Hong Kong Tax Alert: 8 February 2013

Decision of the Court of Appeal

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Crux of the issue in dispute

The core issue in dispute was whether the provision of the moulds by the Taxpayer to its contract manufacturers, in order that the manufacturers could manufacture products for the Taxpayer, constituted a “lease” arrangement.  If the moulds were regarded as being provided under a “lease” arrangement then they would be “excluded fixed assets” and hence not be eligible for a deduction under section 16G(1) of the IRO, section 16G(6) defining “excluded fixed asset” as “a fixed asset in which any person holds rights as a lessee under a lease.”

Ordinary legal meaning of “lease” and extended meaning under section 2 of the IRO

The arguments of the two parties at the CA hinged on whether for the purpose of section 16G(6) of the IRO, the word “lease” should be given its narrow ordinary legal meaning or the wider meaning as defined in the general definition section of section 2(1) of the IRO.

It was apparently common ground of the two parties that the ordinary legal meaning of the term “lease” refers to “a contractual entitlement to exclusive possession of an asset for a defined period of time”. Under this ordinary legal meaning, the provision of the moulds by the Taxpayer to the contract manufacturers would not constitute a “lease” arrangement. This is because the contract manufacturers, being only permitted to use the moulds in the specified and limited circumstances as described above, could not be said to have exclusive possession of the moulds for a defined period of time. 

The definition of a “lease” as regards machinery or plant under section 2(1) of the IRO is comparatively wider, reference being made to “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…” However, as with all definitions appearing section 2(1), this definition of the term “lease” is preceded by the opening words of section 2(1) “unless the context [in the IRO] otherwise requires”.

Arguments put forward by the Taxpayer

At the CA it was accepted by Counsel for the Taxpayer that the statutory definition in section 2(1) of the IRO extends the ordinary legal meaning of the term “lease”. Counsel for the Taxpayer further accepted that if the extended meaning in section 2(1) applied, it would cover the arrangement whereby the moulds were provided by the Taxpayer to its contract manufacturers in the circumstances described above. 

Counsel however contended that the context of section 16G is such that the extended meaning of “lease” in section 2(1) should not apply to the interpretation of what constitutes an excluded fixed asset as defined in section 16G(6) of the IRO. Counsel therefore argued that the narrower ordinary legal meaning of the term “lease” rather than the extended meaning under section 2(1) should be adopted for interpreting section 16G(6) of the IRO.

Counsel noted that the extended meaning of “lease” now appearing in section 2(1) was first enacted in the context of section 39E of the IRO, when that section was introduced in 1986 as an anti-avoidance provision targeting certain “sale and lease-back” and “leveraged leasing” arrangements. By contrast, section 16G, which was introduced by amendments to the IRO made in 1998, is not concerned with anti-avoidance measures. Instead, section 16G is concerned with the provision of a form of depreciation allowance which enables the full cost of certain types of plant and machinery to be written off in the year in which the expenditure was incurred. As such, Counsel argued that the purpose and context of section 16G does not require the application of the extended meaning of “lease”.  As a result, the statutory definition appearing in section 2(1) should not apply.

Counsel submitted that to apply the section 2(1) definition of “lease” in the context of section 16G(6) would render section 16G unworkable or absurd and thereby defeating its purpose, namely the granting of deductions. Counsel argued that by adopting the narrower, commonly understood legal meaning of “lease”, section 16G would have a wider application consistent with its purpose.

Counsel also contended that the full meaning of “lease” in the IRO required the application of both its ordinary legal meaning and its extended meaning under section 2(1), the use of the words “unless the context otherwise requires” being evidence of this contention. 

Counsel went on to note that in the context of section 16G, the ordinary legal meaning of “lease” should be applied, whereas within the context of section 39E, the extended definition should apply.  Counsel concluded that the application of the wider definition to section 16G(6) had the effect of reducing the full meaning of “lease”.

CA rejects the arguments put forward by the Taxpayer

The CA rejected the above arguments put forward by Counsel for the Taxpayer. The CA noted that the extended statutory definition of “lease” was first introduced in 1986 when section 39E was introduced. It was contained in section 39E(5), which made it clear that the extended definition only applied to section 39E itself.  However, when section 16G was added to the IRO in 1998, the definition of “lease” in section 39E(5) was repealed, but the same definition of “lease” was then inserted into the existing section 2(1) of the IRO.

The CA therefore considered that the legislative history of section 16G illustrates that the legislature clearly intended that the extended definition of “lease” should apply to both section 16G and section 39E.  The CA reasoned that if this had not been the legislative intent, there would have been no need to remove the definition of “lease” from section 39E and place it in section 2(1).

The CA also reasoned that its above approach to interpreting the legislative history of section 16G does not mean it has ignored the opening words “unless the context otherwise requires” of section 2(1). The CA noted that these opening words were always there and were not specifically enacted together with the introduction of the definition of “lease” into the definition section of section 2(1) of the IRO.  Rather, these opening words also apply to all other definitions contained in section 2(1) of the IRO. The CA considered that it does not automatically follow that, because the definition section provides for definitions within section 2(1) not to apply, there are necessarily contexts within the IRO to which the definition should not apply.

All that the words “unless the context otherwise requires” signify is an obligation to consider whether or not the definition is appropriate in the particular context. The words say nothing about whether any context in the IRO requiring a definition to be ignored actually exists. The CA therefore also rejected Counsel’s submission that to fail to find a context in which the statutory definition of “lease” should not be applied was somehow not giving the term “lease” its full meaning.

The CA also considered that adopting the statutory definition of “lease” rather than its ordinary legal meaning to interpret section 16G(6) did not defeat or undermine the purpose of the section 16G. The CA was of the view that it was not possible to read more into the purpose of section 16G than to conclude that it was the intention of the legislature to afford a deduction to capital expenditure on fixed assets falling within the statutory definition of “prescribed fixed assets”.

The CA acknowledged that to limit the availability of the deduction to taxpayers who use the plant and machinery themselves, but not to those who permit others to use the same under some arrangement, will mean that fewer taxpayers will be able to take advantage of the deduction. However, the CA considered that it could not be concluded that such a result was something other than what the legislature intended. 

On the basis of the above, the CA dismissed the Taxpayer’s appeal. The Taxpayer has applied to the CA for leave of appeal to the CFA. The CA will hear the leave application in April this year.


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