22 February Issue No. 4. Court of Final Appeal upholds no change of taxpayer intention as regards land site

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1 Hong Kong Tax Alert 22 February Issue No. 4 Court of Final Appeal upholds no change of taxpayer intention as regards land site Even though up to the relevant point of time substantial work such as applying for town planning permission and lease modifications had been undertaken to enhance the value of the site The decision illustrates that where a property is originally acquired by an investor or non-trader owner as capital investment, said owner will not generally be regarded as embarking on a trade if they engage in activities to enhance the value of the asset in order to obtain the best or maximum price upon the sale of the same. However, where the activities undertaken have gone beyond what other non-trader owners might have done in similar circumstances, such activities would be regarded as evidence suggestive of a change of intention from one of investment to trading. If a finding of change of intention is to be made, precision is required as regards the date of the change. This is the case because the relevant tax liabilities will generally be ascertained by reference to the market value of the property on the date the change of intention took place, rather than the historical cost of the property. However, facts and evidence as regards what constitutes property trading versus investment and whether there has been a change of intention are by their nature complicated issues. Clients should seek professional tax advice where necessary.

2 Facts of the Church Body of the Hong Kong Sheng Kung Hui and the Foundation The two taxpayers involved in this appeal were the Church Body of the Hong Kong Sheng Kung Hui and Hong Kong Sheng Kung Hui Foundation, both approved charitable institutions for the purpose of section 88 of the Inland Revenue Ordinance (IRO). Together they owned certain land lots in Tai Po (the Old Lots). An orphanage known as St Christopher s Home run by the taxpayers had been located on part of the Old Lots since the 1930s. Since the 1970s, the taxpayers had planned to redevelop the Old Lots. A July 1978 redevelopment plan indicated that, in addition to some institutional development including the re-provisioning of the orphanage, a high-class private residential estate would also be built on the Old Lots. Thereafter, until September 1989, whilst there were many revisions to the 1978 redevelopment plan, the taxpayers continued to engage in both the institutional development as well as the private residential estate development of the Old Lots. Issue in dispute CIR argues that there was a change of intention Whilst the Commissioner of Inland Revenue (CIR) accepted that the Old Lots were originally a capital or an investment asset, she considered that there was a change of intention on the part of the taxpayers as regards the Old Lots from one of investment to trading, that change of intention occurring in September 1989 at the latest. The taxpayers contended that the gains on the disposal of the units allocated to them under the joint venture redevelopment agreement represented non-taxable capital profits derived from their realization of an investment asset. Furthermore, the taxpayer also contended that if there was a change of intention on the date of entering into the joint venture redevelopment agreement, then the alternative offer price made by the developer for an outright purchase of the Old Lots of HK$1.2 billion (instead of the HK$300 million allowed by the CIR in her determination of the case) should be treated as the deemed cost basis of the taxpayers in calculating their taxable profits. However, a September 1989 redevelopment plan submitted for town planning permission indicated that the taxpayers planned thereafter for only a private residential estate development of the Old Lots, the planned re-provisioning of the orphanage and other institutional development to be carried out separately in other locations. The more significant points of time regarding the development of the Old Lots or the subsequently regranted new lots (New Lots) are shown in the timeline below. Development plan revised for town planning permission to only contain a stand-lone residential development Accepted a developer s offer for a joint development Sold most of the units allocated under the JV Jul 1978 Sept 1989 Dec Aug Dec onwards upon Planned to have both institutional and residential developments Applied to the government for a modification of the lease terms to permit residential development Signed JV agreement with the developer completion of the redevelopment 2

