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In Nice Cheer Investment Ltd v Commissioner of Inland Revenue  HKCU 1221, the court held that unrealised profits fall outside the charge to profits tax under s 14 of the Inland Revenue Ordinance (Cap 112) (IRO) such that the practice of the Inland Revenue Department (IRD), as set out in DIPN 42 Part A to tax unrealised profit arising from the valuation of financial instruments at fair value, is wrong. The judge also considered that the principles in Sharkey (Inspector of Taxes) v Wernher  AC 58 were not applicable in Hong Kong. In Sharkey, a taxpayer transferred trading stock to a non-taxable activity or an associated person at cost or at undervalue. For tax purposes, he/she is deemed to have disposed of the trading stock at market value with the result that a notional profit arises and subject to profits tax. Nice Cheer, therefore, has important implications in Hong Kong taxation.
In respect of accounts for the years of assessment 1999/2000 to 2005/06, the taxpayer, Nice Cheer Investment Ltd (‘Nice Cheer’), valued securities which were trading assets at market value at the balance sheet date and brought the unrealised profits into the profit and loss account. In the notes to the audited accounts, it was stated that this accounting treatment was in accordance with the Statement of Standard Accounting Practice No 24 (SSAP 24) (up to the year ending 31 March 2005) and Hong Kong Accounting Standard No 39 (HKAS 39).
The IRD taxed the aforesaid unrealised profits, and Nice Cheer objected to these assessments. The appeal was directly transferred to the Court of First Instance pursuant to s 67 of the IRO without being heard by the Inland Revenue Board of Review.
There was no dispute that the accounting treatment in question, and adopted by Nice Cheer, was in accordance with ordinary acceptable commercial accounting principles. Both the SSAP24 and HKAS 39 were issued by the Hong Kong Institute of Certified Public Accountants (HKICPA). These two accounting standards decree that financial assets should be valued at fair value in the balance sheet, ie the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. The IRD, by Departmental Interpretation and Practice Notes No 42 (DIPN 42) Part A Taxation of Financial Instruments, proclaimed that it would follow HKAS 39 and tax unrealised profits arising from revaluation of trading assets at fair value, which have been brought into the profit and loss account. Nice Cheer is the first court case in which a taxpayer has challenged the practice as set out in DIPN 42 Part A.
The accounting practice prior to SSAP24 and HKAS39 was to value securities held for trading purposes at cost or net realisable value, whichever is the lower. Thus, the diminution in value would be taken in the profit and loss account while any increase in value would not. This is in accord with the conservative accounting principle.
The Commissioner’s counsel argued that since Nice Cheer adopted SSAP 24 and HKAS 39 in its audited accounts, and because these are acceptable commercial accounting standards, it was bound by its choice:Commissioner of Inland Revenue v Secan Ltd  HKCFAR 411 (CFA). Further, unrealised or notional profit is taxable (Sharkey (Inspector of Taxes) v Wernher  AC 58). In support, counsel referred to the Inland Revenue Board of Review case D35/86 2 IRBRD 259 where unrealised exchange gain was held to be taxable. He added that it would be unfair to exempt unrealised profit while unrealised loss is allowable for tax purposes. This would be the position if the previous practice of valuing trading stock at the lower of cost or net realisable value is followed.
In the CFI, To J ruled in favour of Nice Cheer by finding that assessable profit means real profit arising in, or derived from, the actual buying and selling of commodities in commercial transactions between the taxpayer and his/her trading partners, or supply of professional or other services, and do not include notional, unrealised or anticipated profits. In respect ofSharkey, the judge preferred the view expressed by the CFI judge in Commissioner of Inland Revenue v Quitsubdue Ltd  3 HKC 233 and the Inland Revenue Board of Reviews in D41/91 and D47/91 (1991) 6 IRBRD 211 and 256 respectively, that Sharkey is not applicable to the Hong Kong tax regime. He agreed that, for tax purposes, a person cannot trade with him/herself and s 14 of the IRO charges on ‘real’ profit, ie profit that is taxable only if it is ascertained, accrued or earned, regardless of whether it had been received in cash. Moreover, profit that does not arise from a trade or provision of services, such as a profit on revaluation of an asset, is not subject to tax.
