While the non-taxability of such unrealised gains from
trading stock is now clear, the deductibility of unrealised
losses may in some instances still be unclear.
And taxpayers should also note that year-end translation
gains of an asset denominated in a foreign currency may not be
regarded as being unrealised for tax purposes.
Trading in marketable securities
Nice Cheer Investment Limited (NCIL) carried on a business
which consisted of trading in marketable securities quoted on
the Stock Exchange of Hong Kong.
Before the application of the new accounting standards (that
is, SSAP 24 and HKAS 39), the trading stock of NCIL in the form
of marketable securities was valued at the lower of cost and
net realisable value on the balance sheet date. This approach
mirrored that adopted by traders of goods in general and
resulted in unrealised increases in the value of its listed
securities during an accounting period not being reflected in
its profit and loss account or tax computation.
The relevant new accounting standards required, however,
that securities held for sale at the end of an accounting
period had to be valued at their fair market value on the
period-end date. Under the new accounting standards, any
unrealised revaluation gains or losses had to be credited or
debited to the profit and loss account for the relevant
Adopting the new accounting standards for the years of
assessment 1999/2000 to 2005/2006, NCIL duly recorded in its
profit and loss accounts for the relevant years not only
profits or losses which it had realised by the sale or disposal
of its listed securities, but also unrealised gains and losses
arising from the revaluation of its listed securities held at
the end of the relevant years.
In its tax returns for the relevant years, NCIL excluded the
unrealised gains from assessments but claimed deductions for
the unrealised losses.
The commissioner of Inland Revenue (CIR) determined,
however, that both the unrealised gains and losses arising from
revaluing the listed securities held at the year-end should be
included in NCIL profits tax computations.
The differential between the profits tax thus assessed over
the years and that calculated by NCIL without taking into
account the unrealised gains was very substantial, being in the
region of HK$250 million ($32 million).
NCIL appealed against the CIR’s determination
directly to the courts, bypassing the Board of Review. The
lower courts decided the case in favour of NCIL. The CIR
then appealed to the Court of Final Appeal (CFA).
The CIR’s case
In the CFA the CIR argued that:
- The word "profits" is not defined in the Inland Revenue
Ordinance (IRO), and in the natural and ordinary meaning of
the word unrealised profits are nonetheless profits;
- The amount of the profits during the year of assessment
is primarily a question of fact; and
- The amount of any profits or losses during the year of
assessment must be ascertained by reference to ordinary
principles of commercial accounting unless these are contrary
to an express statutory provision in the IRO.
Decision of the Court of Final Appeal
The judgment of the CFA in this case was given by Lord
Millet, a non-permanent judge of the court, the other four CFA
judges sitting on the case agreeing with the judgment without
adding any individual comments or observations.
What constituted profits for tax purposes and whether a
question of law was involved?
The judge noted that while the amount of any profits, as the
CIR submitted, is a question of fact, what constitutes
"profits" within the meaning of the IRO and whether any
disputed amount represents an assessable profit are questions
Specifically, he rejected the CIR’s reliance on
the case of Re Spanish Prospecting Co Ltd  1 Ch 92 CA as
supporting the CIR’s argument that unrealised
profits were nonetheless taxable profits under the IRO.
On this, Judge Millet noted that:
… the Commissioner’s reliance on that case
was misplaced, since the context in which the word "profits"
was used was completely different. What was in issue was
the meaning of the word "profits" in a contract of employment
where the employee’s salary was payable only out
of the company’s profits…It has been
repeatedly recognised in many different jurisdictions that when
considering the meaning of the word "profits" in the Spanish
Prospecting case Fletcher Moulton LJ [the judge in that case]
was not dealing with its meaning in the context of taxation;
and that in that context the word has always been given a more
The judge then cited the two cardinal principles of tax law
as established by a long series of tax cases, that is, that for
income tax purposes: (i) the word "profits" connotes actual or
realised and not potential or anticipated profits; and (ii)
neither profits nor losses may be anticipated.
Relevance of the principles of commercial accounting
The CIR submitted that the amount of any profits or losses
during the year of assessment must be ascertained by reference
to the ordinary principles of commercial accounting unless
these are contrary to an express statutory provision in the
For this, the CIR relied on the decision of the CFA in
December 2000 in the case of Commissioner of Inland Revenue
v Secan Limited 3 HKCFAR 411. Interestingly,
Judge Millet also delivered the judgement in this case.
In particular, the CIR relied on this passage of the
judgement in the Secan case in support of the
CIR’s above submission:
Both profits and losses therefore must be ascertained in
accordance with the ordinary principles of commercial
accounting as modified to conform with the Ordinance. Where the
taxpayer’s financial statements are correctly
drawn in accordance with the ordinary principles of commercial
accounting and in conformity with the Ordinance, no further
modifications are required or permitted.
