MTR CORPORATION LTD v. COMMISSIONER OF INLAND REVENUE

HCIA 2/2024

[2025] HKCFI 2220

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO 2 OF 2024

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D E C I S I O N

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1.  Introduction

1.1  By a summons dated 4 September 2024 (“Summons”), MTR Corporation Limited (“MTRCL” or “Taxpayer”) applies pursuant to section 69 of the Inland Revenue Ordinance Cap 112 (“IRO”) for leave to appeal against the Decision of the Board of Review (“Board”) dated 6 August 2024 (“Decision”). By the Decision, the Board dismissed the Taxpayer’s appeal (“Appeal”) against profit tax assessments or additional profit tax assessments for the years of assessment 2011/12 to 2017/18.

1.2  At the hearing, the Taxpayer was represented by Mr Stewart Wong SC and the Respondent (“CIR”) by Mr Eugene Fung SC leading Mr John Leung. The same teams of counsel (led by London leaders) also appeared at the Appeal.

1.3  As set out at Decision §§1(A)(16) and 3, the core dispute in the Appeal was whether two yearly payments, namely Fixed Annual Payments (“FAPs”) and Variable Annual Payments (“VAPs”), paid by the Taxpayer to Kowloon-Canton Railway Corporation (“KCRC”) pursuant to a Service Concession Agreement (“SCA”) were capital in nature, and accordingly, pursuant to section 17(1)(c) of the IRO not deductible in computing the Taxpayer’s profits in the relevant years for the purposes of profits tax.

2.  Basic facts

2.1  The agreed facts and the indisputable facts are set out at respectively Decision §§1(A) and 1(B). For present purposes, the following summary will suffice.

2.2  In 2002, the Government began to consider the feasibility of merging MTRCL and KCRC into a single railway company operating both railways. On 24 February 2004, the Government announced that MTRCL and KCRC had been invited to commence negotiations on a possible merger.

2.3  On 11 April 2006, the Government and MTRCL entered into a Memorandum of Understanding which, among other things, recorded the understanding reached between the Government and MTRCL as to the structure and the key terms for the proposed merger (“Key Terms”). One of the key elements recognized in the Key Terms was the expansion of the existing franchise under the MTR Ordinance to provide for the right to operate both railways for an initial period of 50 years which was extendable.

2.4  The proposed merger package contained, inter alia, the following terms.

2.5  In relation to the transaction structure:

(1)  MTRCL would be the legal entity for the future post-merger corporation and its listing status would be maintained. MTRCL would be granted a service concession by KCRC to make use of the latter’s assets to operate the existing and new KCRC railway lines under construction including the Lok Ma Chau Spur Line and the Kowloon Southern Link, as well as KCRC’s other transport-related businesses such as bus operation in the North-West Transit Service Area (collectively referred to as “KCRC System”);

(2)  Under the SCA, MTRCL would be granted the right to use certain KCRC assets and railway land to operate the KCRC System. It would be responsible for the operation, maintenance and improvement of the KCRC System, including replacement of the concession assets, during the “Concession Period” (as defined in the SCA). MTRCL would exercise control over all the operational arrangements of the two networks as an integrated whole and be responsible for the performance of the total system. Upon expiry or termination of the “Service Concession” (as defined in the SCA), MTRCL would be required to return an operating KCRC System to KCRC that would meet the prevailing operating standards. Under the Service Concession arrangement, KCRC would not be disposing of the railway system to MTRCL, and MTRCL would not be acquiring the KCRC assets (except for certain low value items such as spare parts and consumables);

(3)  Apart from the Service Concession arrangement, MTRCL proposed to acquire property-related interests of KCRC as well as the development rights for the property sites on the KSL and the other commercial interests of KCRC as part of the deal.