The judge distinguished D35/86 2 IRBRD 259, which is a case about foreign exchange, and stated that it cannot be universally applied because foreign currency has a ready market and is valued against theHong Kong dollar. It was not a case of taxing anticipated profits but taxing actual profits that had accrued.
In determining the assessable profits or allowable losses, the judge held that ordinary principles of commercial accounting should be followed, subject to any modification to conform with the IRO: Secan per Lord Millet NPJ at 419. The judge thought that Secan did not elevate ordinary commercial accounting principles above the statute or the judge’s interpretation of the statute. In Nice Cheer, ordinary commercial accounting principles are subject to s 14 of the IRO; otherwise, the predicament is that accountants would be given the power to make laws without the need to pass through due legal process.
The argument that it was unfair that unrealised loss could be allowed while unrealised profit was not taxable was rejected by the court because the unfairness was more apparent than real. To J (at ) stated that there should be a dichotomy in tax treatment between profit and loss because s 14 of the IRO prescribes that ‘profit’ for tax purpose must mean ‘profit arising in or derived from Hong Kong ... from such trade, profession or business’ while ‘loss’ is not subject to such qualification.
The judge also found the approach adopted by the Commissioner was inconsistent because the Commissioner allows small- and medium-sized entities to value their financial stock at cost instead of having to adopt HKAS 39 (DIPN 1).
Ordinary commercial accounting principles
Taxable profits are ascertained by reference to acceptable accounting principles: Commissioner of Inland Revenue v Cock Russell & Co Ltd(1949) 29 TC 387; Usher’s Wiltshire Brewery Ltd v Bruce (1915) AC 433; and cited in Nice Cheer and approved by To J (at ). However, the judge pointed out that the IRO prevails over ordinary commercial accounting principles so that where accounting policies adopted in the accounts are inconsistent with the tax law, the accounts must be modified for tax purposes even though the accounting policies follow acceptable accounting principles. The tax law is to be found in the IRO and the judgments of courts.
It is respectfully submitted that, clearly, this must be the correct position. What Secan lays down is that when an accounting policy is chosen and adopted in the account, if it is:
a. based on acceptable accounting principles; andb. not prohibited by the law, then the taxpayer and the IRD are bound by the choice adopted by the taxpayer.
The accounts are not binding for tax purposes where there is inconsistency with the law.
Implications of Nice Cheer
Although Nice Cheer concerned the tax treatment of financial instruments, ie financial assets and liabilities in the form of shares and securities, by declaring that unrealised profits fall outside s 14 of the IRO and that Sharkey is considered not applicable to Hong Kong, the case has more general implications in the valuation of (trading stock) for tax purposes.
Sharkey has been adopted by the IRD and accepted by tax practitioners for over 30 years in Hong Kong. Many Inland Revenue Board of Review cases have adopted Sharkey without questioning its applicability in Hong Kong. Principally, Sharkey has been applied in the real estate business and in the following situations:
a. where there is a transfer of trading stock to fixed assets without any change of ownership – the IRD will deem that the asset has been sold at market value and tax, or allow the difference between the original cost and the market value at the time of change of intention even where there has been no change of ownership (the profit or loss so taxed/allowed is only a notional profit/loss sincethe taxpayer will not have received the said profit or suffered the said loss); and b. where there is a transfer of trading stock to associated persons at prices below market value – the IRD will substitute the market value and tax the deemed notional profit.
In Sharkey, the taxpayer had transferred horses from a stud farm (a business) to a racing stable (a hobby falling outside the scope of taxation). The ownership of the horses did not change. The House of Lords, by a majority, ruled that the market value of the horses at the time of transfer should be brought into account thereby subjecting the difference between the original cost and the market value to tax. In the view of the law lords, in respect of the values to be placed on the credit side of the profit and loss account, there were three alternative treatments:
a. placing it at no value;b. placing it at cost; andc. placing it at market value.
The majority of the law lords preferred to adopt the market value. It should be highlighted that the facts in Sharkey concerned the accounting treatment of assets (trading stock) taken by a person for his own use.