3 Decisions of the Board of Review Upholding the CIR s determination, the Board of Review (BOR) held that the redevelopment of the Old Lots amounted to a trade, and not the mere realization of a capital asset by the taxpayers. The BOR found that from September 1989 at the latest, the development of the Old Lots and the re-provisioning of the orphanage became separate projects. As such, the BOR concluded that the status of the taxpayers as charitable institutions and the re-provisioning of the orphanage did not explain why the taxpayers still proceeded with the redevelopment of the Old Lots after September The BOR found that the taxpayers approached the redevelopment of the Old Lots on commercial principles, with the laudable object of raising as much income as possible; engaged professional advisers including architects and lawyers to work on the development; actively marketed the Old Lots to leading property developers in Hong Kong; and sought to modify the lease terms of the Old Lots by way of a surrender and re-grant of the Old Lots for the purposes of the redevelopment. Two possible dates held for the change of intention as regards the Old Lots The BOR found two alternative dates for the change of intention of the taxpayers. The first date was September 1989 at the latest, when the re-provisioning of the orphanage and the private residential estate development clearly became separate projects. Apparently unsure of its first finding on the issue, and in the event the first date was subsequently proved wrong in any further appeal of the case, the BOR also found December 1990 as an alternative date for the change of intention, i.e., the date when the taxpayers applied to the government for a surrender and re-grant of the Old Lots. Decisions of the lower courts The Court of First Instance (CFI) held that the inference of the BOR on the date of change of intention, which was primarily a matter of fact for the BOR to decide, was not so unreasonable as to require its intervention. Accordingly, the CFI upheld the decision of the BOR. On further appeal, the Court of Appeal (CoA) overturned the decisions of the BOR and CFI, holding that the inference of the BOR was indeed so unreasonable as to require its intervention. The CoA considered that based on the primary facts of the case as found by the BOR, the only true and reasonable inference was that the enhancement work undertaken by the taxpayers on the Old Lots did not indicate the taxpayers had embarked on a trade from September 1989 or December As regards whether the change of intention occurred in August 1993 or December 1993 (when the taxpayers accepted the developer s offer for joint redevelopment of the Old Lots or the subsequently re-granted New Lots) or on some other date, the CoA remitted the matter to the BOR to decide 1. However, the CIR challenged that in expressing its decision the CoA was stating as a principle of law that the process of enhancement for realization could never make an original investor owner become a trader. Not satisfied that there was such an enhancement for realization principle, the CIR appealed against the CoA s decision to the Court of Final Appeal (CFA) 2. Presumably considering that the value of the Old Lots at all possible times for the change of intention did not exceed HK $300 million, the BOR upheld the CIR s determination of the case. Not satisfied with the decision of the BOR, the taxpayers appealed to the courts. 1 The CoA also dismissed the taxpayers appeal that the relevant profits were exempt from profits tax under section 88 of the IRO by virtue of the taxpayers status as charitable institutions. For simplicity sake, the appeal by the taxpayers and the decisions by the BOR and lower courts on the section 88 issue are not discussed in this alert. Clients who are interested in the section 88 issue may refer to our Hong Kong Tax alert - 16 September 2014 (2014 Issue no. 15) reporting on the CoA s decision in this regard. 2 The taxpayers did not cross-appeal against the CoA s dismissal of their appeal on the grounds that the relevant profits were exempt under section 88 of the IRO. As such, the only issue for the CFA to decide was whether the CoA s decision on the issue of the change of intention was correct. 3