2.6  On the financial terms, MTRCL would make the following payments:

(1)  A sum of HK$4,250 million (“Upfront Payment”) for the right to operate the Service Concession and the acquisition of certain short-lived railway assets of KCRC such as stores and spares;

(2)  The FAPs of HK$750,000,000 for the duration of the Service Concession;

(3)  Starting from the fourth year of the Service Concession, the VAPs which were based on a percentage of the actual revenue generated from the KCRC System;

(4)  A payment of HK$7,790,000,000 for the acquisition of property and other related commercial interests.

2.7  On 8 June 2007, the Legislative Council enacted the Rail Merger Ordinance (Ordinance No 11 of 2007) (“Rail Merger Ordinance”) to provide the necessary legislative framework for the merger. The Rail Merger Ordinance came into operation on 2 December 2007 (“Merger Date”). In the meantime, a suite of transactional documents including the SCA were executed on 9 August 2007.

2.8  On the Merger Date, MTRCL paid KCRC inter alia the Upfront Payment pursuant to Clause 6 and paragraph 1 of Schedule 3 being the agreed fee for the right to operate the Service Concession and the consideration for the “Purchased Rail Assets” (as defined in the SCA).

2.9  MTRCL also acquired certain KCRC’s trade and other receivables and assumed KCRC’s trade payables and other liabilities with a net liability of HK$226 million (“Cut-over Liabilities”).

2.10  Pursuant to Clause 6 and paragraphs 2 and 3 of Schedule 3 of the SCA, on various dates, MTRCL paid FAPs and VAPs to KCRC.

2.11  MTRCL filed its profits tax returns, together with audited financial statements and profits tax computations, for the years of assessment 2007/08 to 2017/18. In computing the returned assessable profits, amortisations of HK$3,924 million (“Concession Upfront”), amortization of Cut-over Liabilities assumed, the FAPs and the VAPs were claimed as allowable deductions (collectively “Sums”). However, the Assessor raised the Assessments to disallow their deduction on the basis that they were capital in nature.

2.12  The Assessments were confirmed by the CIR in the Determination of 20 May 2022, from which MTRCL appealed to the Board.

2.13  In the Decision, the Board recorded the following matters:

(1)  MTRCL accepted that the Concession Upfront was capital in nature and not deductible. CIR on the other hand accepted that the consideration for the Purchased Rail Assets as deductible so that there was no longer any disputes about the Upfront Payment;

(2)  MTRCL also conceded that the Cut-over Liabilities, being part of the price of acquiring the Service Concession, could not be deducted as expenses of its own trade and therefore not deductible in computing its profits.

2.14  Thus, the only dispute in the Appeal, as noted above, was the deductibility of the FAPs and the VAPs.

3.  The Decision

3.1  The Board’s conclusionary findings are set out at Decision §8, namely:

(1)  The Service Concession was an advantage of an enduring nature relating to the enlargement of the profit-earning structure of MTRCL’s business. It was therefore a long-term asset acquired by MTRCL in the merger;

(2)  The FAPs and the VAPs had the same nature as the Concession Upfront, in that they were deferred consideration designed to be payable together with the Upfront Payment by MTRCL for the acquisition of the Service Concession;

(3)  The FAPs and the VAPs were therefore expenditures of a capital nature.

3.2  In reaching the above conclusions, the Board conducted an expansive analysis, as set out at Decision §7:

(1)  The Board began by observing that before determining the ultimate question in the Appeal, namely the true nature of the FAPs and the VAPs, it was necessary for the Board to examine the background and circumstances leading to the merger in the form of a Service Concession. The Board noted that prior to the Service Concession model, there were disagreements on other proposals, for example an outright sale of KCRC to MTRCL and a “lease model” under which KCRC would lease its system assets to MTRCL in exchange for inter alia an upfront payment and annual payments. Those other proposals were not pursued due to differences in valuations. The Board further noted that the term “Rail Merger” had been used by all the parties even though there was no merger of the ownership of the two companies (Decision §§7(1)-(3));