Tax professionals used to adopt the reverse treatment in cases where fixed assets were appropriated to trading stock. For example, if a person has resided in a house for 20 years and later he/she decides to demolish the house and develop it into a high rise building, and eventually sells the units for profit, his/her tax representative would treat this as a change of intention from holding a fixed asset for the long term to trading. For tax purposes, the market value at the date of change of intention would be treated as the deemed cost of the house in computing the assessable profits from the project. The effect is to enjoy a tax free capital gain. Sharkey was strictly not applicable as it was about changing a trading asset to a fixed asset, not vice versa.Nevertheless, the IRD, in practice, has approved similar treatment in the case of a change from a fixed asset to a trading asset: see Aust-Key Company Ltd v Commissioner of Inland Revenue  HKCU 238. However, Sharkey was not mentioned in Aust-Key.
Hong Kong cases on Sharkey
Nice Cheer is the second case where Sharkey has been considered in Hong Kong courts. The first is Quitsubdue. This is somewhat surprising because Sharkey has been adopted in Hong Kong for many years. Both Nice Cheer and Quitsubdue cast doubt on the applicability ofSharkey in Hong Kong. As far as Hong Kong cases are concerned, there is no case supporting the application of Sharkey while Quitsubdue and Nice Cheer are against it. To date, these are the only two court cases in Hong Kong that have attempted to deal with Sharkey.
In Southtime Ltd v Commissioner of Inland Revenue  HKCU 374, a taxpayer held units in the same building for investment and trading but the trading had ceased while investments continued. The market value on the date of change was assessed to tax. However, the assessment was made pursuant to s 15C of the IRO which applies to cessation of business. The taxpayer company’s real estate trading business ceased upon the change of intention and Sharkey was not an issue in Southtime.
It seems that D41/91 and D47/91 (where the Chairman of the Inland Revenue Board of Review for these two cases was Mr Litton QC, as he then was) are the only (Board of Review) cases casting doubt on its applicability.
What happens if Sharkey is not applicable in Hong Kong?
If Sharkey is not applicable, when a trading stock becomes a fixed asset, what happens when the fixed asset is eventually sold? Will the entire profit be exempt from tax as a capital gain? Can the IRD apportion the profit and tax the portion attributed to the period from the time of acquisition to the time of change of intention? It appears that the entire profit could be exempt should Sharkey be held not to beapplicable.
On the other hand, if a fixed asset is changed into a trading asset, on the eventual sale of the trading stock, will taxpayers lose the benefit of a tax free capital gain, ie the profit attributable to the period from the date of acquisition to the date of change of intention? This may not necessarily be so. The CFI in Nice Cheer held that s 14 of the IRO does not include unrealised profits and there is no ruling in relation to deductions. There is also no prohibition in the IRO against deducting the open market value on the date of change of intention in computing the profit on the eventual sale for tax purposes in such a scenario. As noted by To J at :
"The word ‘profits’ has a wide meaning under ordinary commercial accounting principles than that under section 14(1) as qualified by the expression ‘arising in or derived from Hong Kong ... from such trade, profession or business’. That qualification does not apply to the word ‘loss’ ...”
Aust-Key is a case where such tax free capital gain was granted. There was no suggestion that this was granted pursuant to Sharkey.
In Nice Cheer, the financial instruments remained in the same category of assets under the ownership of the taxpayer while in Sharkey, the horses were changed from being a business to a hobby. It may be that the substitution of an open market value could be stronger in the case of Sharkey. Nevertheless, To J observed, although in obiter, that Sharkeywas not applicable to Hong Kong, agreeing with Quitsubdue.
