Aviation Fuel Supply Co v CIR - -	Taxability of income under sections 14, 15(1)(m) and 15A of the Inland Revenue Ordinance

On 8 July 2011, the Court of First Instance (the "CFI") made its judgment in Aviation Fuel Supply Company v Commissioner of Inland Revenue. The court case illustrates the importance in correctly identifying the nature of a taxpayer’s income when determining the taxability of its profits under section 14 of the Inland Revenue Ordinance (the "IRO") and made an interpretation on the transfer of a right to receive income within the meaning of sections 15(1)(m) and 15A. Background The case of Aviation Fuel Supply Company (the "taxpayer") is summarized as follows: The HK Airport Authority (the "Authority") and the taxpayer entered into a Franchise Agreement (the FA), pursuant to which the taxpayer was responsible for financing, designing, constructing and commissioning the aviation fuel service system (the Facility); Pursuant to the FA, the Authority and the taxpayer also entered into a lease ("the Lease") under which the Authority granted the right to occupy certain premises (known as the Facility Area) as a tenant to the taxpayer for a period of 20 years; The Authority and a nominee company of the taxpayer (the Operator) entered into an Operating Agreement (the OA), pursuant to which the Operator was responsible for operating and maintaining the Facility; and The taxpayer further granted a licence to the Operator to use the Facility Area for the purposes of observing and performing its obligations under the OA. Pursuant to the OA, the Operator was obligated to make monthly Facility Payments to the taxpayer. In the event the Authority elected to make the Accelerated Facility Cost Payment to the taxpayer, the Facility Payments would thereafter be payable by the Operator to the Authority instead of the taxpayer to recover the cost of the Accelerated Facility Cost Payment. In 2002, the Authority made the election for accelerated payment. Then, a lump sum of around US$449 million ("the Sum") was paid to the taxpayer and the Facility vested in the Authority. Issues The issue in dispute was whether the Sum was chargeable to profits tax under sections 14, 15(1)(m) and 15A of the IRO. Issue 1: Should the Sum be chargeable to profits tax under section 14 of the IRO In resolving Issue 1, the CFI had considered the 3 questions below: 1. What was the taxpayer's trade or business? The CFI agreed with the taxpayer that it was carrying on a business of developing the Facility for its own benefit and exploiting or operating the Facility with a view to profit rather than developing the Facility as a service to the Authority for a profit. Since the Facility Payments were made by the Operator to the taxpayer (for the Operator's right to use the Facility), as opposed to by the Authority to the taxpayer (for the taxpayer's provision of services in respect of the Facility), the CFI then concluded that the taxpayer, and not the Authority, was the owner of the Facility. 2. Did the Sum represent a profit arising from the taxpayer's trade or business? The CFI took the view that the Sum was not a replacement of the Facility Payments because the nature of the Sum was fundamentally different from that of the Facility Payments. The Sum was made for the purposes of preventing future Facility Payments payable to the taxpayer rather than to compensate for the unpaid Facility Payments that had become due. Hence, the Sum was not considered as a profit arising from the taxpayer's business. 3. Was the Sum capital or income in nature? The CFI held that the Sum is capital in nature on the following grounds: a. The Sum was made to terminate the taxpayer's business and resulted in a change of ownership of the Facility. b. The fact that the calculation of the Sum was based on the future Facility Payments (which is revenue in nature and taxable) during the unexpired lease term is irrelevant. c. The unexpired lease term of the FA is 15 years, which tends to suggest that the Sum is capital in nature. d. The taxpayer treats the Facility as its fixed assets in its books of account and claims tax depreciation allowances on the Facility. This indicates that the taxpayer's intention was to keep the Facility for generating income before the time of disposal, even though there is an option in the FA for the Authority to make the Accelerated Facility Cost Payment and to take over the Facility. Issue 2: Should the Sum be chargeable to profits tax under sections 15(1)(m) and 15A of the IRO For issue 2, the Court also held that the Sum was not chargeable under sections 15(1)(m) and 15A on the following grounds: a. The extinguishing of the right of the taxpayer to receive the Facility Payments from the Operator and the arising of the right of the Authority to receive payments from the Operator does not constitute to a "transfer of a right" within the meaning of sections 15(1)(m) and 15A as the two sets of rights are different and independent. b. Even if a transfer of right was concluded, the exception in section 15A(3) applies as the taxpayer’s ownership of interest in the property (i.e. the Facility) was also transferred to the Authority together with the transfer of the right to receive income. Implications Capital vs. revenue The judgment of CFI shows that the purpose of making the payment and the effect of the payment are crucial in determining its nature whereas the basis or computation method of arriving at the amount payable is irrelevant. Interpretation of sections 15(1)(m) and 15A of the IRO The CFI interprets that the extinguishing of one set of rights together with the arising of another set of new rights are different from an assignment of the right to use a property and is not to be regarded as a "transfer of a right" within the meaning of sections 15(1)(m) and 15A. 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