in any event. According to the sale and purchase agreement, the property was to be transferred to the appellant at a price to be assessed at the date of completion. Hence, the timing of the agreement was probably not aimed at obtaining an advantage in the price. Compared with the purchase price and the interests payable on the loans to pay for the purchase price, the licence/rental income derived from such use was quite insignificant. In fact, Mr. Gongaza Li confirmed that the Depot was to be purchased by the appellant even without the licence rentals. The purchase of the Depot was clearly not intended for obtaining the licence/rental income during the period when it was still occupied by Tramways. 43. When Mr. Gonzaga was asked why it was necessary to transfer the property to the appellant before it was ready or about to be ready, he said that from the appellant's point of view, it would like to be sure that the property was in its hand rather than having it hanging loosely and that the group structure might change. I do not think that could be a satisfactory reason for the transfer of the Depot from one company within the Group to another before Tramways was ready in moving its depot. I can see no necessity to transfer or agree to transfer the Depot to the appellant before the site was ready for redevelopment. If the arrangement was deferred until it was, it would not be necessary to pay interest on loans during this 20 month period even if it should be decided that loans were required to pay for the price. (4) the accounting evidence 44. In the appellant's accounts for the year ended 31st March 1988, the Depot was classified in the Balance Sheet under the category of "Fixed Assets - Properties Held for Development". In Note 1 (a) (ii), it was stated: "Interest payable on loans relating to properties held for development is capitalised up to the date of completion of development". However, contrary to this note, interests paid during that year were treated as an operating expense in the Profits and Loss Account. The same occurred in the accounts for the year ended 31st March 1989 notwithstanding the presence of a similar note. Counsel for the appellant submitted that the Note to the Accounts was strictly not incorrect but that it would have been better worded if it had included words to the effect that capitalisation commenced from the beginning of construction work. 45. Mr. Quinn Y K Law, who was a Senior Accountant, the Financial Controller and the Chief Accounting Officer of the Wharf Group and also a director of the appellant during the relevant period, was involved in formulating accounting policies for the Wharf Group. According to him, one of the accounting policies was to capitalise in certain circumstances the interests payable on loans relating to a property as a part of the project cost. The company would start capitalisation of interest once construction commenced but not before that and would cease after the development had been completed and started to earn income. He said that the reason for capitalisation was that during the construction period, the development was not earning any return and that charging interest in the profit and loss account would unnecessarily depress profits by the deduction of a cost which in the period had no matching or any return. In the case of the Depot, he said that the property when it was acquired was earning rental income even before the redevelopment and it could not be redeveloped immediately upon acquisition. Hence, the rental income received from Tramways was included in the appellant's Profit and Loss Account and the interests paid on the loans for the acquisition of the Depot were matched as an expense. 46. It is clear from the relevant accounts that although interests were not capitalised, there was, in 1987/88, a capitalisation of $1.6 million of expenses incurred in the incidental activities connected with the redevelopment project and in 1988/89, another sum of $12 million for such redevelopment related expenses was capitalised. 47. Mr. Roger Best, an accounting expert called by the appellant, took the view that the appellant's policy of dealing with the item of interest expenditure was quite proper and in accordance with accounting practice and standards. He noticed no amount of interest was disclosed in Note 3 or elsewhere as having been capitalised and said that if interest had been capitalised, he would expect that this would be disclosed in the financial statements. Since this was not, he could say that no interest had been capitalised. He accepted that there was a deficiency in Note 1 (a) (ii) of the accounts in that it failed to accurately describe the policy adopted and that when he looked at that statement, he would assume there was capitalisation of interest. However, he was of the opinion that the accounts would still present a true and fair view of the financial position of the appellant. He said that he was aware that there was a capitalisation of $1.6 million in the 1987/88 accounts, although he had no knowledge of the details of this sum. He did not think that would be of any significance in view of the large cost of the property. He was however not aware of the capitalisation of $12 million in 1988/89 when he prepared his witness statement. He admitted that this was a deficiency in the accounts for that year which might require elaboration, but did not think that this would be misleading. He said that this was also not significant when compared with the assets of the company. 48. Evidence had been adduced both by the appellant and the Commissioner with regard to the accounting practice prevailing in Hong Kong. The position seems to be this. Accountants preparing and auditing accounts must adhere to the requirements of the Statements of Standard Accounting Practice. Where there is a deviation from such practice, the deviation must be disclosed and explained in a note to the accounts. The financial effects of the deviation should be estimated and disclosed unless such estimation would be impractical and misleading. If the financial effects of the deviation are not disclosed, the reasons should be stated. Accountants and auditors are also guided by the Accounting Guidelines. However, these guidelines are regarded as indicators of best practice only. They need not be adhered to and can be departed from without disclosure. Nevertheless, such guidelines should normally be followed and accountants should be prepared to explain deviations from the guidelines if called upon to do so. 49. With regard to the treatment of interest, there was and still is no accounting practice regarding the capitalisation of interest on borrowed funds. However, in the periods under consideration, there was an accounting guideline on this issue. It was Statement 2.205 entitled "Accounting Guideline - Capitalisation of Borrowing Costs" which was issued in October 1985 by the Hong Kong Society of Accountants and modelled on the International Accounting Standards, IAS 23, which was released in March 1984. According to these guidelines, there are two views on the appropriate accounting treatment of interests on borrowed funds. The first is that such costs are essentially period costs and should be charged to income regardless of how the borrowing is applied; and the other view is that borrowing costs in certain specific instances form part of the cost of the asset with which they can be identified (either directly or indirectly) and accordingly should be capitalized, under certain prescribed conditions, as part of the carrying amount of such assets (Articles 2 and 3 of Statement 2.205 and see Article 4 of the IAS 23). They also recommend that if capitalisation of borrowing costs is adopted, it should commence when:
(Article 7 of Statement 2.205 and see Article 9 of IAS 23) and should cease when the asset is brought to its working condition or a saleable condition or when the borrowing costs have ceased to be incurred (see Article 8 of Statement 2.205 and Article 10 of IAS 23). 50. According to Mr. Best, the appellant's expert, it was correct for the appellant not to capitalise the interests on loans until active development commenced since this was consistent with the spirit of Statement 2.205; and activities necessary to prepare an asset for its use or sale were understood by accountants to mean actual physical construction of the project. He said that it was consistent with the accruals concept to regard interests paid by the appellant as a cost incurred in generating rental income and to charge them against the rental income generated in determining whether or not a profit or loss had been derived from the investment, property activity being undertaken in the periods prior to the commencement of development. He further said that it was also consistent with the prudence concept for the appellant to treat the interests in the way they were treated because the economic environment in Hong Kong could have changed dramatically thus severely affecting the viability of the proposed redevelopment. 51. Mr. Meocre Li was called as an expert by the Commissioner. He accepted that there was no accounting standard governing the capitalisation of interests paid on loans and that according to the accounting guidelines, there were two ways to deal with such interests. However, he said that according to his experience, it was a practice in Hong Kong that interest paid on borrowed funds should be capitalized. He emphasised that in accounting, the true and fair view principle was of the utmost importance and transactions should be presented in accordance with their substance and financial reality and not merely their legal form. With regard to the accounts of the appellant for the years 1987/88 and 1988/89, he said that the accounting policy stated in the notes regarding the capitalisation of borrowing costs were inconsistent with the accounting treatment actually adopted. He took the view that the inconsistency was so significant as to render the accounts misleading and not presenting a true and fair view. To illustrate this, he pointed out that if in 1987/88, the interest costs less the rental income (i.e. $45,115,848) were capitalised and not expensed, the appellant's Profit Before Taxation would be increased by 25 %, and if in 1988/89, the interest costs less rental income (i.e. $267,080,386) had been capitalized, the appellant would, instead of having a Loss Before Taxation of $136,865,573, have reported a profit of over $130 million, that is an increase of 195%. 52. Mr. Li said that accounting policies should be applied consistently from one year to the next and that any change in policy should be disclosed by way of notes in the accounts and clearly and fairly explained. He believed that both the borrowing costs and the rental income should be capitalised in the present case because it was in such a way that the true substance or nature of the transaction could be reflected. The appellant acquired the Depot for the purpose of redevelopment and long term investment with the full knowledge that the place would not be available for a period of 20 months and that there would be substantial deficits during that period. These deficits, that is, the excess of interests over rental income, should properly constitute part of the property's acquisition cost and must be capitalized. He said that the substance of the transaction was that the property was held for development and not yet an investment rental property until after the redevelopment. According to him, all costs incurred prior to, and necessary for, development should be matched against the market value or proceeds accruing from the property after development and this required capitalisation. He further said that capitalising the interests would also be in accordance with the "prudence concept". 