(2)  Although there was no real dispute that the Service Concession was an asset, the Board was of the view that it needed to fix its true nature at the outset. The Board found that the 50-year service concession was considered to be a long-term investment by all the parties involved (Decision §7(5)-(7)). In particular, the Board did not accept the Taxpayer’s submission that the Service Concession was akin to a lease of KCRC's assets to MTRCL for the specific purpose of operating the KCRC transport system, and having considered all the background and circumstances leading to the merger, the Board was satisfied that the Service Concession was a long-term asset of MTRCL’s business and was acquired by MTRCL subject to it making the Concession Payments (Decision §§7(5)-(12));

(3)  The Board then examined what it entailed when MTRCL had acquired the Service Concession by reference to the various transaction agreements and other statutory provisions. Having scrutinized the definitions of Service Concession and Concession Property as stated in the relevant contractual and statutory provisions, the Board thought it abundantly clear that the Service Concession, once granted to MTRCL, would entitle the company to access, use and possess the Concession Property for the operation of the railways and related services. It was therefore difficult to justify any distinction between the right to operate the Service Concession on the one hand, and the right to use or the actual use of the Concession Property to operate the Service Concession on the other as submitted by the Taxpayer. The Board accepted CIR's contention that as a matter of logic and practical reality, the distinction was an artificial one. The Board therefore found that the grant of the right to operate the Service Concession necessarily encompassed a grant of the right to use, possess and operate the Concession Property (Decision §§7(13)-(15));

(4)  The Board then identified that the Concession Payments comprised the Upfront Payment, the FAPs and the VAPs. The Board was of the view that the real determinative question was straightforward: Were the three components of the Concession Payments: (a) one and the same thing as the CIR contended, namely they were of the same nature and together constituted the purchase price of the Service Concession or (b) as the Taxpayer contended only the Upfront Payment was paid to cover the 50-year of Service Concession, and the FAPs and the VAPs were merely rent paid for the use of the Concession Property for a period of 12 months. The Board was of the view that, reduced to its bare bones, the question was: Were the FAPs and the VAPs rent or part of the consideration for the acquisition of the Service Concession assets (Decision §§7(16-19));

(5)  In deciding against the Taxpayer, the Board (a) repeated its view that the distinction between the right to operate the Service Concession and the right to use the Concession Property to operate the Service Concession sought to be drawn by the Taxpayer was artificial (Decision §7(24)), (b) did not accept the Taxpayer’s argument that only the promise to pay the FAPs and the VAPs and not the payments of the FAPs and the VAPs themselves formed part of the consideration for acquiring the Service Concession (Decision §§7(26)-(27)), (c) rejected the Taxpayer’s argument that the SCA could not be treated as meaning something which it did not say or could otherwise be treated as having some substance other than its form, and as such, the Board was not entitled to disregard the form of the transaction chosen (Decision §§7(28)-(33), (d) reiterated that given the parties’ negotiations and relevant background, it accepted the CIR’s contention that the parties clearly understood that the FAPs were deferred non-contingent consideration and the VAPs were deferred contingent consideration of a nature similar or analogous to an earn-out, namely deferred contingent consideration calculated by reference to the future revenues of the KCRC system so as to ensure a fair valuation if the performance of the KCRC system improved (Decision §7(34)) and (e) preferred the CIR’s argument that, on a proper construction of the SCA, that each FAP and VAP was not payable for the right to use the Concession Property in a particular year only (and therefore akin to yearly rent) but the FAPs and VAPs were payments for the right to use the Concession Property on an “as is” basis throughout the Concession Period, partly by reason of the hell and highwater clause in paragraph 6 of Schedule 3 of the SCA by which the obligation to pay the FAPs and VAPs was absolute and unconditional even if the Concession Property did not exist in the specific year or 12-month period (Decision §§7(35)-(40)).