4 Decision of the CFA All five judges of the CFA agreed with the views or judgment on the case expressed by each, and unanimously dismissed the CIR s appeal. Main judgment of the decision made by Mr. Justice Tang PJ Mr. Justice Tang PJ considered the enhancement for realization principle is not absolute, i.e., depending on the facts of a particular case enhancement for realization may or may not amount to a change of intention in the process. In this context, the judge considered that the following guidance (described as the 7 th badge of trade) provided by McHugh NPJ in Lee Yee Shing v CIR was useful in determining the issue: Whether the taxpayer has expended time, money or effort in selling the asset or commodity that goes beyond what might be expected of a non-trader seeking to sell an asset of that class? Applying this 7 th badge of trade, the judge noted that the BOR s view that the change of intention occurred by September 1989 at the latest was based on the evidence that by then the development of the Old Lots and the reprovisioning of the orphanage became separate projects. The judge however considered that this piece of evidence could only support the inference that the taxpayers had by then decided to sell the Old Lots (as a capital asset), but not that there had been a change of intention. Neither did the judge consider as supportable the BOR s alternative finding of the change of intention by December 1990, i.e., the time when the taxpayers applied for a surrender and re-grant of the Old Lots. The judge considered that the enhancement work undertaken by the taxpayers up to December 1990 undertaken with a view to maximize the development potential and value of the Old Lots did not go beyond what other non-trader owners might have done in similar circumstances. As such, the relevant enhancement work did not support a finding of change of intention on the part of the taxpayers by September 1989 or December Thus, the judge upheld the CoA s decision in overturning the decision of the BOR that the taxpayers had by September 1989 or December 1990 changed their intention as regards the Old Lots from one of investment to trading. Separate concurring judgment made by Mr. Justice Fok PJ In his separate concurring judgment on the case, Mr. Justice Fok PJ first criticized the BOR s finding of the two alternative dates for the change of intention as being inherently contradictory and lacking in the precision required. The judge then noted that in August 1993 the taxpayers had two options, i.e., either to accept the developer s offer to purchase the Old Lots outright or to enter into a joint venture agreement with the developer for the redevelopment of the Old Lots. In this regard, the judge remarked that had the taxpayers accepted the developer s offer to purchase the Old Lots outright, it would be difficult for the CIR to contend that the taxpayers would be trading in the Old Lots. The remark indicated that any change of intention on the part of the taxpayers would likely be in August or December 1993 when the taxpayers accepted the offer from the developer to jointly redevelop the Old Lots. Commentary Whilst the CFA has held that the enhancement for realization principle is not absolute, the decision does indicate that an original investor owner can generally engage in activities to enhance the value of their asset in order to obtain the best or maximum price when he disposes of it, without thereby embarking on a trade. However, facts and evidence as regards what constitutes a change of intention may be case specific. For example, the CoA noted that the BOR had not made any finding that, prior to the taxpayers entering into the joint venture agreement with the developer in August or December 1993, there had already been a decision by the taxpayers to embark on the redevelopment of the Old Lots with leading developers on a joint venture basis. Had such a finding of fact been made by the BOR, or had the taxpayers not invited leading developers to make the two offers of either an outright purchase of the Old Lots or a joint redevelopment of the Old Lots, the outcome of the case could have been different. The finding and presentation of the relevant facts and evidence as regards property trading versus investment, and whether there has been a change of intention, are by their nature complicated issues. Clients should seek professional tax advice where necessary. The judge also held that it was right for the CoA to remit the case to the BOR for the BOR to consider whether the change of intention of the taxpayers occurred in August 1993 or December 1993 (when the taxpayers accepted the offer of joint redevelopment of the Old Lots from the developer) or on some other date. 4

5 Hong Kong office Agnes Chan, Managing Partner, Hong Kong & Macau 22/F, CITIC Tower, 1 Tim Mei Avenue, Central, Hong Kong Tel: / Fax: Head of Tax, Ernst & Young Tax Services Limited Tracy Ho tracy.ho@hk.ey.com Hong Kong Tax partners Agnes Chan agnes.chan@hk.ey.com Joe Chan joe-ch.chan@hk.ey.com Owen Chan owen.chan@hk.ey.com Wilson Cheng wilson.cheng@hk.ey.com Chee Weng Lee chee-weng.lee@hk.ey.com May Leung may.leung@hk.ey.com Grace Tang grace.tang@hk.ey.com Karina Wong karina.wong@hk.ey.com Jo An Yee jo-an.yee@hk.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com Ernst & Young Tax Services Limited. All Rights Reserved. APAC No ED None. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/china