53. In my view, the accounting practice and evidence on how interests paid or payable on borrowed funds should be and/or were treated may throw some light on the issues I have todecide in this appeal. On the evidence presented before me, I think a number of points can be made. 54. First, it is clear from the notes set out in the relevant accounts that the appellant had adopted or intended to adopt a policy of capitalising interests payable on loans relating to properties held for development, at least, as it said, in certain circumstances. A person looking at the accounts would notice such a policy stated in Note 1 (a)(ii). He would also notice that the Depot was listed as a property held for development. He can see under Note 3 an item: "Interest on bank loans, overdrafts and other loan facilities wholly repayable within five years" with a figure indicating the amount of interest paid during the accounting period. He can also see under the section of Fixed Assets that there was an "Addition" to the item "Properties held for Development". In the 1987/88 accounts, the Addition to Properties held for Development was over $3 billion (that included the acquisition of the Depot during the year) and in the 1988/89 accounts, it was $36 million. Looking at all these, he would, as the appellant's expert Mr. Best admitted, have been led to believe that the appellant had indeed made a capitalisation of the interests paid on borrowed funds for the acquisition of the Depot. However, nowhere in the accounts can he find any such capitalisation and in fact, there was none. To this extent, the notes to the accounts if not also the accounts are inaccurate and confusing if not also misleading. I do not accept that the notes were simply incomplete. 55. Second, the accounting guidelines recommend that if capitalisation is adopted, this should commence when activities which are necessary to prepare the asset for its use or sale are in progress. I do not propose to give any definition of what are or are not such activities. Each case depends on its own circumstances. Physical construction work is clearly such an activity. But where a property is acquired for redevelopment, it is not always the case that physical construction work can be commenced immediately upon acquisition. Some planning and preliminary work would have to be carried out before that and expenses would have to be incurred. In many cases, such work would also be regarded as activities to prepare the asset for use or sale. In the present case, it was the clear intention of the appellant to acquire the Depot for redevelopment. As I found earlier, the rental income derived from the use of the place as a tram depot had little or nothing to do with the decision in its acquisition and the appellant would have acquired the Depot even if there was no such rental. The appellant had been conducting negotiations with the relevant government authorities for approval for the redevelopment before as well as after the acquisition. Expenses had been incurred in connection with the project. Such expenses, $1.6 million in 1987/88 and $12 million in 1988/89, were capitalised in the accounts in the respective financial years. These were not small amounts. Under such circumstances, it is reasonable, in my view, to conclude that some activities to prepare the property for use had already commenced or at least, it was regarded by the appellant that such activities had commenced. One would expect that the interests paid on loans borrowed for the acquisition of the Depot should also be capitalised if, as the notes to the accounts said, a policy of capitalisation was adopted by the appellant. 56. Third, the amount of interest paid during the relevant periods cannot be regarded as insignificant. In 1987/88, the excess of interests paid on the loans over rentals received from use of the Depot was $45 million. This represented a 5.5 % of the total turnover for that year of $814 million and nearly a quarter of the profit (before taxation) of $182 million which the appellant had made during the year. In other words, if the interests had not been put as an expense but were capitalised, the accounts would have shown that the appellant had made 25 % more of profit. In 1988/89, the excess of interests on the loans over the rentals received from use of the Depot was $267 million. This represented 26.8 % of the total turnover for that year of $996 million. In that year, the accounts showed that the appellant had made a loss (before taxation) of $136 million. If the interests paid on loans had not been put as an expense but were capitalised, the accounts would have shown that the appellant, instead of making a loss, had made a profit (before taxation) of $130 million during that year. It is true that the total asset of the appellant for 1987/88 was over $10 billion and for 1988/89 over $17 billion. However, I think it would be more appropriate to make the comparison in terms of the business turnover and profit (or loss) made during the year. Looking at the impact of expending the interests in the profit and loss account instead of capitalisation, I am not satisfied that the accounts had presented a true and fair view of the financial position of the appellant company or had reflected the true substance of the transaction in acquiring the Depot for redevelopment and long term investment. 57. Fourth, I accept that there was no accounting standard regarding the appropriate treatment of interests on borrowed funds and that the accounting guidelines suggested two different ways of dealing with them. The Commissioner, based on Mr. Meocre Li's opinion, argued that there was a practice in capitalising such interests. It would be helpful if I am to examine the guidelines again. There are arguments for and against capitalisation, of interest. Those in favour of capitalisation, are:
The arguments in favour of the view that borrowed costs should always be treated as a charge to income, regardless of how the borrowing is applied are:
58. I would agree that there is no universal rule or practice that interests paid on borrowed funds must be treated one way or the other. This may depend on a number of factors including the type of business or enterprise concerned and the sort of policy it has previously adopted. However, a closer examination of the accounting guidelines seems to suggest that a policy of capitalisation would be preferred in certain circumstances. Article 4 of Statement 2.205, for example, says: "This guideline recommends the capitalisation of borrowing costs although such treatment is not mandatory". Article 6 further says: "If borrowing costs are significant to an enterprise, it is recommended that they be capitalised as part of the cost of an asset which requires a substantial period of time to get it ready for its use or sale by applying a capitalisation rate to expenditures on its acquisition, construction or production. Borrowing costs are not usually capitalised for stock which is routinely manufactured or otherwise produced in large quantities on a regular basis". 59. The International Accounting Standard 23 have provisions similar to Articles 4 and 6 of Statement 2.205. While Article 3 of IAS 23 says that it does not insist on capitalisation of borrowing costs, Article 5 says: "For many years public utilities in various countries and companies in the construction industry have capitalised borrowing costs. This practice has been increasing in other industries". Articles 8 and 22 of IAS 23 are expressed in the same terms as Article 6 of Statement 2.205 and suggest that borrowing costs should be capitalised when such costs are significant to the enterprise and there had been expenditures on assets that require a substantial period of time to get them ready for their intended use or sale. 60. In the present case, the purchase price of the Depot was over $3 billion which was quite substantial compared with the total asset of the appellant in 1987/88 of $10 billion and in 1988/89 of $17 billion. The price was completely financed by borrowing and large amounts of interests were paid or payable. The project would take a few years to complete. It seems, in my view, that this case would fall within the provisions of Articles 4 and 6 of Statement 2.205 and Articles 5, 8 and 22 of IAS 23 which suggest that the interests paid should be capitalised. As I said, the appellant had adopted or at least intended to adopt such a policy. The Commissioner's Reasons for Determination 61. In his reasons for determination, the Commissioner formulated the question to be decided as follows: whether the interest expenses on loans raised to finance the acquisition of the Depot for redevelopment purposes should be allowed in full for the pre-development period or to the extent of the rental income generated under an existing licence for the same period. 62. He said that to be deductible for profits tax purposes, the interest expenses must satisfy both s. 16 (1) (a) and s. 17 (1) (c) of the Ordinance. In his opinion, in ascertaining the purpose in the context of s. 16 (1) (a), one must have regard to the declared intention of the use of the loans and the objective circumstances of the particular case and in the case of loans for a dual purpose, the interest expenses had to be apportioned between the qualifying and non-qualifying purposes. 63. He took the view that since the loans were raised to finance the acquisition of the Depot for the purpose of redevelopment and long term investment, such purpose was clearly of a capital nature. He said that since the rental income generated under the existing licence pending redevelopment was so small as compared with the interests paid during the same period, it could not, on an objective analysis, be attributable as the purpose for the acquisition of the Depot. At best, it could only be described as a subsidiary purpose. He was prepared, to be on the more generous side, to accept the assessor's proposal to allow an equivalent amount of interest expenses as having been incurred in producing the rental income for the relevant period. 64. As regard to the remainder of the interest expenses, he took the view that they were related to the dominant purpose of redevelopment and as such were not deductible for being of a capital nature. He said that it was the accepted practice in Hong Kong that interest expenses incurred on loans raised to finance the construction of a building during the construction period should be capitalised. He relied on the cases of Tai On Machinery Works Ltd. v. C.I.R. 1 HKTC 411; Ben-Odeco Ltd. v. Powlson 52 TC 459 and Chancery Lane Safe Deposit and Offices Co. Ltd. v. CIR 43 TC 83. He refused to follow the Australian cases and Papua New Guinean case of Travelodge Papua New Guinea Ltd v. Collector of Taxes 16 ATR 867 saying that in view of the structural difference in the statutory provisions of the two places, such authorities were of no assistance. The relevant provisions 65. I shall start by referring to the relevant provisions of our ordinance. Under s.14 of the Inland Revenue Ordinance, profits tax shall be charged on a company carrying on a business in Hong Kong in respect of its assessable profits arising in or derived from Hong Kong as ascertained in accordance with Part IV of the Ordinance. Section 15 deems certain sums to be receipts arising in or derived from the business and ss. 16 and 17 provide for the deductions to be permitted or excluded for the purpose of ascertaining the assessable profits upon which profits tax shall be charged. I shall perhaps set out the relevant parts of these two sections as follows:
66. Sections 16 and 17 provide exhaustively for the sort of outgoings and expenses that are to be allowed as deductions for the ascertainment of assessable profits. The correct approach to these sections was formulated by the Privy Council in two cases from Hong Kong. In Commissioner of Inland Revenue v. Mutual Investment Co. Ltd. [1967] AC 587, Sir Garfield Barwick said at p.598:
67. Lord Brightman, delivering the judgment of the Judicial Committee of the Privy Council in Lo & Lo v. Commissioner of Inland Revenue [1984] 2 Hong Kong Tax Cases 34, said at p.71:
68. I would respectfully follow this approach. The issues to be decided 69. In the present case, the appellant claims that between the 3rd August 1987 and 20th March 1989, it had paid $51,275,848 (in the year 1987/88) and $276,071,999 (in the year 1988/89), that is, a total of $327,347,847, as interests on loans which it had borrowed by way of short term borrowing to pay for the purchase price of the Depot. It is the appellant's case that it is entitled to the deduction of these amounts in the ascertainment of its assessable profits for the years 1987/88 and 1988/89. The issues which have arisen for determination are:
The first issue (1)application of section 16 (1)(a) 70. Counsel for the appellant submitted that s. 16 (1)(a) applied to the present case. He said that it was clear that the appellant acquired the Depot for redevelopment as a major office and retail development from which it was intended that rental income would be received. That was its long term intention. But as a short term consideration, the Depot was acquired for the receipt of the immediate and current rental income payable under the licence to Tramways. In other words, the acquisition of the Depot was intended for the collection of immediate rental from Tramways before the redevelopment and of the future rental from the completed building after redevelopment. Counsel submitted that with that intention in mind, the appellant borrowed loans to acquire the Depot. The money so borrowed was for the purpose of producing assessable profits, that is, rental income. Counsel submitted that the appellant had incurred expenses by way of interest paid on the borrowed funds which were necessary to acquire the Depot and that being the case, the interest paid on those loans was clearly incurred in the production of immediate rental income as well as future rental income. 71. It was further submitted that the size of the expenditure incurred, that is, the amount of interest paid, as compared to the expected profits likely to be produced during the relevant periods, was immaterial and could not prevent it from being deductible if it was otherwise deductible. Counsel also argued that it was important that the interests were incurred during the years of assessment in question. It was irrelevant that a reasonable amount of rental income could only be received in future outside these two years of assessment. Section 16, he argued, catered for the situation where income was to be received in future provided that the expenditure was indeed incurred during the year of assessment in question. 72. On the other hand, counsel for the Commissioner submitted that to be deductible, an expenditure had to be incurred in the production of profits which were chargeable tax. This requirement in itself excluded expenditure of a capital nature. Counsel took the view that there was in fact an overlapping in the opening words of s. 16 (1) and the various items set out in that subsection as well as s. 17. He further argued that the Court should also look at the purpose for the obtaining the loans. 73. In my view, the effect of s. 16 (1) is this. It permits deduction, in the process of ascertaining chargeable profits, of all outgoings and expenses which satisfy two criteria. First, they must be incurred during the basis period for the year of assessment in question. Second, they must be incurred in the production of chargeable profits. Whatever the amount of the outgoings and expenses may be, only such portion of them which satisfies these two criteria would be deductible. It matters not that such outgoings or expenses are incurred for the production of profit not in the year of assessment in which the outgoings and expenses are incurred but in some other periods. 74. The sub-section continues to set out, by way of inclusion, nine categories of outgoings and expenses which would fall within its ambit. These categories must, by necessary implication, be governed by the opening words of the subsection and be subject to the two criteria I have mentioned. This is also clear from the provisions of these paragraphs. In some of the paragraphs specified in s. 16 (1), it is expressly stated that the outgoings and expenses must be incurred for producing profits. They are paragraphs (b), (e), (f) and (g). The expenditure referred to in some of the other paragraphs, although not directly related to the production of profits, can be regarded as expenditure which is intrinsically connected with such purpose: paragraph (c) deals with the payment of overseas tax, an obligation arising from the production of profit; paragraph (d) deals with bad debts, a factor which would affect the amount of the receipts and hence the profit made from the business; and paragraph (8a) deals with special expenditure for scientific research, technical education and business-related patents, an expenditure aimed at advancing or improving the process of producing profit. I leave out paragraph (h) which relates to any deduction that may be prescribed by the rules. 75. As to the last category, that is paragraph (a), it covers interest payable upon money borrowed. According to this paragraph, the loan upon which interest is payable must meet two criteria: first, it must satisfy the conditions set out in sub-s. (2) and second, it must be borrowed for the purpose of producing chargeable profit. 76. In my view, in order to fall within s. 16 (l)(a), it is necessary to show not only that the interestas an item of expenditure is incurred during the basis period of the particular year of assessment and for the production of chargeable profits for any period, (i.e. the interest falls within the criteria in the opening words of sub-s. (1)) but also that the loanupon which the interest expenditure is incurred must, apart from satisfying the conditions in sub-s. (2), be borrowed for the purpose of producing chargeable profits (i.e. the loan falls within the criteria of paragraph (a)). In other words, it is necessary to show that both the loan is obtained and the interest is incurred for the purpose of producing chargeable profits. With respect to counsel for the appellant, I do not think it is correct to say that the status of the loan is irrelevant for the purpose of deciding whether an interest expenditure on loans is deductible under s. 16 (l)(a). 77. Counsel for the appellant submitted that underlying the Determination of the Commissioner were two key assumptions of law which were wrong: the first was the assumption that expenditure can only be deducted in a year of assessment if it produces in the same year of assessment profits of at least an equivalent sum; and the second was the assumption that expenditure which was incurred in the form of the payment of interests was capital in nature if the loans upon which it arises were taken out to fund a capital project. The first assumption relates to the application of s. 16 and the second relates to the application of s. 17 which I shall deal with at a later stage. 78. With regard to the first assumption which the appellant alleged that the Commissioner had made, I would agree with counsel for the Commissioner that this had resulted from a misreading of the Determination. As I understand it, the Commissioner took the view that it was necessary, in order to qualify under s. 16 (l)(a), to show the purpose with regard to the use of the loan. He was of the opinion that the loans in question were for the purpose of redevelopment and long term investment, that is, for future income after the completion of the project and that at best they were for a dual purpose. He was therefore prepared to allow the deduction of the amount of interests which covered the rental income derived from the licence of the Depot to Tramways. That was however a concession which has somewhat distracted us from the main issues in this case. (2) sections 16 and 17 - separate issues 79. Counsel for the appellant seemed to suggest that since interest payable on capital borrowing was in itself deductible under s. 16 (l)(a), it would follow that it was outside s. 17(1)(c) and that it was not necessary to consider that section at all. With respect, I do not think it can be argued that interest which falls within s. 16 (l)(a) is per se a deductible revenue item and that s. 17(1) does not apply to such expenditure items. On the other hand, counsel for the Commissioner argued that if an expenditure was of a capital nature, it was necessarily excluded by s. 16 (1) since s. 16 and s. 17 overlapped with each other. With respect, I do not think one can go as far as that. 80. In my view, ss. 16 and 17 are separate provisions and perform different functions. One offers inclusion for certain types of outgoings and expenses in the process of ascertaining assessable profits while the other provides exclusion of certain types of outgoings and expenses in the same process. In almost all of the cases, it is of course true that outgoings and expenses which do not fall within s. 16 are outside s. 17 and those which are excluded under s. 17 would not normally qualify under the inclusive provision of s. 16. However, the two issues are to be dealt with separately. The correct approach is that one should consider first of all whether an item of expenditure falls to be included under s. 16 and then whether it is excluded under s. 17. If the item does not fall within s. 16, that is the end of the matter. It will not be allowed as a deduction. But even if it falls within s. 16, it has still to be considered whether it is excluded under s. 17. If it is excluded, it will not be allowable as a deduction. It is only when a particular item qualifies under both s. 16 and s. 17 that it is permissible as a deduction for the purpose of ascertaining the assessable profits. I derive support for this view from what Lord Brightman said the Lo and Lo case at p.71 (and cited above at p.29 of this judgment.) 81. One example can be seen from the Tai On Machinery case. It seems that the Board of Review fell into the error of considering only s. 16 but failing to make a specific finding on s. 17. And McMullin, J. said at p.429:
(3) whether the loans were for producing profits 82. As I said, in order to satisfy s. 16 (l)(a), it is necessary to show that both the loan as well as the interest thereon must be obtained or incurred in the production of assessable profits. "In the production of assessable profits" and "for the purpose of producing assessable profits" have and should have the same meaning. It means "with a view to" producing profits for the business (see Yang, J., as he then was, in Commissioner of Inland Revenue v. Swire Pacific Limited [1979] HKTC 1145 at p.1160 and also the decision of the Court of Appeal from p.1162), or "in the course of" producing assessable profits and "incidental and relevant" to the business (see Ronpibon Tin N.L. v. Federal Commissioner of Taxation (1949) 8 ATD431 at p.435). Normally, if it can be shown that the loans were borrowed for the purpose of producing assessable profits, it would follow that the interest expenses were also incurred for that purpose. 83. Counsel for the Commissioner submitted that the expenses were not incurred for the purpose of earning or gaining profits and he relied on three grounds:
84. The second point relates to the question of whether interest expenditure was of a capita1 nature and the third point deals with any possible apportionment. These are dealt with at a later stage. 85. On the first point, counsel submitted that the transfer of the Depot was not an arm's length transaction but merely an asset re-shuffle within a group of companies. He submitted that there was no commercial sense or purpose in the transaction. He said that the purpose of shuffling the transaction and the loans in the way they were shuffled was to enable the Wharf Group to use the borrowed funds to make exempted interests from the deposit of the money offshore and to create a claim for a massive deduction in profits tax and that the purpose of the transaction and the loans was clearly not to enable the appellant to produce chargeable profits. 86. It is clear from the evidence that funds were in fact borrowed and borrowed by way of short term loans in view of the impending removal of the tram depot to new locations. The loans obtained were indeed for the purpose of paying and were actually used to pay for the purchase price of the Depot. In my view, although it may be said that the motive for obtaining the loans to acquire the Depot was to enable and/or facilitate the channelling by the Wharf Group of money offshore, the loans were put to immediate use for the purpose for which they were borrowed, that is, to pay for the acquisition of the Depot. The acquisition of the Depot was for the purpose of redevelopment and the redevelopment was for the purpose of producing profits. One must not confuse the purpose of the transaction with the motive behind it. The motive of all these transactions, namely, the transfer of the Depot from one company to another within the same Group and the obtaining of loans by the appellant to pay for the purchase price, might be to save stamp duty which would have been payable upon transfer of the property and to obtain liquid cash to be utilised overseas by the Group. The Court is however not concealed with the motive behind these transactions. There is nothing to prevent a person who is in possession of a large capital from borrowing from a bank or financial institution to commence or continue his business instead of using his own capital. The purpose of the loan is to use it as capital in his business and that is what he has done. He may have a private motive to serve in borrowing, but that is not important. If by borrowing he can have a tax or other advantage in that he can claim deductions under the provisions of the Ordinance, that is perfectly permissible and is entirely a commercial decision for him. 87. Counsel for the Commissioner submitted that the interest expenses paid by the appellant were incurred for a purpose unrelated to the earning or gaining of the rental income during the 20 month period which was the only relevant chargeable profit. It was argued that the loans and the interest expenses incurred were therefore not obtained or incurred for the production of profit. With respect, I do not agree. Under the opening provision of s. 16(1), it is not necessary to show that the outgoings and expenses must be incurred for the production of profit in the year in which the outgoings and expenses were incurred, but in any other year of assessment. By parity of reasoning, I do not think it is necessary to show that the loans must be obtained for producing profits within the year of assessment in which the loans were made, so long as it is clear that the loans were obtained for the purpose of producing assessable profits for any period of assessment. Counsel's submission has, with respect, overlooked the important words of "for any period". The licence rentals from Tramways during the years of assessment in question were not the only relevant assessable profits that must be looked at. One must also consider any possible or intended profits for any other periods. 88. During arguments, counsel for the Commissioner mentioned but, if I understand him correctly, did not really rely on the "fiscal nullity principle". Although he referred me to a number of authorities on this point, I do not think he went as far as to suggest that the Court should hold all the transactions in question to be a sham. In the present case, I do not propose to deal with these authorities or the “fiscal nullity principle”. There is no similar provision in our Ordinance as in the legislation in other jurisdictions on this point. The nearest we have is s. 61A which is quite clearly not applicable in this case and counsel did not argue that it was. 89. In my view, the loans in the present case were borrowed in the course of the appellant's business and with a view to pay for the purchase price of the Depot. They were obtained for the purpose of acquiring the Depot. And the purpose of acquiring the Depot was for redeveloping it into a commercial complex so that future rentals could be generated after its completion. In other words, the loans were borrowed for the purpose of acquiring an income generating asset. That being the case, the interests paid on the loans were closely connected with such purpose. It follows that the interest expenses paid or incurred during the relevant basis periods were incurred by the appellant in the production of its assessable profits after the completion of the redevelopment. It was only incidental that licence rentals were collected during the mean time. I would hold that such payments fall within s.l6(l)(a). The second issue 90. I now turn to the second issue relating to s.17 (1)(c). The question is whether the interest expenses incurred by the appellant during the 20 month period are expenditure of a capital nature. If they are, they would be excluded under this provision. (1) application of s.17 (l)(c) 91. Counsel for the appellant submitted that interest was itself specifically referred to as deductible in s.16 (l)(a) provided that certain conditions set out in subsection (2) were satisfied and that it mattered not whether the interest was of a capital nature. He said that under s.16(2)(e), interest on money borrowed wholly and exclusively to finance capital expenditure incurred on the provision of machinery or plant which qualified for depreciation allowance under Part VI would be deductible and so would, interest payable on a debenture under s.16(2)(f). It followed, he argued, that the terms of s.16(1) and (2) were, such that interest was deductible for tax purposes even if it was incurred on long term capital loans and that to read s.17(1)(c) as disallowing such interest expense was to render in particular s.16(2)(e) and (f) meaningless. He submitted that the only construction which could give effect both to ss.16 and 17 was that s. 17 (1)(c) did not apply to interest on loans. 92. I do not agree that since interest is specifically referred to in s.16(1)(a), then s.17(l)(c) is not applicable. As I said, these are different provisions and require separate considerations. It is necessary to show that a particular item, to be deductible, falls within s.16(1) and fall outside s. 17(1). I do not think subsections 16(2)(e) and (f)(i) can support counsel's argument. These paragraphs in subsection (2) provide as follows:
93. When one examines s.16(2) carefully, it can be seen that the main theme is more on defining the types of lender, that is, the sources of the funds, which are permissible. It specifies that loans from other types of lender and on certain terms are acceptable and loans from other types of lender are not acceptable for the purpose of subsection (l). The purpose of having these conditions is to ensure that the loans are geniune. This is illustrated from the provisions in the various paragraphs. As to section 16(2)(e), it refers to two types of borrowing, namely, for the provision of machinery or plant which can properly be regarded as tools of trade for which depreciation allowance is claimable under Part VI and for the purchase of trading stock which can be regarded as circulating capital. But that is not the only criterion in that paragraph. It goes on to stipulate that the lender must not be a partner of the borrower if it is a partnership or a shareholder or officer of the borrower if it is a company or an associated company. In other words, both criteria must be satisfied : the loan must be for the provision of machinery or plant and it must not be from a partner or an officer. As to s.16(2)(f)(i), it does not cover all kinds of debenture, only those which are restrictively defined in subsection (3)(ba), that is, debentures listed in a stock exchange in Hong Kong or one recognized by the Commissioner of Inland Revenue. Furthermore, a debenture can be on a fixed or floating asset of a company which may or may not be a long term capital. Therefore, in my view, it would be taking subsection (2)(e) and (f)(i) out of context to say that they indicate that s.16(1)(a) allows deduction of interest on borrowings per se even if it is incurred in respect of long term capital borrowings. (2) relevant circumstances 94. Counsel for the appellant further submitted that under s.17 (1)(c) of the Hong Kong ordinance, it was only necessary to decide whether the sum which was sought to be deducted was itself of a capital nature. He argued that the status of the interests was the determining factor and that the status of the loans was not relevant. He submitted that interest was and could not in itself be of a capital nature. It was a recurrent payment of a revenue character calculated by time for the use of money borrowed. It was not an instalment of a larger capital sum but was merely the regular expenditure or price for the use of money. He argued that there was no difference both conceptually as well as from a practical point of view between interest and rent: rent was payment to secure the use of premises and interest was payment to secure the use of money. He said that the Commissioner was wrong in his assumption that expenditure incurred in the form of payment of interests was capital in nature if the loans upon which the interests arose were taken out to fund a capital project. He argued that interest was the fruit of capital and income from the deposit of capital. As such, interest was never capital and could not be excluded under s.17 (l)(c). It would always be deductible provided that it satisfied the conditions of s.l6 (2) because it was revenue in nature whatever the length of the term of the loan, whatever the application of the borrowed monies and whatever the accounting treatment of the same. He further submitted that it was incompatible with the terms of s.16 to argue that the status of a loan was relevant for determining whether interest paid on the loan fell within s.17 (1)(c). 