Whether income arising from the sale of land is chargeable to profits tax?
The Court of Final Appeal (CFA) overturned the lower court’s decision and held that the taxpayer had not changed his intention to hold a piece of land as a capital asset. The money received by the taxpayer under the redevelopment agreement should be regarded as “capital” rather than “income” in nature and therefore not subject to profits tax.
BACKGROUND
Perfekta Enterprises Limited (Perfekta) v Commissioner of Inland Revenue
The taxpayer is engaged in the manufacture of toys and has owned a piece of land in Hong Kong since the 1960s and 1970s. The building on the land was used as a manufacturing plant until 1987. From 1991 to 1993, the taxpayer submitted various applications to the Government for redevelopment of the land.
Subsequently, the Board of Directors of the taxpayer discussed the developer’s proposal to redevelop the said land and decided that any joint development with the developer should be carried out by a subsidiary. In July 1994, the Taxpayer entered into a redevelopment agreement with the Developer. Under the agreement, the taxpayer was to receive a sum of HK$165 million from the developer’s subsidiary. The taxpayer transferred ownership of the land to its wholly-owned subsidiary and caused it to enter into a new joint venture agreement with the developer’s subsidiary for the redevelopment project.
The Taxpayer then transferred the Land to its wholly-owned subsidiary, which also entered into a new joint venture agreement. The taxpayer also received the down payment under the redevelopment agreement.
The Inland Revenue Department (“IRD”) considered the downpayment to be revenue in nature and raised a profits tax assessment against the taxpayer. The taxpayer disagreed with the IRD’s decision and appealed to the Board of Review, which ruled in favor of the taxpayer. The IRD appealed to the higher courts on a number of occasions. This tax case was finally appealed to the Court of Final Appeal.
Disputes
Both the Court of First Instance and the Court of Appeal held that the taxpayer had changed his intention from holding land as a capital asset to trading stock. Therefore, the down payment was essentially trading income and was chargeable to profits tax.
The taxpayer appealed to the Court of Final Appeal (“CFA”), arguing that the holding of land as a capital asset and the downpayment were in essence capital receipts and not subject to profits tax. Moreover, any intention to trade was the intention of its subsidiary, which was a separate legal entity.
Court of Final Appeal’s ruling
The CFA unanimously ruled that the taxpayer had not changed its intention with respect to the land and had not formed a joint venture in the nature of a trade to dispose of the said land.
The Court of Final Appeal held that the fact that a subsidiary of the taxpayer was utilized for the redevelopment of the land was very important. In limited circumstances, the court could disregard the principle that a parent company and its subsidiary are two separate legal entities. However, there was no indication that such circumstances applied in this case, nor had the IRD sought to invoke them. The CFA pointed out that the lower court had wrongly overlooked the fact that the taxpayer’s subsidiary was a separate legal entity and had set up a trading joint venture in its own name to redevelop the land. The redevelopment agreement had clarified the taxpayer’s intention that any redevelopment of the land would be carried out by the subsidiary and not by the taxpayer. Thereafter, the subsidiary was formed to fulfill its role in the redevelopment, became the owner of the land and entered into a subsequent agreement with the developer to which the taxpayer was not a party.
In this regard, the CFA held that the steps taken by the taxpayer to enhance the value of the land by obtaining planning permission, variations to the government lease and approval of building plans were exactly the same as the steps taken to dispose of the land as capital. Disposing of an asset at the best price available did not necessarily indicate that the taxpayer intended to enter into a joint venture to carry out the transaction.
The CFA also rejected the IRS’s alternative argument that the taxpayer was engaged in a sourcing trade or business and procured a subsidiary to form a reconstruction joint venture. The taxpayer was a toy manufacturer and had held capital assets in the form of land for a long period of time. The land transaction in question is essentially a disposal of a capital asset. The “procurement” of the joint venture for the developer was not part of the taxpayer’s business.
The Court of Final Appeal therefore ruled that the taxpayer had not changed its intention in relation to the land and had not entered into a transaction of a trade in nature to dispose of the land. The money received by the taxpayer under the redevelopment agreement should be regarded as “capital” rather than “income” in nature and not subject to profits tax.
Conclusion
The decision in this tax case is an important one. The Court of Final Appeal has provided clear analysis and guidance on the various issues of whether a taxpayer is liable for profits tax when disposing of land in the course of redevelopment.
The question of whether there is an intention to change is a question of fact and depends on the specific facts and circumstances of each case. In resolving the issue in this case, the CFA evaluated various documents, events (both before and after the execution of the agreement) and factors. As such, this decision demonstrates the importance of carefully structuring the wording of transactions and contractual documents, as well as preserving other documentary evidence. If you have any questions, please consult a tax or legal professional.
