Hong Kong Tax Alert: 2 January 2013
Facts and issue in dispute
The following two diagrams depict the key arrangements of the case.
In December 1995, the Airport Authority (the Authority) entered into a franchise agreement with Aviation Fuel Supply Company (AFSC). AFSC was a limited partnership formed by aviation fuel suppliers and airline companies.
Under the franchise agreement and in return for the consideration as detailed below, AFSC undertook to finance, design, construct and commission a facility on a certain area of the Chek Lap Kok airport then under construction for the supply of fuel to aircraft (the Facility).
As part of the terms of the franchise agreement, the Authority also granted a land lease to AFSC in respect of the land upon which the Facility was located with the lease running for 20 years from the opening date of the airport on 6 July 1998. Upon the expiration or early termination of the lease, the Facility, being a fixture on the land, would then be owned by the Authority.
Between the Authority and AFSC, it was agreed that AFSC was to claim tax depreciation allowances on the Facility so constructed while the lease was in force. The Facility was also disclosed as being a fixed asset of AFSC in its accounts.
On the same day as the signing of the franchise agreement, the Authority separately entered into an operating agreement with AFSC’s nominee (the Operator) for the latter’s operation of the Facility for a term of 20 years from the opening date of the airport on 6 July 1998.
Under the operating agreement, the Operator would charge users of the Facility for each gallon of aviation fuel delivered into an aircraft. Under Clause 10 of the franchise agreement, the Authority undertook to procure the Operator to pay to AFSC a certain portion of the Operator’s revenue as facility payments on a monthly basis (the Facility Payments). The Facility Payments were so computed to ensure that AFSC would recover its costs of financing and constructing the Facility over the term of operation of the Facility with an internal rate of return of 15%.
Under Clause 11 of the franchise agreement, the Authority can, at any time from the fifth anniversary of the opening day of the airport, elect to accelerate AFSC’s recovery of the costs of the Facility by making an accelerated payment calculated according to a predetermined method (the Accelerated Payment). Upon the Authority making the Accelerated Payment, the land lease granted to AFSC would terminate and the Operator would thereafter pay the Facility Payments to the Authority instead of AFSC.
On 23 October 2002, the Authority exercised the option contained in Clause 11 of the franchise agreement and notified AFSC of its election to make the Accelerated Payment on 7 July 2003. A major component of the Accelerated Payment was a sum of US$449,043,000 (the Sum), being the net present value of the expected Facility Payments which AFSC would otherwise have received for the remaining term of the lease discounted at the pre-determined rate of 12%.
Issue in dispute
AFSC claimed that the Sum was a payment made by the Authority to acquire its business, and as such was capital in nature and not chargeable to tax under Section 14 of the Inland Revenue Ordinance (IRO). The Commissioner of Inland Revenue (CIR) however determined that the Sum was chargeable to profits tax on the following grounds:
- The Sum could be regarded as being a substitute for the Facility Payments which would otherwise have been received by AFSC for the remaining term of the lease. The CIR considered that the receipt of a lump sum payment in lieu of the Facility Payments (which were accepted to be taxable) did not change the income nature of the payment; or
- The Sum was a consideration for AFSC’s transfer of a right to receive income from a property without the legal or equitable interest in the underlying property being transferred, and therefore, caught by the deeming provisions under Sections 15(1)(m) and 15A of the IRO.
AFSC’s appeal against the CIR’s determination was directly transferred to be heard by the CFI, thereby by-passing the Board of Review.