95. Interest itself is of course not capital. It is also not an instalment or part payment of a larger capital sun. However, one cannot look at it in vacuum. One does not pay interest without a reason. It is paid in order to achieve a particular purpose. In many respects, rent and interest are similar: interest secures the use of money and rent secures the use of premises. But there is one practical difference. As for rent, however much and for however long it is paid, it cannot and will not help either directly or indirectly in the acquisition of the premises. It simply secures the use of the premises as long as it is paid during the term of the lease. The premises for which rent is paid can be used to conduct business from which income can be generated, but at the end of the lease, the premises had to be returned to the landlord. On the other hand, interest secures the use of the money which can be employed in many ways : as circulating capital for the business, to purchase machinery and plants or stock in trade, or to purchase a fixed asset such as premises. At the end of the loan period, if the money was used to purchase premises, the premises purchased will be acquired upon repayment of the loan. Hence, apart from securing the use of the money, the payment of interest plays a part, albeit indirectly, towards the acquisition of the asset or premises. This difference may be fine but it illustrates the importance of not only looking at the status and nature of the expenditure but also the reason and purpose for which, and the circumstances under which the expenditure is incurred. 96. Counsel for the appellant further submitted that the Commissioner was wrong to rely on the U.K. authorities for the distinction, between capital and revenue items of expenditure. Counsel argued that the Commissioner had failed to appreciate a crucial distinction between the relevant U.K. legislation and sections 16 and 17 of our Ordinance. It was accepted that U.K. authorities as to what is a capital item and what is a revenue item are relevant in this case. However, he argued that the tests provided in the U.K. authorities were 19 be applied to a different subject matter as we have in Hong Kong in view of the difference in the legislation between the two places. He said that the U.K. legislation (which was s.74(f) of the Income and Corporation Taxes Act 1988) provided that in computing the taxable profits or gains, no sums shall be deducted “in respect of ……. any sum employed …… as capital in the trade". He submitted that under the U.K: provision, the question to be asked was whether the expenditure (for which a deduction was sought) was itself in respect of a sum employed as capital in the business. It followed that the first step was to decide whether the sum employed was a capital of the business or not. If it was, then there could be no deduction for the expenditure incurred in respect thereof. In other words, counsel argued that under the U.K. legislation, one was directed to consider the nature of the money borrowed and not the nature of the interest itself. Hence, under the U.K.provision, interests paid in respect of capital loans was not deductible while interests paid in respect of revenue loans would be deductible. He submitted that the Hong Kong legislation was different in that under s.16(1) and (2); interest was deductible even if the interest was on capital loans; and so, he argued that under the Hong Kong legislation one only had to look at the status of the interest and not at the status of the loan. He submitted that because of the difference in legislation, in Hong Kong, the capital/revenue tests were to be applied to the interest whereas in U.K., such tests were to be applied to the loan. He said that this was a fundamental distinction which the Commissioner had failed to appreciate. 97. With respect, I do not accept this argument. Under the Hong Kong s.17 (1)(c), "no deduction shall be allowed in respect of any expenditure of a capital nature ..... ". While there is a difference in the wordings between the U.K. legislation and the Hong Kong legislation, I do not think one can place such a narrow construction on our s.17(1)(c) as submitted by counsel. Section 17 (l)(c) provides that no deduction shall be allowed in respect of any "expenditure of a capital nature". In my view, it covers expenditure which is itself incurred as a capital and expenditure which, although not a capital in itself, is payment of a capital nature. If the expenditure is a capital payment, it is of course caught by the section. But even if it is not a capital payment, the Court has to consider whether it is of a capital nature or revenue nature. 98. There is no definition of expenditure of a capital nature in the Ordinance. Part VI which deals with Depreciation contains in s.40 (1) a definition of "capital expenditure". It is in the following terms:
99. In a decision of the Board of Review in Case No. D 12/88 which was chaired by Mr Henry Litton Q.C. (now a Justice of Appeal), s.17 (1)(c) came up for consideration. In that case, the taxpayer owned restaurant premises for rental. It acquired the adjoining site and redeveloped it, incorporating it with the restaurant premises. It claimed a deduction for interest costs incurred in acquiring and redeveloping the adjoining site. It was held that the interest costs were of a capital nature and therefore excluded under s. 17 (l)(c). The Board took the view that "expenditure of a capital nature" in s.17(1)(c) could be construed in the same way as "capital expenditure" in s.40(1)(a). They remarked as follows :
100. The facts of that case were similar to those in the present case. Quite apart from the relevance of this decision to the issue before me, I would respectfully say that there is good sense in this remark. 101. In my view, in order to decide the question of whether an expenditure is of a capital or revenue nature, one has to examine not only the status or nature of the expenditure but also the reason or purpose for which and the circumstances under which it is incurred. Thus, in Commissioner of Inland Revenue v. Swire Pacific Company Limited, the court examined not only the status of the lump sum payment but also the reason and the objective behind the making of such payment. In Lo & Lo v. Commissioner of Inland Revenue, the Privy Council also considered the purpose of the payment towards the pension scheme. Again, the Privy Council in the Commissioner of Inland Revenue v. Mutual Investment Company Limited examined the circumstances in relation to the payment of the expenses in question. These authorities clearly show that not only the status of the payment must be looked at, but also the purpose of the payment, the objective to be achieved by the payment and the circumstances under which it was made. In the case of an interest expenditure, this would include a consideration of the purpose of the loan for which the interest expenditure is incurred. This is the correct approach to the determination of whether a certain payment, be it interest or other kinds of expenditure, is of a capital or revenue nature under our s.17(l)(c). (3) the tests to be applied 102. I have been referred to quite a number of authorities on the issue of whether a particular payment or item of expenditure can be regarded as capital in nature. These previous decisions seem to lay down various tests for the determination of this issue. In my view, these tests illustrate how the courts had applied various relevant considerations to the facts before them. Some of these tests came from U.K. cases and others from Australian cases. Once it is realised that these tests are only factors for consideration in determining what is the nature of a particular expenditure in the factual matrix of a particular case and that none of these tests is decisive, it is pointless or even counter-productive to try to decide whether one should follow the U.K. or Australian authorities. As McMullin J. said in the Tai On Machinery case, legislation in the different jurisdictions are similar but there are bound to be differences. It may be true that the Australian legislation is more in line with the Hong Kong legislation. Yet it can be noted that U.K. courts when they came to decide on the same or similar issue, did very often refer to Australian authorities such as the Sun Newspapers Limited and Australian courts had also referred to U.K. authorities such as the British Insulated case. I think it would be wrong not to have regard to any of these tests and considerations on the ground that it was formulated in a U.K., Australian or Commonwealth case. 103. In some of the previous decisions cited to me, the expenditure in question was clearly of a capita] nature while in other cases, it was clearly of a revenue nature. However, there were borderline cases where it would be difficult to come to any firm conclusion one way or another. I do not propose to go into each of these cases or try to follow or distinguish any of their decisions. They turned on their respective facts and the different governing statutes. Several tests had been suggested in these authorities. None of these tests is decisive. The courts had placed greater reliance on one test in a particular set of circumstances and on another in a different set of circumstances. At the end of the day, the answer to this vexed question depends very much on the facts of each case. (See the comments of Stark J. in Hallstrom Pry Limited v. Federal Commissioner of Tax [1946] 72 CLR 634 at 644). It seems that ultimately it is "a common sense appreciation of all the guiding features" which would provide the answer (see Lord Pearce in B.D. Australia Limited v. Federal Commissioner of Tax [1965] 112 CLR 386). The comments of the learned Law Lord at p.397 are most enlightening:
104. With respect, I would entirely agree with these comments. I shall now deal with the more important and common tests which I shall treat as relevant factors for consideration in the present case. (i) Fixed/circulating capital test 105. One of the usual tests is the fixed or circulating capital test. The question to ask is whether the expenditure in question is incurred in respect of fixed or circulating capital of the business. If it relates to fixed capital, the expenditure is of a capital nature. If it however relates to circulating capital, it is of a revenue nature. (See Ammonia Soda Company v. Chamberlain. [1918] 1 Ch.D.286 and B.D. Australia Limited v. Federal Commissioner of Tax). Swinfen Eady L.J. in the Ammonia Soda Company case said at p.286
Lord Pearce in the B.D. Australia Limited case said at p.398 :
(ii) Once and for all recurring expenditure test 106. Another more commonly used test is the once and for all or recurring expenditure test. The question to be asked is whether the expenditure has been made to meet a continuous demand for expenditure as opposed to expenditure made once and for all. This test was explained by the Lord President in Vallambrosa Rubber Company Limited v. Farmer [1910]5 TC 529 at 536:
The size of the payment and the regular intervals at which the payments are made are also factors which should be taken into consideration. (iii) Enduring benefit test 107. Another test which follows very closely from the once and for all test is the enduring benefit test. The question to be asked under this test is whether the expenditure payment would result in an enduring benefit for the business. This test was explained by Viscount Cave L.C. in British Insulated and Helsby Cables Limited v. Atherton [1926] AC 205 at p.213 :
(iv) Profit yielding structure test 108. Another test which has been formulated and adopted as a useful test is the profit yielding structure test. The question to be asked under this test is whether the expenditure in question relates to the structure within which the profits are earned or whether it relates to part of the money earning process. This was formulated by Dixon J. in Sun Newspapers Limited & Associated Newspaper Limited v. Federal Commissioner of Tax [1938] 5 ATD 87 at pp.93-94 :
(v) The 3 matters considered by Dixon J. 109. These are the major tests which have frequently been applied in various cases. Furthermore, Dixon J. in the Sun Newspapers Limited case suggested that in the consideration of this issue, several matters had to be examined. He said at p.363 :
110. It is interesting to note that similar matters were also adopted and considered by Megarry J. in the English case of Pitt v. Castle Hill Warehousing Company Limited [1974] 49 TC 638 where he said at p.644 :
111. As I understand it, counsel for the appellant did not seek to argue that I should not apply these tests or take these factors into consideration in deciding whether the interest expenses in the present case were of a capital or revenue nature. All he was suggesting was that when applying these tests or taking these factors into consideration, I should apply or consider them only in relation to the interest expenses. 112. With respect, I do not find this submission to be very helpful. As I said earlier, when applying these tests, the Court has to consider all the circumstances of the case including the purpose of the expenditure, the circumstances under which it is incurred and the purpose and nature of the loans. The various tests and/or factors for considerations are to be put into the scales in order to arrive at a conclusion using a common sense appreciation of all the guiding features in the case. It would not be proper to restrict consideration to any particular matter. (4) the Tai On Machinery case 113. Before I apply these tests and/or considerations to the facts of the present case, I should deal with the case of Tai On Machinery Company Limited v. Commissioner of Inland Revenue [1969] HKTC 411. That case dealt with provisions of the Ordinance which had no practical difference from the existing provisions I have to deal with. 114. The facts of that case were very similar to those of the present case. There the taxpayer company obtained bank facilities in the form of overdrafts for the construction of a building. Interests on the facilities were paid. Parts of the completed building were used for the company's manufacturing purposes while the other floors were let to other companies thus drawing rental income therefrom. The company claimed that the interests paid on the overdraft facilities during the construction period was deductible under s.16 and s.17(1)(c) of the Ordinance. The Board of Review held that the words "for any period" in s.16 were wide enough for the case to fall within s.16. There was no discussion or mention of s.17 (l)(c) in the decision of the Board of Review. On appeal by the Commissioner, McMullin J. held that interests paid on the overdrafts during the construction period were not a deductible expenditure, it being an expenditure of a capital nature falling within s.17 (1)(c). 115. Counsel for the appellant submitted that this decision was wrongly decided and that I should instead follow the decision in Travelodge Papua New Guinea Limited v. Chief Collector of Taxes [1985] ATC 4432. Counsel argued that the learned judge in the Tai On Machinery case had wrongly assumed that interests could only be deducted if there was a direct link between the interests and the profits generated and had no justification for distinguishing interests paid for the purchase of the land prior to and after development. Counsel also submitted that the learned judge had proceeded upon the basis of the U.K. approach of examining the status of the loan rather than that of the interest. He further argued that the learned judge had applied the U. K. approach without recognising the crucial difference between the U.K./Hong Kong legislation. 116. As I said earlier, I do not think it is proper to apply those Capital/revenue tests or considerations only to the expenditure - in this case the interest expenses - and not to take into account all the circumstances of the case. In the Tai On Machinery case, the learned judge was well aware of the different authorities in different jurisdictions with regard to the question of whether an expenditure was capital or revenue in nature. He said at p.428 :
117. It is quite clear that the learned judge had reminded himself of the similarities and differences in the legislation between the U.K., Hong Kong and other jurisdictions. He was merely considering the various tests and applying them to the facts before him. He had placed reliance on the once and for all test and the enduring benefit test as suggested in British Insulated and Helsby Cables Limited v. Atherton. I do not think the learned judge had fallen into error in referring to and applying those tests and considerations to the facts in his case. This was what he said at p.429 :
118. The learned judge also dealt with the question of whether the interests could be regarded as capital or revenue expenditure in the following paragraphs :
119. With respect to the learned judge, I think he was correct to examine the use to which the overdraft was put and to draw the distinction between interests paid on overdraft employed to produce a building and interests on overdrafts used by a company as stock of trade. One should not look at the interest or the overdraft in isolation. The interest was no doubt paid to secure the overdraft. But there must be a reason or purpose behind the obtaining of an overdraft upon which interest is paid or payable. Counsel for the appellant is of course right in saying that interest is interest and cannot be capital. But the issue to be decided is whether the interest, when looked at in the circumstances of the whole case, can be regarded as of a capital nature for the purpose of profits tax. I do not see how the learned judge can be validly criticised for taking what I would also consider as the proper approach. 120. Counsel for the appellant argued that the decision in the Tai On Machinery case would create an anomaly in that the interest incurred prior to completion of the building would be expenditure of a capital nature whereas after completion, the expenditure in the form of interest payments would be considered as expenditure of a revenue nature. I do not agree. This is because before the completion of the redevelopment, the property was still not yet an income earner apart from the meagre amount of rental income. And this income was not a relevant consideration for the decision to purchase the Depot. It was the rental after the completion of the commercial complex which was the object of the whole exercise. It was after the completion of the complex that income derived therefrom would then hopefully be applied to cover the interest on the loans as well as sufficient to repay the loans. There is clearly a difference between the situation before and after the completion of the project. This is consistent with the accounting guidelines on capitalisation of borrwing costs. I do not see any anomaly in adopting this. (5) the Travelodge case 121. Counsel for the appellant submitted that I should follow the case of Travelodge Papua New Guinea Limited v. Chief Collector of Taxes. He argued that that case dealt with a provision in the Income Tax Assessment Act 1981 (PNG) which was similar to the Hong Kong legislation. He said that the court in that case had correctly applied the test on the status of the sum sought to be deducted and not the status of the sum in respect of which the sum is sought to be deducted. On the other hand, counsel for the Commissioner submitted that that case was inconsistent with a number of cases such as Sun Newspapers Limited v. Federal Commissioner of Taxes; B.P. Australia Limited v. Commissioner of Taxation of the Commonwealth of Australia; and Commissioner of Tax v. Nchanga Consolidated Copper Mines [1964] AC 948. He also drew my attention to the fact that the Travelodge case was either not followed or was distinguished in various cases decided by the Australian Administrative Appeal Tribunal which was the equivalent of the Board of Review in Hong Kong. He argued that the Travelodge case was inconsistent with the approach adopted by the Hong Kong Court of Appeal in the Swire Pacific case and McMullin J. in the Tai On Machinery case. 122. In the Travelodge case, the taxpayer was incorporated in 1971 to construct and operate a hotel in Papua New Guinea. Construction of the hotel was completed in 1978. In its account during the construction period, the taxpayer capitalised interests on borrowed money used to finance the construction. It also capitalised outgoings on rates and rents. In 1981 and 1982, the taxpayer claimed that the interests, rates and rents incurred or paid in the years prior to the hotel earning income were deductible. This was disallowed and the taxpayer appealed to the court. The court held that the interests, rates and rents incurred prior to the opening of the hotel should be characterised as incidental and relevant to the production of the successful income from the hotel. The interests were paid for the hire of money to build the hotel and the rents and rates for the hire of the land. Both should fall within the provision allowing for deduction. The court also held that the payment of interests was not essential to the creation of an asset, and did not enhance the value of the asset. The interests were a recurrent expenditure and was paid to service money borrowed. It was not so integrally connected with the creation of the capital asset that it amounted to payment of a capital nature. The true nature of the disputed outgoings was not capital and not of a capital nature. 123. Before I examine that decision in greater detail, I would like to make two general remarks. First, the learned judge, Bredmeyer J. dealt with the same problem and a similar legislation which I have to deal with in this case. However, the learned judge applied the various tests and considerations as suggested in both the U.K. and Australian authorities to the facts before him. He did not indicate that he would prefer Australian to U.K. authorities or vice versa. Second, the learned judge seemed to have adopted an approach which was wider than that suggested by counsel for the appellant. That is to say, he went into the reason and purpose for the interest payments and the circumstances under which they were incurred and did not merely consider the nature of interest. 124. In the Travelodge case, the court dealt with s.68(l) of the Income Tax Act which was said to be identical with the s.51 (1) of the Australian Act. The learned judge set out in his judgment s.68(1) as follows:
To summarise that section in a way which is relevant for the present purpose, it reads: Outgoings which are incurred in the production of assessable income are allowable deductions unless they are of a capital nature. The learned judge there had to decide first of all whether the interest incurred or paid on the borrowed monies was incurred in the production of assessable income. This was an issue similar to that raised by s.16 (l) of our Ordinance. He took the view that it must be shown that the interest expenditure was incidental and relevant to that purpose. It is interesting to note what he said in connection with this issue at page 4435 :
125. What the learned judge there had in mind was the kind of expenditure used to secure capital which were used or closely connected with the operation or activities of the business. This would cover the paying of interest on an overdraft or a loan which was used for the ordinary daily expenses of the business or for the purchase of stock in trade. 126. With regard to the second question: whether the interest expenditure was capital or revenue in nature, the learned judge appeared to have based on the various matters which were suggested by Dixon J. in the Sun Newspapers case. He dealt with them in the following way at p.4441 :
127. In his judgment, Bredmeyer J. referred to an Australian case which was cited to him by reference of 13 C.T.B.R.(N.S.) Case 4. It was a decision of the Commonwealth Taxation Board of Review and one of its members was Mr J.D. Davies who was later to become Mr Justice Davies of the Federal Court of Australia. The facts of that Case 4 as recited by the learned judge were as follows:
128. The reasons for decision of the Taxation Board of Review was summarised by the learned judge in the Travelodge case. According to the Board, the expenditure claimed was properly characterised, not as a revenue expenditure which is deductible from assessable income, but as part of the non-deductible costs of setting up the business from which the income was derived. The Board said that the distinction between a revenue outgoing and the capital cost of establishing a business, depends upon matters of degree. It said that "the characterisation of a particular payment depends upon the application of the broad principles to the particular payment rather than upon the application of precise or definitive tests" (my emphasis). The facts of that case were, as the learned judge rightly pointed out, distinguishable from the Travelodge case. But I think the reasoning of the Chairman of the Board, Mr Davies (as he then was) was consistent with the common sense approach favoured by Lord Pearce in B.D. Australia Ltd. and I would respectfully agree with it. 129. Bredmeyer J. also referred in his own judgment the case of Somers Bay Investment Pty. Limited v. Federal Commissioner of Taxation [1880] TC 4411 which was cited to him during argument. It was a case of Jones J. of the Western Australia Supreme Court. In that case, joint venturers took out a policy against risk during the construction of a building. The policy covered the period of construction and 12 months thereafter. The taxpayer claimed the payment of premium as deduction during the year in which the building was under construction and not producing any rental income. It was reported that Jones J. held that the premium payment was an outgoing incurred in carrying on a business for the purpose of gaining or producing assessable profit but further held that it was caught by the exclusion in the latter part of the section in that it was an outgoing of a capital nature. Jones J. further held that the taxpayer by paying the premium gained the protection of its interest during the construction of the new building which when completed would constitute a fixed capital asset and that the payment was a once and for all payment and the term of the policy for a limited period. J ones J. also said that the payment of premium was in fact "integrally connected with the establishment of the capital asset", the new building. It was his opinion that the payment was directly connected with an expenditure of capital and was therefore an outgoing of a capital nature. 130. With regard to the Somers Bay case, Bredmeyer J. took the view (at p.4442) that it "was partly wrong in that part of the premium was to purchase protection against public liability, and that was a recurring need and liability. He further said that alternatively that case was distinguishable. However, the learned judge did not say anything with regard to that part of the decision of Jones J. in the Somers Bay case concerning the premium payment for the policy against risk during the time of construction. He merely cited part of Jones J.' s judgment without any comment, neither approving it nor disapproving it. In that case, some of the premium payments were made on a recurring basis while some on a once and for all basis and this must be one of the factors for consideration. However, I think Jones J. must be right in saying that since the expenditure in question was integrally connected with the establishment of a capital asset, it could be regarded as capital in nature. That is an equally important consideration which must not be ignored in deciding whether the expenditure incurred is of a capital or revenue nature. 131. It would therefore seem that there were two Australian decisions before the Travelodge case which would suggest that expenditure in similar situations would be regarded as of a capital nature. I also note that in none of the decisions of the Administrative Appeals Tribunal was the Travelodge case followed or applied. 132. As to the reasoning of Bredmeyer J. ' s own judgment in the Travelodge case, the following points can be made. First, the learned judge said that the interest paid was to service the loan obtained to build the hotel and was different in kind from the money paid to build the hotel. But it can be argued that without the payment of interest, there would be no money to build the hotel. So the interest is necessary not only to secure but also to obtain the money to build the hotel. 133. Second, he said that the payment of interest was not essential to the creation of the asset because if the company had sufficient funds it could build the hotel without borrowing. But, it was precisely because the company did not have sufficient funds that it had become necessary to borrow money from outside and to pay interest for such borrowing. The interest was in that sense essential to the funds which were necessary to create the asset. To use the words of lanes l. in the Somers Bay case, the interest so paid was integrally connected with the setting up of the hotel which was a capital asset. If one were to ask the company how much it would cost to build the hotel and if the company had sufficient funds itself, the answer would be $X. But since the company did not have sufficient funds and had to borrow and to pay interest in doing so, the company would say that it has cost it $X plus the interest paid on the loan to build the hotel. Looking at it in this way, the payment of interest is closely connected with the creation of the asset. 134. Third, the learned judge said that the hotel, when erected, was worth $6 million and that it was worth no more because it was built with borrowed funds. However, from the point of view of the company, the net value of the hotel to it after the completion of the hotel was $6 million less $X (the building cost) if it had sufficient funds itself to build the hotel but would be $6 million less $X less the interest paid if it had to borrow. 135. Fourth, the learned judge said the advantage of paying interest was that the loan would not be called up so that the hotel would be erected using the loan. While I agree with this, I would, with respect, say that there is yet another advantage in the payment of interest and that is, it plays an important part in the creation of a fixed asset. 136. Fifth, the learned judge also emphasised that the payment of rent were periodic recurring payments. But, as McMullin J. (at p.429) said in the Tai On Machinery case, each payment of interest was '"an item paid once and for all towards the bringing of that asset into-existence". 137. Finally, the learned judge in the Travelodge case seemed to place much emphasis on the analogy of payment of rent with the payment of interest as counsel for the appellant did. As I said earlier, the practical difference between rent and interest lies in how one puts to use the premises for which rent is paid or the loan for which the interest is paid. Different considerations are called for depending on the use of the loan which is secured by the payment of interest, such as whether it is used to acquire circulating or fixed assets. In my view, this difference is important in the determination of whether the payment of interest is of a capital or revenue nature. 138. Having considered the reasoning and decision of Bredmeyer J. in the Travelodge case, I would, with respect, disagree with them. I am in agreement with the reasoning and decision of McMullin J. in the Tai On Machinery case. I should perhaps also point out that the learned judge in the Travelodge case applied the three matters suggested by Dixon J. in the Sun Newspapers case while McMullin J. in the Tai On Machinery case appeared to have applied the tests and considerations suggested by Viscount Cave in the British Insulated and Helsby Cables Limited case and by Lord Dunedin in the Vallambrosa Rubber Company case. In the Sun Newspapers case, the test suggested by Viscount Cave in the British Insulated and Helsby Cables Ltd. case had been considered by Dixon J. So I do not think it is a question of whether the wrong tests or considerations had been used in the Travelodge case or the Tai On Machinery case but how they are to be applied to the facts in each case. For the reasons which I have discussed above, I would prefer to follow the Tai On Machinery case. (6) Nature of the interests in this case 139. I shall now apply the various tests and considerations to the facts of this case as I find them. I bear in mind that none of these tests or considerations would be decisive and ultimately it would be a common sense appreciation of the guiding features of the case which would provide the answer to the question as to whether the interest expenses in this case are expenditure of a capital or revenue nature. 