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 accounting period.
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 of law.
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 restricted meaning.
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 IRO.
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 Ordinance”.
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 deductible
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 this case.
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 Commissioner.
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 (ii).
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 controversial.
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
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