Is a taxpayer liable to profits tax on a lump sum payment received on termination of a contract?

The Court of Final Appeal (CFA) of Hong Kong ruled on December 15, 2014 that a lump sum received on termination of a contract is not chargeable to profits tax under section 14 of the Inland Revenue Ordinance.

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Background

Aviation Fuel Supply Co v Commissioner of Inland Revenue

The taxpayer entered into a franchise agreement with the Airport Authority. Under the Concession Agreement, the Airport Authority granted the Taxpayer a concession to design and construct aviation fuel supply facilities at the Hong Kong International Airport at Chek Lap Kok. The agreement also contained provisions for the Airport Authority to grant the Taxpayer a 20-year lease for the aviation fuel supply facility and the Taxpayer had the right to appoint an operator to operate and maintain the facility.

The taxpayer designated an affiliate as the operator of the Aviation Fuel Supply Facility and entered into an operating agreement with the Airport Authority. The operator earns fees from users of the facility and makes periodic payments to the taxpayer, which are expected to help the taxpayer recover the costs incurred in building the facility.

Under the above franchise agreement, the Airport Authority has the right to terminate the taxpayer’s franchise and lease of the facility after a certain period of time and elects to make a payment to the taxpayer. The payment is based on future user fees expected to be collected and is calculated on a net present value basis.

Upon the expiration of the term, the Airport Authority terminated the Taxpayer’s right to the concession and lease and made a lump sum payment to the Taxpayer of the equivalent of USD 449,000,000 as described above.

The taxpayer argued that the payment was made by the Airport Authority for the acquisition of its business and was therefore a capital receipt for the relinquishment of its business, which was not chargeable to profits tax under section 14 of the Inland Revenue Ordinance. However, the Inland Revenue Department (IRD) is of the view that the amount can be regarded as a substitute for the payment for the facilities and should therefore be taxed as income under section 14 of the IRO or as a transfer of the right to receive income from property for the purpose of computation under section 15(1)(m) and section 15A of the IRO.

Controversies

There were two main issues in this case:

Is the amount received by the taxpayer on termination of the franchise agreement subject to profits tax?

Whether the disposal of a loan for which capital allowances had been claimed would attract a balancing charge?

The Lower Court’s Decision

This case was the subject of a number of appeals. On appeal to the Court of First Instance, the Court of First Instance held that a lump sum payment made by the Airport Authority to the taxpayer could not be regarded as being derived from the taxpayer’s business. Even if the payment was derived from the taxpayer’s business, it was a capital gain on the renunciation of its business. Therefore, it is not chargeable to profits tax under section 14 of the Inland Revenue Ordinance. Further the Court of First Instance also pointed out that even if it was held that the right to the revenue had been transferred to the Airport Authority, the legal interest in the property would be transferred to the Airport Authority along with the right to receive the revenue and that section 15(1)(m) and section 15A of the Inland Revenue Ordinance would not apply.

On appeal to the Court of Appeal, the Court of Appeal also ruled in favor of the taxpayer. The Court held that the amount was not earned in the course of business but arose outside the course of business activities. It was also not a replacement or compensation for the loss of the loan. The taxpayer did not transfer to the Airport Authority the right to receive the income from the business. Since the Airport Authority succeeded to the business and the aviation fuel supply facility had been passed by way of succession, it could not collect the balancing charge under sections 39B(7) and 39D(3) of the Inland Revenue Ordinance.

In the end, the IRD has not appealed against section 14 of the Inland Revenue Ordinance for treating the lump sum as revenue, or under sections 15(1)(m) and 15A of the Inland Revenue Ordinance. The IRD has only applied for leave to appeal to the Court of Final Appeal (CFA) as to whether a balancing charge should be imposed on the taxpayer as a result of the sale of the assets.

The Court of Final Appeal’s ruling

In December 2014, the Court of Final Appeal (“CFA”) handed down its judgment. The CFA held that the important issue it needed to decide was whether the Taxpayer should have been allowed to raise the issue of the balancing tax at the last minute before the Court of Appeal hearing.

The CFA held that the taxpayers had in fact sold the facilities and machinery to the Airport Authority in the course of succession to the business. Sections 39B(7) and 39D(3) of the Inland Revenue Ordinance therefore did not apply and the industrial building structures and prescribed fixed assets might give rise to a balancing charge even if they were transferred to the Airport Authority by way of succession rather than sale.

However, although revised assessments under section 67(7) of the Inland Revenue Ordinance are not subject to the six-year statutory limitation period, it would be unfair to deprive the taxpayer of the protection of the normal six-year limitation period. The Court of Appeal (CA) is empowered to entertain IRD’s advice on the taxation of a taxpayer’s balances only if it has acted fairly. The Court of Final Appeal therefore dismissed IRD’s appeal. As the Court of Final Appeal dismissed the IRD’s appeal, it was not necessary for the Court to decide whether the lump sum payment made by the Airport Authority was subject to balancing charge.

Conclusion This tax case is a useful reference on the taxability of lump sum payments in relation to termination of contracts. However, the question of balancing tax, particularly whether there is inheritance when the plant and machinery passes to a successor other than by sale, depends on the facts. Each case should be decided on its own merits. If you are in any doubt, please consult a tax or legal professional.