LO TIM FAT v. COMMISSIONER OF INLAND REVENUE

HCIA 13/2005

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 13 OF 2005

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J U D G M E N T

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1.  This is an appeal by Mr. Lo Tim-fat (hereinafter called the Appellant) by way of a case stated pursuant to section 69 of the Inland Revenue Ordinance (“the Ordinance”) against the decision of the Board of Review dated 25 May 2005.

2.  The relevant factual background is summarized in paragraphs 4 to 12 of the Case stated.

3.  Briefly, the Appellant entered into a contract contained in or evidenced by a “letter of undertaking (“LOU”)” dated 6 November 2001 with American International Assurance Company (Bermuda) Limited (“AIA”) agreeing to be an insurance agent for AIA for a minimum period of 5 years.  Under this LOU the Appellant was to enter into a Career Representative’s Contract and a related Career Representative Leader’s Contract and to abide by the terms and conditions of those contracts (the “Contracts”).  In return under the LOU, AIA was to make certain payments, namely Initial Signing Fee, Balance Signing Fee, and a maximum of 12 months monthly bonus, to the Appellant on the terms set out in the LOU.  For the purpose of this appeal, the following clauses in the LOU are relevant:

“3. Subject to clause 8 and clause 9 below, after the Applicant [i.e. the Appellant] has (i) signed the Contracts, (ii) registered with the Hong Kong Federation of Insurers as agent of the Company [i.e. AIA] and (iii) commenced service as an agent of the Company (the “Commencement Date”), the Company agrees to pay the Applicant an Initial Signing Fee based on proof of income provided by the applicant, amounting to HONG KONG DOLCLARS five hundred eighty five thousand and eight hundred and eleven only (HK$585,811.00).  The Applicant warrants and represents to the Company that the income proof provided is true and accurate in all respects.

4. The Applicant agrees to faithfully perform all obligations of the Contracts and to remain as a bona fide insurance agent of the Company for a minimum of 60 months from the Commencement Date.

6.(a) Subject to Clause 8 and Clause 9 below, the Company agrees to pay to the Applicant the Balance of Signing Fee for Year 1 at the end of the twelve (12) month period immediately after the Commencement Date provided that this amount does not exceed 100% for the Initial Signing Fee.

[Sub paragraphs (b) & (c) provide for the method for the computation of the Balance of the Signing Fee and are not relevant here]

7. Subject to Clause 8 and Clause 9 below, the Company will pay the Applicant a Monthly Bonus in the sum of Hong Kong Dollars forty eight thousand and eight hundred and eighteen only (HK$48,818.00) at the end of each month for a maximum period of 12 months subject to the Applicant’s meeting the following validation requirements in relation to the annualized first year premium net after terminations for individual life and personal accident business written with the Company by the agency managed by and including the applicant at the end of the following dates (measured from the Commencement Date):

End of	1st Quarter	2nd Quarter	3rd Quarter	4th quarter
Percentage of amount	20%	45%	70%	100%

Payment of the Monthly Bonus will cease immediately upon the Applicant’s failure to meet the above validation requirement on a timely basis for any reason.  If the above validation requirement cannot be met at the end of a quarter but is satisfied at a later time by end of the 4^th quarter, then payment of the Monthly Bonus will resume and any Monthly Bonus previously unpaid will be paid to the Applicant.

8.        In the event that any of the Contracts is terminated for any reason by either the Applicant or the Company within 12 months after the Commencement Date, the Applicant agrees to refund to the Company (i) the whole of the Actual Singing Fee paid in Clause 3 and Clause 6 above, and (ii) all of the Monthly Bonus paid in Clause 7 above from the Commencement Date up to the date of termination, immediately and unconditionally.

9.         In the event that any of the Contracts is terminated for any reason by either the Applicant or the Company within the period from the 1^st to 5^th year after the Commencement Date, the Applicant agrees to refund part o the Monthly Bonus paid and Actual Signing Fee as defined below to the Company immediately and unconditionally as follows:-

Termination of Contract after The Commencement Date	Percentage of Monthly Bonus and Actual Signing Fee to be refunded
Within the 2nd year	80%
Within the 3rd year	60%
Within the 4th year	40%
Within the 5th year	20%”

4.  The Appellant was registered with the Hong Kong Federation of Insurers as an agent of AIA on 1 March 2002 and commenced services as an agent of AIA on that date.  Hence the Commencement Date under the LOU was 1 March 2002.

