The BOR found that the moulds were excluded fixed assets, unable to qualify as prescribed fixed assets under Section 16G (6) of the IRO.
In the recent tax tribunal case D39/11, the Board of Review (BOR) held that an arrangement, whereby a taxpayer only permitted a contract manufacturer to use moulds owned by the taxpayer to manufacture goods ordered by the taxpayer, constituted a lease arrangement.
As such, the BOR held that the moulds did not qualify as prescribed fixed assets eligible for a 100% immediate tax write-off under Section 16G of the Inland Revenue Ordinance (IRO).
The Taxpayer has lodged an appeal against the BOR’s decision to the Court, the hearing of which is expected to take place later this year. Tax dispute or litigation is by its nature a complicated matter and clients facing similar situations should seek professional tax advice where appropriate.
The facts of the case are depicted in the diagram below:
The Taxpayer carried on a business of supplying plastic products and packaging materials. Company C was an independent contract manufacturer of the Taxpayer operating overseas.
In addition, Company C also produced the moulds necessary for the manufacture of the goods required by the Taxpayer. Company C charged the Taxpayer a fee for producing the moulds and the Taxpayer owned the moulds at all relevant times.
Since the designs of the goods traded by the Taxpayer were unique and bore certain trademarks, the required moulds were also very specific in nature.
After producing the moulds for the Taxpayer, Company C, as part of its contractual arrangement with the Taxpayer, would retain and use the moulds for the manufacturing of the goods ordered by the Taxpayer.
The Taxpayer claimed that the moulds were prescribed fixed assets owned by the Taxpayer qualifying for a 100% immediate tax write-off in the year of acquisition under Section 16G (1) of the IRO.
The Commissioner of Inland Revenue (CIR) however, denied the Taxpayer’s claim. The denial was made on the basis that the provision of the moulds by the Taxpayer to Company C constituted a lease arrangement and, as such, the moulds did not qualify as prescribed fixed assets as defined in Section 16G(6) of the IRO. The Taxpayer then appealed to the BOR against the CIR’s denial of its claim.
Decision of the BOR
Unchallenged evidence of the Taxpayer
At the BOR, the CIR did not challenge the Taxpayer’s evidence, namely that the Taxpayer owned the moulds which were required by Company C for the manufacturing of the goods ordered by the Taxpayer; Company C could only use the moulds under the Taxpayer’s specific instructions; and that due to the specific features of the moulds, Company C could not, practically or commercially, use the moulds other than for the production of goods ordered by the Taxpayer.
Given the above facts, the only issue that the BOR had to decide upon was whether the provision of the moulds by the Taxpayer to Company C constituted a lease arrangement, the existence of which would disqualify the moulds from being prescribed fixed assets under Section 16G(6) of the IRO.
Under Section 16G (6), a fixed asset in which any person holds rights as a lessee under a lease will be an “excluded fixed asset”, thereby precluded from qualifying as a prescribed fixed asset.
Should the ordinary or extended meaning of the term “lease” be used to interpret Section 16G (6)?
While the term “lease” is not specifically defined for the purposes of Section 16G (6), the same term in relation to any machinery or plant is defined in Section 2(1) of the IRO to include “any arrangement under which a right to use the machinery or plant is granted by the owner of the machinery or plant to another person…”
This definition of the term “lease” in Section 2(1) applies to all other sections of the IRO unless the context requires otherwise.
Counsel for the Taxpayer argued that the term “lease”, when used in relation to immovable or movable property, is a legal term, meaning a contractual entitlement to exclusive possession for a defined period of time. Counsel then contended that under the contractual arrangement in question, the Taxpayer only permitted Company C to use the moulds for a particular purpose, namely for the manufacturing of the goods according to Taxpayer’s instructions and specifications for the goods.
Given this specific use of the moulds dictated by the Taxpayer to Company C, Counsel argued that Company C did not have an exclusive possession of the moulds for a defined period of time.
Thus, the arrangement only amounted to a license rather than a lease of the moulds under the legal or ordinary meaning of the term “lease”.
Counsel noted that the extended definition of the term “lease” contained in Section 2(1) of the IRO creates a statutory fiction.
The fiction is that an arrangement – under which a person other than the owner is only permitted to use the machinery or plant for a specific purpose – constitutes a “lease” despite the fact that such an arrangement is not a “lease” under the legal or ordinary meaning of the term.
Counsel then argued that the context of Section 16G requires that the extended or fictional definition of the term “lease” contained in Section 2(1) of the IRO should not apply, and that the legal or ordinary usage of the term should apply instead.
To reinforce this argument, Counsel contended that, in contrast to Section 16G, Section 39E was the “context” for the application of the extended or fictional definition of the term “lease” contained in Section 2(1) of the IRO.
Counsel argued that this was because Section 39E is an anti-avoidance section targeting certain leasing arrangements and the legislature intended, by way of the extended or fictional definition of the term “lease”, to give Section 39E the efficacy or potency required to tackle the tax avoidance arrangements concerned.