140. For the 20 month period in question, the appellant had made various payments of interest for the loans which it had borrowed on short term basis. The size of the interest payments was of course large in itself but small when compared with the size of the loans. The interest payments were made from time to time during the relevant period. It could, in this sense, be regarded as recurrent payments. On this test or consideration, one would be more inclined to think that the interest payments in the present case have the indicia of an expenditure of a revenue nature. 141. But as Dixon J. in the Sun Newspapers case said at p.362, "The idea of recurrence and the idea of endurance or continuance over a duration of time both depended on degree and comparison". The real test is "between expenditure which is made to meet a continuance demand, as opposed to an expenditure which is made once for all" (per Rowlatt J., Ounsworth v. Vickers Limited [1915]3 KB273). By this, Dixon J. understood to mean that "the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely." But he added that "recurrence is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure" (see p.362). Hence, looking at it from the point of view of the costs to the appellant, each payment may be regarded as an accretion of capital and in that sense, they may be regarded as items paid once and for all towards the bringing about of an asset, that is, the Depot. 142. Then there is the fixed or circulating capital test. The interests were paid upon the loans granted by various financial institutions and/or banks. These loans were used to finance the purchase of the Depot which was an asset or fixed capital of the appellant. In other words, the, interest payments were made and the expenses incurred for the purpose of and in close connection with the acquisition of a fixed capital of the company. It is to be contrasted with the situation where the appellant had borrowed money from the banks and/or financial institutions for use as circulating capital of the business. If a company is short of liquid cash and requires an overdraft account or short term loans from the bank in order to meet the daily expenses of the business, such as the payment of rent, salaries, utilities etc., the amount withdrawn from the overdraft account or borrowed from the bank would be used as circulating capital. The interest paid or payable on these loans or overdraft accounts would therefore be regarded as closely connected with or incurred for the purpose of acquiring circulating capital for the business. It is also different from the situation where a company borrows from the bank to acquire stock in trade which would be sold or used up in the course of the business. The borrowed money in these situations would be used as circulating capital and the interests paid thereon would be of revenue nature. The interest payments in the present case are certainly not within these categories. 143. As to the enduring benefit test, it is my view that the interest payments were made to secure the loans which were to be used to acquire the property. In other words, the expenditure in the form of interest payments was incurred with a view to bringing, albeit indirectly, into existence the property which was to be a fixed asset of the appellant. This property would add to the overall asset or capital of the appellant and would have an enduring benefit for the company. Looking at it in that way, the interest expenses would, in my view, be regarded as attributable not to revenue but to capital. Similarly one would come to the same conclusion when applying the profit yielding structure test. The loans were made to purchase the Depot which would be redeveloped into a commercial complex. The commercial complex would in due course generate rental income for future years of assessment. In other words, the Depot, after its redevelopment, would be a profit yielding structure for the appellant. The interests payable on the loans would be regarded as closely or integrally connected with the establishment of the new profit yielding structure of the appellant. 144. I now come to consider the three matters suggested by Dixon J. in the Sun Newspapers case. First, what was the character of the advantage sought? The advantage to be gained by the payment of interest was to secure the use of the loans. As long as interest was paid, the appellant would continue to have the benefit of the loans or the use of the money. However, in a commercial enterprise, it does not make sense to borrow money and pay interest without a purpose. Although on the face of it, the advantage in paying interest was to buy time, it was in fact to obtain the use of the money for the time being. The money was used for the purchase of the Depot. Without the loans, the appellant would have to obtain the necessary finance from either its parent company or associated companies through inter company accounts, or might not have sufficient funds to buy the property. In my view, the advantage gained by the payment of interest was in effect to enable the appellant to obtain the money in order to acquire a fixed asset. 145. What then was the manner in which the advantage was used, relied upon or enjoyed? The loans which was secured by the payment of interest was used to purchase the Depot for redevelopment and long term investment. This acquisition had a degree of permanence. The Depot was to be redeveloped into a commercial complex which would be held for some time and let out to generate rental income in future. The money borrowed by means of the payment of interest was not used as circulating capital in the business or for the buying of raw material or stock in trade. 146. What was the means adopted to obtain the advantage? This was to be achieved by the payment of interest, that is by a periodical payment in order to have the continued use of the money. In this respect, it would look like an expenditure of a revenue nature. However, each payment of interest from the commencement of the redevelopment project to its completion added to the cost of the whole project. The ultimate result was that the payment of interest was an accretion to the capital asset of the appellant. 147. In deciding whether the interests paid in the present case during the period in question should be regarded as capital or revenue in nature, it is also worthwhile to mention the accounting evidence. The accounting guidelines seem to prefer the capitalisation of interest on borrowed funds where the borrowed costs are significant to the enterprise and the asset acquired requires a substantial period of time to get it ready for use or sale (Articles 4 and 6 of Statement 2.205 and Articles 5,8 and 22 of IAS). This case would appear to fall within that sort of situation. In fact, the appel1ant had adopted such a policy and this was stated in its accounts. This indicates that the appellant had accepted at least in principle that the interests which would have to be incurred on the loans should be considered as part of the capital costs of the redevelopment. The reasons for not capitalising such interests in the accounts during the period relevant to this appeal were that actual construction work had not commenced and that the property was still receiving licence rental from Tramways. I do not think they were satisfactory reasons. Preliminary work had already been carried out and the expenses incurred in connection therewith were indeed capitalised. That is to say, the appellant had considered that activities to get the property ready for use or sale had begun. Further, as to rental income from Tramways, the evidence clearly shows that this was not regarded by the appellant as of any importance and the appellant would have purchased the Depot with or without such rental income. 148. I have earlier referred to the decision of the Hong Kong Board of Review in Case No D 12/88. The facts of that case bear some resemblance to those in the present case. The Board (chaired by Mr Litton Q.C. as he then was) held that the interest costs in that case were not deductible and took the view that s.17 should be construed in the same way as s.40(1)(a). The definition of "capital expenditure" in s. 40(1)(a) includes interest paid in respect of a loan made for the sole purpose of financing a commercial building. This is of course expressed to be applicable to Part VI only. But in my view, the rationale behind this definition must be this. Part VI deals with the permissible allowance due to depreciation of the capital asset of the enterprise. In this connection, the legislation sees fit to include interest paid on a loan to finance the project as part of the capital expenditure for the purpose of calculating depreciation allowance on the capital asset of the business. In other words, the interest paid can be regarded as part of the costs of the capital asset which is subject to depreciation. The same rationale should apply to "expenditure of a capital nature" in s. 17(1)(c). 149. At the end of the day, having considered all the facts and the circumstances of this case and applying the various tests and considerations to them, I have come to the conclusion that the interest expenses in the present case must be regarded as an expenditure of a capital nature. They fall within s.17(1)(c). Conclusion 150. For the reasons which I have set out above, I am of the opinion that the interests paid by the appellant during the period between 3rd August 1987 and 20th March 1989 fall within s.16 (1)(a) but are excluded under s.17(1)(c). These expenses cannot be allowed as deductible expenses in ascertaining the chargeable profits for the two relevant years of assessment. The Commissioner conceded that an allowance may be made in respect of and to the extent of the licence income received from Tramways and disallowed only the excess of the interests paid over the licence income received during those periods of assessment. I think that was a generous concession. He was right in not allowing the deduction of the balance of the interest expenses. This appeal is therefore dismissed. I would also make an order nisi of costs against the appellant. 151. Finally, I would like to take this opportunity to express my thanks to all counsel for the most helpful assistance they had rendered me in this appeal.
Mr John Gardiner, Q.C. and Mr Stewart Wong, inst'd by Messrs Baker and McKenzie, for the Appellant Mr Barrie Barlow, inst'd by the Attorney General's Chambers, for the Respondent |
Cases cited in this judgment