In this case, the company challenged the capital nature of a permanent export quota required for trading.
The Court of First Instance set out several tests to test the capital nature of an expense and ruled in 2008 that even though the permanent quota was limited in duration, it was still inherently capital in nature and therefore the expense was not allowed to be deducted from the calculation of assessable profits.
Canton Industries Ltd. v CIR
At the beginning of the millennium, there was a company engaged in the textile industry which exported textile products to Europe and the United States. At that time, no company could export textile products to Europe and the United States without a quota. At that time, Hong Kong had two types of textile quotas that were transferable. They were permanent quotas and temporary quotas.
Permanent quotas gave the quota holder the right to use the quota allocation year after year for the duration of the quota period, provided that he or she had used a certain percentage of the quota in the previous year. Temporary quotas, on the other hand, only give the holder the right to use the transferred quota for the relevant year, and generally, there will be no further allocation of quota for the following year.
The textile export company in this case has both permanent and temporary quotas as part of its business. The company’s accounting policy is to use the permanent quota and write it off on a straight-line basis over the useful life of the quota. The permanent quota is classified as a non-current asset in its balance sheet. Conversely, the Company considers temporary quota as part of its cost of textile sales and is included in its income statement.
However, the quota system is expected to end on December 31, 2004 as a result of the PRC’s formal membership in the World Trade Organization at the beginning of the millennium. As a result, the permanent quotas granted to the Company in the relevant years are also expected to be valid only for a short period of time.
The Company therefore deducted the expenses related to the permanent and temporary quotas from the calculation of assessable profits for the financial years 2000/01 to 2004/05. The Commissioner of Inland Revenue agreed that the income earned and expenses incurred from the temporary quota transactions were revenue in nature and therefore deductible. However, at the same time, the IRS rejected the Company’s claim in its tax return that the use of the permanent quota was an expense of a capital nature. Therefore, under section 17(1)(c) of the IRO, the relevant expenses were not allowed to be deducted from the computation of assessable profits.
The Company appealed, but the Board of Review upheld the Commissioner’s decision and dismissed the Company’s appeal.
The main issue in this litigation was whether the expenses incurred by the company in acquiring the permanent quota were capital in nature.
The Textile Company argued that its permanent quota holdings were in fact limited in duration because the quota system was expected to end in 2004. By writing off the acquisition cost of permanent quotas over the life of the quotas, the company is effectively prorating the expense to a specific year as part of the cost of sales incurred in that year.
In this case, there is no meaningful distinction between permanent and temporary quotas. If temporary quotas are not capital expenses, then permanent quotas are not capital expenses either.
Court of First Instance’s Decision
The Court of First Instance agreed with the decision of the Board of Review and dismissed the Textile Company’s appeal.
The Court held that the duration of the quota was not determinative. Rather, once the permanent quota was acquired, the quota would become part of the earnings structure or fixed capital of Textile’s business. This provides a lasting benefit to the company in the form of continued trading capacity with Europe and the United States; and in the form of income from the transfer of permanent quotas. Although the duration of the quota may not be very long, this transience is not conclusive.
Moreover, unlike temporary quotas that companies purchase from time to time, as needed, in different years, the purchase of permanent quotas is a “once and for all” expense. With a permanent quota, the company only needs to keep its exports at a certain level and the company can use the exclusivity attached to the quota to generate trading profits for the duration of the quota.
Therefore, once a permanent quota is held, it should be incorporated into the company’s earnings structure or fixed capital.
Finally, the court also noted that the expenditure of the permanent quota was not of a circular or recurring nature and did not have the characteristics of a periodic expenditure incurred as part of the process of generating periodic returns through the textile trade.
The Textile Company’s appeal was therefore dismissed.
In this case, the court set forth several tests to test the capital nature of an expense, namely
The “lasting benefit” test: This test considers whether the expenditure builds an asset to realize a lasting benefit from the trade.
The “once and for all” test: This test considers whether the expenditure is a one-time, “once and for all” thing
“Fixed or liquid capital” test: This test considers whether expenses are incurred in relation to fixed capital that do not require further action to generate revenue for the business.
The “profitability structure” test: This test considers whether expenses are incurred to create, replace or expand the business structure in order to generate profits.
As long as one of these tests yields a “yes” result, the expenditure is likely to be capital in nature.
It is important to note, however, that the court also noted that the above tests are not necessarily conclusive. Each expense is different in nature, depending on the circumstances, and sometimes it is difficult to determine whether an expense is capital in nature. Therefore, if you have any questions, please consult a tax or legal professional.