4.  The present application

4.1  Six questions of law are identified in the Summons:

(1)  Whether the Board has erred in law in failing or refusing to construe, understand and apply the meaning and effect of the SCA, in particular paragraphs 1 to 3 of Schedule 3 thereto (“the Relevant Provisions”), as being that thereunder the FAPs and the VAPs are subsequent annual payments for the use of the Concession Property for the period in question, as long as only if the Service Concession is still subsisting, and are thus akin to rent and revenue in nature, after the Service Concession giving rise to the right to access, use and operate the Concession Property had already been acquired and paid for by the Concession Upfront (“Q1”);

(2)  Whether the Board has erred in law in “finding” that the FAPs and VAPs have the same nature as the Concession Upfront, are “deferred consideration designed to be payable together with the Upfront payment by MTRCL for the acquisition of the Service Concession” and are “therefore expenditures of a capital nature” (“Q2”);

(3)  Whether the Board has erred in law in failing or refusing to recognise that the Service Concession and a lease are analogous for present purposes, so that the annual, recurring FAPs and VAPs paid for the use of the Concession Property for specific annual periods are analogous to rent and are revenue in nature (“Q3”);

(4)  Whether the Board has erred in law in failing to recognise and give effect to the real and genuine distinction, which the parties had the freedom to, and did, make, between the right to operate the Service Concession and the right to use and in actually using the Concession Property to operate the Service Concession for a specific annual period, and to provide for different payments for each and that, in paying for the latter, the FAPs and the VAPs are payments of a revenue nature (“Q4”);

(5)  Whether the Board has erred in law in failing to recognise and give effect to the principle that the time to test deductibility and the character of the payment is when the liability to make it is actually encountered in the form payment and not when the future liability to make it is originally incurred, and thus in applying the said principle, the FAPs and the VAPs are payments of a revenue nature (“Q5”);

(6)  If and in so far as it has relied on any of the features refer to at paragraphs 7(33) and 7(34) of the Decision in coming to the “finding” that the FAPs and the VAPs are payments in the acquisition of the Service Concession and are of a capital nature, whether the Board has erred in law in that it has thereby (i) taken into account irrelevant matters; and/or (ii) failed to give any or any proper effect to the clear and unambiguous meaning and effect of the Relevant Provisions that the FAPs and the VAPs are clearly, and agreed, and intended and calculated to be, annual payments for the use by MTRCL of the Concession Property, and are revenue in nature; and/or (iii) come to a conclusion that is contrary to the true and only reasonable conclusion (“Q6”).

4.2  The Relevant Provisions referred to at Q1 are as follows:

“[1] UPFRONT PAYMENT

On the Merger Date, [MTRCL] shall pay to KCRC an amount totalling HK$4.25 billion, being the agreed fee for the right to operate the Service Concession and the consideration for the Purchased Rail Assets (the Upfront Payment).

[2] Fixed Annual Payments

2.1 On the day immediately preceding each anniversary of the Merger Date which falls during the Concession Period (including, without limitation, on the Natural Expiry Date and on any New Expiry Date (as the case may be)), [MTRCL] shall pay to KCRC, in arrears, a fixed amount of HK$750 million for the right to use and operate the Concession Property for the operation of the Service Concession in respect of the 12 month period up to and including the date on which such payment falls due (each, a Fixed Annual Payment) …

[3] Variable Annual Payments

3.1 [MTRCL] shall pay to KCRC, in arrears, a variable annual payment in respect of each financial year of [MTRCL] which ends during the Concession Period for the right to use and operate the Concession Property for the operation of the Service Concession (each such payment a Variable Annual Payment). The Variable Annual Payment payable by [MTRCL] for each financial year shall be calculated on a tiered basis by reference to the amount of the KCRC System Revenue for that financial year, in accordance with the following table…”

4.3  In the Taxpayer’s Statement filed pursuant to section 69(3)(a)(ii) of the IRO, Mr Wong has identified 5 appeal grounds.