Relying on this passage, the CIR argued that there was no
express provision of the IRO to exclude unrealised profits. As
such, the CIR contended that profits, both realised and
unrealised, as reflected in the accounts of NCIL, which were
prepared in accordance with the ordinary principles of
commercial accounting, should be taxed.
On this, Judge Millet ruled that the CIR had misread his
judgment in the Secan case. He pointed out that what
he said in Secan was "in conformity with the
Ordinance", not "in conformity with an express provision of the
Judge Millet then went on to explain that:
[w]hile the amount of that profits must be computed and
ascertained in accordance with the ordinary principles of
commercial accounting, these are always subject to the
overriding requirement of conformity, not merely with the
express words of the statute, but with the way in which they
have been judicially interpreted.
As such, the two cardinal principles of interpreting tax law
cited earlier by the judge, that is, that (i) the word
"profits" connotes actual or realised and not potential or
anticipated profits; and (ii) neither profits nor losses may be
anticipated, remained relevant.
Judge Millet concluded that:
[i]t is clear beyond argument that accounts drawn up in
accordance with the ordinary principles of commercial
accounting must nevertheless be adjusted for tax purposes if
they do not conform to the underlying principles of taxation
enunciated by the courts even if these are not expressly
stated in the statute… In particular, the principles
of commercial accounting must give way to the core principles
that profits are not taxable until they are realised and that
profits must not be anticipated.
On the basis of this, the judge held that the unrealised
gains on the revaluation of listed securities held for sale on
the relevant year-end date as reflected in the accounts of NCIL
were not chargeable to tax in Hong Kong.
Whether unrealised revaluation losses on trading stock are
In NCIL, the CIR only contended that the unrealised
revaluation gains from listed securities held at year-end were
chargeable to tax in Hong Kong. The CIR did not mount an
alternative argument that if the unrealised revaluation gains
were held to be non-taxable, the corresponding unrealised
revaluation losses should not be deductible.
As such, whether the unrealised revaluation losses on listed
securities held at year-end were deductible was not at issue in
Even so, in his judgment in NCIL, Judge Millet
explained why under the two cardinal principles of tax law
cited above, unrealised revaluation losses from trading stock
are generally deductible while unrealised gains from the same
are not chargeable to tax:
[b]ut it does not follow that an unrealised loss cannot be
used to reduce liability for profits tax. In a proper case
this can be achieved by making provision in the profit and
loss account for the diminution in the value of trading stock
during the accounting period. At first sight this seems to be
merely another way of anticipating unrealised losses, but it
is not. The auditors will not normally allow such a provision
to be made unless they are satisfied that the diminution in
value is material and likely to be permanent. Moreover, if
such a provision is made it can be challenged by the
He then went on to use this example to explain the
difference between making a provision for a diminution in
value, and substituting market value for cost in accordance
with accounting standards SSAP 24 and HKAS 39:
Suppose the value of an item of trading stock which cost
$100 fluctuates between $95 and $105 during the accounting
period and is worth (i) $102 or (ii) $98 at the end of the
period. The application of the [two cardinal] principles of
taxation results in neither taxable profit nor allowable loss
in either case (because the profit in (i) is unrealised and the
loss in (ii) does not justify a provision). Under the new
accounting standards, however, the financial statements will be
required to show a profit of $2 in (i) and a loss of $2 in
It is welcome that the CFA reaffirmed the two cardinal
principles of tax law that (i) the word "profits" connotes
actual or realised and not potential or anticipated profits;
and (ii) neither profits nor losses may be anticipated.
Taxpayers should however note that according to the judgment
in this case, it appears that only those provisions for
diminution in value of trading stock which are material and
permanent in nature would qualify for a tax deduction.
As such, the IRD may challenge deductions for year-end
revaluation losses from trading stock which by its nature
fluctuates widely (such as the listed securities in NCIL), the
argument being that the losses in question are not permanent
enough to justify a deduction.
Taxpayers should also note the comments made by Justice To
in the Court of First Instance (CFI) in NCIL that
year-end translation gains from assets held in a foreign
currency would not be regarded as being unrealised for tax
purposes. In this regard, Justice To remarked that "[p]roperly
understood, [the taxing of translation gains] was not a case of
taxing on anticipated profits, but on actual accrued profits
valued on balance sheet date."
Judge Millet did not express his view on these comments in
the CFI. As such, the issue of the taxability or deductibility
of year-end translation gains or losses especially for
non-financial institutions could still remain
This is the case because Justice To’s comments
in NCIL in the CFI could possibly be regarded as only
being a general remark, not forming part of his reasoning for
the decision of the issue in dispute in the case.
Tracy Ho (firstname.lastname@example.org
), Tax managing partner, EY HK and Macau
Patrick Kwong (email@example.com
), Executive director, EY