It has generally been the practice of the Inland Revenue of Hong Kong to disallow payments made on the closure of a business as being non-deductible expenses for the purpose of a profits tax computation. The Hong Kong Court of Appeal recently examined this practice in the context of severance (ie redundancy) payments in The Commissioner of Inland Revenue v Cosmotron Manufacturing (Civil Appeal No. 75 of 1996).
The taxpayer started business as a manufacturer of metal products in 1968. During the basis period of the year of assessment 1990/91, the taxpayer ceased business, dismissed its employees and made severance payments totalling HK$2,937,981 as required under the Employment Ordinance. When the taxpayer submitted its 1990/91 profits tax return, the taxpayer sought to treat this sum as a deductible expense in its tax computation such that a loss was declared. However, the Commissioner of Inland Revenue disallowed this. The taxpayer appealed against the Commissioner's decision, which was subsequently reversed by the Board of Inland Revenue. The High Court affirmed the Board's decision. The Commissioner appealed.
The central issue of this case was stated to be whether "the severance payments made by the taxpayer upon the cessation of its business [were] to be regarded as having been incurred in the production of profits and therefore deductible for the purpose of ascertaining taxable profits".
In Hong Kong, profits tax is chargeable on every person carrying on a trade, profession or business in Hong Kong in respect of assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business as ascertained in accordance with the Inland Revenue Ordinance. Assessable profits are determined after taking into account the deductions and allowances provided under the Ordinance.
Sections 16 and 17 of the Ordinance govern the deductibility of outgoings and expenses incurred by the person subject to profits tax liability. Section 16(1) of the Ordinance provides that in calculating the profits tax liability of any person, there shall be deducted all outgoings and expenses to the extent of which they are incurred in the production of profit. Section 17(1)(b) of the Ordinance further stipulates, among other things, that no deduction shall be allowed in respect of any disbursements or expenses not being money expended for the purpose of producing profits.
The Commissioner's argument
The principal line of argument of the Commissioner against the deductibility of the severance payments was that they were incurred for the purpose of closing the taxpayer's business and not in the production of profit.
The Commissioner's second argument was to challenge the judge's conclusion that the severance payment payable on cessation was an accrued liability and therefore "an expense incurred" under the Ordinance, which was held in a previous Privy Council decision to include an "accrued liability which is undischarged".
By a majority decision (two to one) the Court of Appeal upheld the High Court's decision.
The two judges giving the majority decision conceded that the immediate purpose of making the severance payments was to comply with the mandatory requirement of the law on the dismissal of employees by reason of redundancy under the Employment Ordinance. Despite a dissenting judgment to the contrary, the two majority judges were of the view that this requirement was unavoidable and must be accepted as the price of procuring and retaining employees for the purpose of producing profits.
In addressing the Commissioner's second contention that the High Court judge failed to take into account the fact that the liability to pay severance payments did not accrue until cessation of business, the two majority judges gave different reasons in their respective judgments, on the classification of whether the severance payments were just "expenses incurred" or an "accrued liability which was undischarged".
One judge in the majority, Bokary JA, considered that the liability to make severance payments arose in a contingent form before cessation, and then crystallized on cessation while the other judge, Nazareth VP, was of the view that the employees of the taxpayer had no vested right to severance payments prior to their dismissal and therefore there was no accrued liability which was undischarged. In any event, he considered that the severance payments were themselves in the nature of expenses incurred in the production of profits, hence providing a justification for their deduction under the Ordinance.
It would appear that the effect of the decision would overturn the previous practice of the Commissioner in allowing severance payments as deductions where they are paid while business is continuing but not on a cessation of business.
Stephenson Harwood & Lo