4.4  Q1 and Q2 relate to Ground 1. Ground 1 contends that (a) the Board has failed to properly construe and understood that the FAPs and the VAPs are payable under provisions which are different from, and have different purposes to, the provisions which create the Concession Upfront, (b) the different characteristics of the Concession Upfront on the one hand and the FAPs and the VAPs on the other, are supported by the analogy which can rightly be drawn between the Service Concession and a lease and by the contrast between rent under a lease and a premium paid for the grant of a case, by reference to the analysis in Commissioner of Taxation of Commonwealth of Australia v Citylink Melbourne Ltd (2006) 228 CLR 1, (c) even if the FAPs and the VAPs were payments by MTRCL for the acquisition of the Service Concession, it would not necessarily follow that the FAPs and the VAPs were capital in nature, (d) the adoption of the analogy with earn-out by the Board was flawed and (e) the hell and highwater clause did not assist the CIR in the proper construction of the Relevant Provisions.

4.5  Q3 relates to Ground 2. Ground 2 contends that the Board had rejected any analogy between the Service Concession and a lease apparently on the basis that the Service Concession was an asset, but the Board failed to recognize that a lease is also an asset. It is said that its failure to recognize the analogy is a flaw which runs through the Decision and has misled it into mischaracterizing the FAPs and the VAPs as part of a capital purchase price when they do to pay the price for anything except the use of assets in the period in respect of which they were paid.

4.6  Q4 relates to Ground 3. Ground 3 challenges the Board’s reluctance to draw a distinction between the right to operate the Service Concession on the one hand and the right to use or the actual use of the Concession Property to operate the Service Concession on the other. Ground 3 contends that it is clearly possible for MTRCL to pay for a long term right and separately for use in specified annual periods, and on a proper construction of the Relevant Provisions, the parties had precisely made provisions for the same.

4.7  Q5 relates to Ground 4. Ground 4 contends that the Board erred in law (1) by misstating the ratio and misunderstanding the arguments put to it based on Cliffs International Inc v The Commissioner of Taxation of Commonwealth of Australia (1979) 142 CLR 140, (2) by ignoring certain arguments based on Citylink and (3) by misapplying the decision in Ausnet Transmission Group Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia (2015) 255 CLR 439 where the payments in issue were so manifestly different from those in the Appeal. The Taxpayer contends that the point made by the forgoing cases is that the time to test deductibility and the character of a payment is when the liability to make it is actually encountered in the form of a payment and not when the future liability to make it is originally incurred. Test it accordingly the FAPs and the VAPs can only be revenue payments because they have no capital aspect to them at all.

4.8  Q6 relates to Ground 5. Ground 5 is directed at Decision §7(34) in which the Board listed out 12 matters, all relating the parties negotiations and background. Ground 5 contends that instead of applying the approach advocated by the Taxpayer, the Board had relied on the 12 matters in preference to a consideration of what the FAPs and the VAPs were truly payments for from a proper construction of the SCA.

5.  Whether leave should be granted

5.1  Under Section 69(3)(e) of the IRO, the Court of First Instance shall not grant leave to appeal unless it is satisfied (1) that a question of law is involved in the proposed appeal and (2) that the proposed appeal has a reasonable prospect of success or there is some other reason in the interest of justice why the proposed appeal should be heard. It is common ground that the merit threshold is not a high threshold: China Mobile Hong Kong Co Ltd v CIR [2018] 2 HKLRD 146 (“China Mobile Leave Decision”) §§16 and 21.

5.2  I have considered CIR’s Statement filed pursuant to section 69(3)(b) of the IRO, counsel’s skeleton submissions and the submissions made at the hearing. Despite (1) acknowledging the cogency of the reasoning given by the Board and (2) the persuasion with which Mr Fung has advanced CIR’s opposition, I am satisfied that the proposed appeal has met the requisite merit threshold. As I am of the view that leave ought to be granted, it would not be appropriate to delve deeply into the merits of the appeal other than stating the following brief reasons.