Ho Chi MingBarrister-at-Law
未實現利潤在香港是否應課稅？何志明大律師檢討原訟法庭在Nice Cheer Investment Ltd v CIR一案中的決定。他指出，該裁決尤其會對香港未實現利潤的稅務問題帶來影響。
在Nice Cheer Investment Ltd v Commissioner of Inland Revenue  HKCU 1221一案中，法院裁定未實現利潤(unrealised profits)並不屬於《稅務條例》（第112章）第14條所指的應課利得稅的範圍，因而稅務局在《稅務條例釋義及執行指引》第42號(DIPN 42)甲部中，對金融工具以公允價值量計所產生的未實現利潤進行課稅的做法是錯誤的。法官還認為，Sharkey (Inspector of Taxes) v Wernher  AC 58一案的原則不適用於香港。在Sharkey一案中，一名納稅人以成本值或較低市值將營業存貨轉到無須課稅的活動或關聯人。就稅務目的而言，他／她被視為以市值賣掉營業存貨，因而產生假設利潤(notional profit)並須繳付利得稅。因此，Nice Cheer判決對香港的稅務有重大影響。
就1999/2000課稅年度至2005/2006課稅年度的帳目而言，納稅人Nice Cheer Investment Ltd（下稱「Nice Cheer」）以結帳日的市值對屬於營業資產的證券進行估價，並將未實現利潤計入損益帳中。已審計帳目的附注指出，這種會計處理方式符合《會計實務準則》第24號（SSAP 24）（截至2005年3月31日為止），以及《香港會計準則》第39號（HKAS39）。
稅務局對上述的未實現利潤課稅，Nice Cheer 對這種評稅方式提出異議。根據《稅務條例》第67 條，上訴直接移交原訟法庭，而未有經稅務上訴委員會進行聆訊。
Nice Cheer採納的相關會計處理方式符合公認的一般商業會計原則，這一點是沒有爭議的。《會計實務準則》第24號及《香港會計準則》第39號都是由香港會計師公會發出。這兩項會計準則宣稱，資產負債表中的金融資產應以公允價值計價，即在知悉情況及自願的當事人之間的正常業務交易內，用作交換資產的款額。稅務局通過《稅務條例釋義及執行指引》第42號甲部－金融工具的稅務，表明局方會遵循《香港會計準則》第39號，並對以公允價值計量且其變動已計入損益帳的營業資產重估所產生的未實現利潤課稅。Nice Cheer是首宗法院案例，涉及納稅人對《稅務條例釋義及執行指引》第42號甲部所訂的做法提出質疑。
稅務局局長的代表律師指出，Nice Cheer在其已審計帳目中採用了《會計實務準則》第24號及《香港會計準則》第39號，因為它們都是公認的商業會計準則，該公司應受其選擇所約束：見Commissioner of Inland Revenue v Secan Ltd  HKCFAR 411 (CFA)。再者，未實現利潤或假設利潤是應課稅的（Sharkey (Inspector of Taxes) v Wernher  AC 58）。為支持其論據，局方代表律師引述了稅務上訴案例D35/86 2 IRBRD 259。在該案中，稅務上訴委員會裁定對未實現匯兌增益進行課稅。他補充，就稅務目的而言，對未實現利潤豁免課稅，而對未實現虧損可予扣除，並非是公平的做法。如遵循先前的做法，以「成本與可實現淨值熟低基準」對營業存貨進行估價，便會出現如此情況。
原訟法庭法官杜溎峰判Nice Cheer勝訴。他認為應評稅利潤是指納稅人及其交易夥伴在商業交易中實際買賣商品或提供專業或其他服務所產生或獲得的實質利潤，但不包括假設利潤、未實現利潤或預計利潤。就Sharkey一案而言，法官傾向於採納原訟法庭法官在Commissioner of Inland Revenue v Quitsubdue Ltd 3 HKC 233一案及稅務上訴委員會在D41/91 (1991) 6 IRBRD 211及D47/91 (1991) 6 IRBRD 256中所表達的觀點，即：Sharkey一案不適用於香港稅制。他贊同，就稅務目的而言，一個人根本無法與自身進行交易，而《稅務條例》第14條是對「實質」利潤徵稅（即是說僅當利潤已確定、累計或賺取的情況下才應課稅，不論其是否以現金方式獲得）。而且，並非由交易或服務提供而產生的利潤（譬如就資產價值重估的利潤）無須課稅。
法官將一宗涉及外匯的案件(D35/86 2 IRBRD 259)與上述兩宗案例區別開來，表示該案無法普遍適用，因為外匯擁有現成市場且兌港元計價。該案並非對預計利潤評稅，而是對累計的實際利潤評稅。
