First, 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 unrealized profits are nonetheless profits.
Secondly, the amount of the profits during the year of assessment is primarily a question of fact.
Thirdly, 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.
The judgment of the CFA in this case was given by Lord Millet NPJ, 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?
Lord Millet NPJ 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, Lord Millet NPJ 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 unrealized profits were nonetheless taxable profits under the IRO.
In this regard, Lord Millet NPJ 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 recognized 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.”
Lord Millet NPJ then cited the two cardinal principles of tax law as established by a long series of tax cases, namely that for income tax purposes: (i) the word “profits” connotes actual or realized 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.
In this regard, 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, the judgment of the CFA in the Secan case was also delivered by Lord Millet NPJ.
In particular, the CIR relied on the following passage of Lord Millet NPJ 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 the above quoted passage, the CIR argued that there was no express provision of the IRO to exclude unrealized profits. As such, the CIR contended that profits, both realized and unrealized, as reflected in the accounts of NCIL, which were prepared in accordance with the ordinary principles of commercial accounting, should be taxed.
In this regard, Lord Millet NPJ ruled that the CIR had misread his judgment in the Secan case. Lord Millet NPJ pointed out that what he said in the Secan case was “in conformity with the Ordinance”, not “in conformity with an express provision of the Ordinance”.
Lord Millet NPJ 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 Lord Millet NPJ, namely that (i) the word “profits” connotes actual or realized and not potential or anticipated profits; and (ii) neither profits nor losses may be anticipated, remained relevant.
Lord Millet NPJ 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 realized and that profits must not be anticipated.”
On the basis of the above, Lord Millet NPJ held that the unrealized 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 unrealized revaluation losses on trading stock are deductible
In NCIL, the CIR only contended that the unrealized revaluation gains in respect of the listed securities held at year end were chargeable to tax in Hong Kong. The CIR did not mount an alternative argument that if the unrealized revaluation gains were held to be non-taxable, the corresponding unrealized revaluation losses should not be deductible.
As such, whether the unrealized revaluation losses in respect of listed securities held at year end were deductible was not at issue in this case.
Nonetheless, in his judgment in NCIL, Lord Millet NPJ did explain why under the two cardinal principles of tax law cited above, unrealized revaluation losses in respect of trading stock are generally deductible whilst unrealized gains in respect of the same are not chargeable to tax.
Lord Millet NPJ stated that “[b]ut it does not follow that an unrealized 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 unrealized 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.”
Lord Millet NPJ then went on to use the following 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 unrealized 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).”