5.3  The starting position is that it is common ground between the parties in the Appeal and the present leave application that the general principles in determining whether an expenditure is capital or revenue in nature are those summarized by the Court of Appeal at China Mobile Hong Kong Co Ltd v CIR [2022] 5 HKLRD 666 §§26-29. In gist:

(1)  Whether an expenditure is capital or revenue in nature is a question of law, which must be answered in light of all the circumstances which it is reasonable to take into account, and the weight to be given to a particular circumstance in a particular case must depend on common sense rather than on strict application of any single legal principle.

(2)  Further, the question must be answered from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

(3)  Although there is no single decisive test, the courts have held that these factors may usefully be taken into account: (a) whether the expenditure is incurred once and for all, or is going to recur every year; (b) whether the expenditure is incurred with a view to bringing into existence an asset or advantage for the enduring benefit of a trade, a benefit is enduring for this purpose if it is of a permanent quality or has sufficient durability, it does not have to be everlasting; and (c) whether the expenditure relates to the cost of creating, acquiring or enlarging the permanent structure of which the income is to be the produce or fruit, or instead represents the cost of earning that income itself or performing the income-earning operations.

5.4  In my view, the proposed appeal meets the requisite threshold for the following reasons:

(1)  The parties have advanced competing (arguable) contractual interpretations of the Relevant Provisions;

(2)  Despite the agreed principle that the ultimate question should not depend on the juristic classification but should be answered from a practical and business point of view, the resolution of the competing interpretations advanced arguably would still feature in determining what was the practical and business point of view from which the question of whether an expenditure is capital or revenue is to be answered;

(3)  In my view, apart from Q2, the other questions identified in the Summons are permutations of the issues identified in the preceding 2 subparagraphs.

5.5  Whilst I am of the view that leave should be granted for the proposed appeal, I agree with Mr Fung that no leave should be granted in respect of Q2 since it is not a proper question of law as it merely turns the Board’s ultimate conclusion into a question.

5.6  I also accept Mr Fung’s criticism that Q4 is not a proper question of law since the distinction set out therein is neither a legal distinction nor mandated to be made by the authorities. However, as ventilated at the hearing, that objection may be met by rephrasing Q4 to one premised on a proper construction of the Relevant Provisions along the following lines:

“Whether the Board has erred in law in recognizing, on a proper construction of the Relevant Provisions, there was a real and genuine distinction, which the parties had the freedom to, and did, make, between the right to operate the Service Concession and the right to use and in actually using the Concession Property to operate the Service Concession for a specific annual period, and to provide for different payments for each and that, in paying for the latter, the FAPs and the VAPs are payments of a revenue nature.”

5.7  Indeed, Taxpayer’s Statement §§18-20 which are in support of the Q4 is couched in terms from the perspective of a proper construction of the Relevant Provisions. At the hearing, Mr Fung accepted once rephrased along the above lines, there was “less room” for any further objections.

5.8  There is no dispute between counsel that the China Mobile Leave Decision is an authority for the proposition that where the court considers that a taxpayer’s proposed appeal is reasonably arguable, it would not be right to dismiss the leave application without giving the taxpayer an opportunity to amend (§§22-32). At the hearing, I think counsel were content with not insisting upon a formal amendment, as long as it is made clear that at the substantive appeal Q4 should be understood in the light set out at §5.6 above.

6.  Conclusion

6.1  Leave is granted to the Taxpayer to appeal on Q1, Q3, Q4 (as rephrased at §5.6 above), Q5 and Q6.

6.2  In my view, a fair order is that, on an nisi basis, the costs of and occasioned by the present application be in the cause of the appeal, with a certificate for 2 counsel, save that the Taxpayer should pay to the CIR 10% of such costs in any event to reflect the outcome in relation to Q2 and the original Q4.