在確定應評稅利潤或可扣除虧損時，法官認為應遵循一般商業會計原則，並須為符合《稅務條例》而進行任何調整：見Secan一案，非常任法官苗禮治勳爵的判辭 (at 419)。案中法官認為，Secan一案並未令一般商業會計原則凌駕法規或法官對法規的闡釋。在Nice Cheer一案中，一般商業會計原則都受《稅務條例》第14條約束，否則便會出現會計師獲賦權立法，而無須經過適當的法律程序之窘境。
可評稅利潤參照公認的會計原則予以確定： 見Commissioner of Inland Revenue v Cock Russell & Co Ltd (1949) 29 TC 387; Usher’s Wiltshire Brewery Ltd v Bruce (1915) AC 433；而Nice Cheer一案曾援引上述案例，並得到杜溎峰法官批准（at ）。但杜溎峰法官指出，《稅務條例》凌駕一般商業會計原則，因此倘若帳目中所採納的會計政策有悖於稅法，即使該會計政策遵循公認的會計原則，該等帳目亦須為稅務目的而進行調整。稅法須以《稅務條例》和法院判決為據。筆者鄭重指出，顯然這是正確的立場。Secan案例所規定的是：倘若在帳目中所選擇和採用的某項會計政策是：
a. 基於公認的會計原則；及b. 不為法律所禁止，那麼納稅人和稅務局受該納稅人所選取的選擇約束。
a. 倘若營業存貨轉為固定資產，而所有權不作任何變動－即使所有權沒有變動，稅務局將認為該資產已按市值出售，並在持有資產的目的改變時對原始成本與市值之間的差額進行評稅或扣除（利潤或虧損被評稅或獲扣除僅為假設利潤／虧損，因為納稅人未獲得相關的利潤或蒙受相關的虧損）；及b. 倘若營業存貨以低於市值的價格轉讓予關聯人－稅務局將以市值代之，並對認定的假設利潤評稅。
a. 不計任何價值；b. 以成本計價；及c. 以市場價值計價。
在固定資產轉為營業存貨的資產歸類轉變的案件中，稅務專業人員往往採用逆向處理方式。譬如，倘若某人在一棟房子住了20年，後來他／她決定拆除房子，將其建成高樓大廈，並最終出售單位謀利，他／她的稅務代表會將此轉變當作為意向的改變（即改變持有資產的目的）－從長期持有固定資產轉為持有物業作買賣用途。就稅務目的而言，在計算該項目的應評稅利潤時，意向改變當日的市值會被接納為該棟房子的成本，結果享有免稅資本增益。Sharkey案例絕不適用，因為該案關乎將營業資產轉為固定資產，而非相反情況。但在實務中，稅務局曾在固定資產轉為營業資產的情形中批准類似處理方法：見Aust-Key Company Ltd v Commissioner of Inland Revenue  HKCU 238。而Aust-Key一案並未提及Sharkey案例。
香港採納Sharkey案中原則已行之多年，但香港法院至今只在兩宗案例中曾考慮Sharkey案中原則（首宗是Quitsubdue一案，第二宗是Nice Cheer一案），這有點叫人意外。Nice Cheer和Quitsubdue兩案均對Sharkey案例在香港的適用性提出了質疑。就香港案例而言，沒有案例支持Sharkey的應用，Quitsubdue和Nice Cheer兩案對Sharkey案中原則持異議。迄今為止，香港僅有兩宗法院案例試圖處理Sharkey案中原則。
在Southtime Ltd v Commissioner of Inland Revenue  HKCU 374一案中，一名納稅人在同一建築物內持有的單位用作投資及交易用途，但後來停止交易用途，只繼續投資用途，於是稅務局按資產歸類轉變當日的市值評稅。然而，稅務局是根據《稅務條例》第15C條評稅，該15C條只適用於停業時之營業存貨。納稅人公司在改變持有物業的目的時房地產買賣業務已終止，Sharkey案中原則在Southtime一案中並未被採用。
看來，D41/91 6 IRBRD 211及D47/91 6 IRBRD 256（在上述兩宗案件中，當時的稅務上訴委員會主席為御用大律師烈顯倫先生）是唯一兩宗（稅務上訴）案例對Sharkey案中原則的適用性提出質疑。
反過來，如果是固定資產轉為營業資產，最終出售營業存貨，納稅人是否會喪失免稅資本增益（即歸屬購買當日到意向改變當日這段期間所得的利潤）的好處？情況並非一定如此。原訟法庭在Nice Cheer一案中裁定，《稅務條例》第14條不包括未實現利潤，就扣除稅務問題並無裁定。另外，《稅務條例》並無條文禁止在意向改變當日扣除公開市值，以計算在此等情況下就稅務目的而言最終出售所賺得的利潤。正如杜溎峰法官指出[at 80]：
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