5.  In fact on or about 9 November 2001 the Appellant had received the sum of $1,757,433 from AIA by way of loan on the terms set out in a letter of undertaking dated 7 November 2001.   The figure of $1,757,433 was in fact the total of (i) the sum of $585,811 Initial Signing Fee payable under clause 3 of the LOU, (ii) the sum of $585,811, being the maximum amount of Balance of Signing Fee payable under clause 7 and (iii) the sum of $585,811 being approximately 12 monthly bonus of $48,818 ($48,818 x 12 = $58,816).   By the term of this undertaking, the loan was repayable by setting off the amounts payable to the Appellant under the LOU for year 1.  Of course, if by the terms of the LOU the Appellant became liable to repay any amount paid to him by the operation of clauses 8 and 9, then the Appellant would have to repay these amounts with interest. 

6.  The Board of Review decided that of the amount of $1,757,433, the sum of $585,811 being the Initial Signing Fee plus the amount of $48,818 being the 1^st of 12 monthly bonuses had accrued to the Appellant on 1 March 2002 and 31 March 2002 respectively.  Thus these 2 sums were to be part of the trading receipts for the tax year of 2001/2002.  As to the balance sum of $1,122,804 ($1,757,433- $585,811 - $48,848 = $1,122,804), being the amount of the Balance Signing Fee and the remaining 11 monthly bonuses, the decision of the Board of Review was that it should be treated as the trading receipts for the tax year 2002/2003.

7.  The main contention of the Appellant both before the Board and before me is that although the whole sum of $1,757,433 was payable to him under the LOU by 1 March 2003, i.e. 12 months after the Commencement Date, he could not be treated as having earned or made a profit in that amount because under clauses 9 he would be liable to refund the sum or a certain part thereof if for any reason his Contracts with the AIA is terminated between the 2^nd and the 5^th year.  It is not until the end of the 5^th year i.e. until 1 March 2007 that it could be ascertained whether his Contracts with AIA has been terminated within the 5 years or not.   It is not until then that it could be said that he has earned the whole of the profit of $1,757,433.  This is because the Career Representative’s Contract and the Career Representative Leader’s Contract that he signed with AIA are liable to be determined by AIA in the event of his failure to meet the performance criteria required by AIA under those Contracts.  In order to keep that amount, he would have to spend effort and incur expenses to meet the performance criteria throughout until the end of the 5^th year.   Since under clause 9 after the first year (i.e. by 1 March 2003), he would only be liable to refund 80% of $1,757,433 (being the total amount of Actual Signing Fee and monthly bonuses received), only 20% of the amount of $1,757,433 should be treated as assessable profit for the year 2002/2003.

8.  I should point out that in the Case stated, there is no finding of fact on whether under the Contracts between the Appellant and AIA, AIA would be entitled to terminate the Contracts in the event of the Appellant’s performance not meeting a certain performance criteria.  In fact I was told that since the decision of the Board of Review the Appellant had written and submitted documents to the Board on this point.  However the Board did not include anything on this point in the Case stated.  I was also told by the Respondent’s counsel that having seen the documents submitted by the Appellant to the Board, the Respondent would not agree to the proposition that AIA would be entitled to determine the Contracts with the Appellant in the event of the Appellant’s failure to meet certain performance criteria.  In the absence of any such finding in the Case stated, and in the absence of any agreement between the parties, I am unable to proceed with the determination of this appeal on the basis that the Contracts between the Appellant and AIA are liable to be determined by AIA in the event of the Appellant’s failure to meet certain performance criteria.  

9.  However the Respondent is prepared to agree that the Contracts between the Appellant and AIA may be determined by either party within the 5 years.  I will proceed on this basis although I do not think that there is any practical difference between what the Respondent is prepared to agree and what the Appellant would like to contend.  Plainly the reality of the situation is that it is not a matter of course or certainty that the Contracts would last throughout the 5 years and the plainly the Contracts would not be kept alive if either party to the Contracts are not happy with the continuous existence of the Contracts.  I would be very surprised if the Appellant’s performance is not a major factor in AIA’s decision on whether to determine the Contracts or not.

10.  In support of his contention, the Appellant refers to a case where the Respondent assessed the profit tax liability of one of his colleagues in the same position as his on the basis that only a certain portion of the Signing fees were treated as trading receipt for the first year.  The Appellant contended that his colleague was in fact in the same position as his and the documentations signed were also similar.  The Respondent’s response is that under the Ordinance, the Respondent cannot divulge information about other taxpayers and is thus unable to comment on this case referred to by the Appellant.  Having considered the material submitted to me on the Appellant’s colleague’s case, I would consider that the case is of little value in assisting me in the determination of this appeal.  Even assuming that the 2 cases are in fact indistinguishable, and that there is a discrepancy in the Respondent’s treatment of the Appellant’s case and his colleague’s case, it does not show that the treatment of the colleague’s case is necessarily correct. 

11.  The Appellant also complains of certain procedural unfairness in the hearing before the Board of Review and certain unreasonable conduct on the part of the Respondent.  I do not think that those matters are relevant to the determinations of this appeal and for that reason I express no view on them.  The question for this appeal as set out in the Case stated is: whether on true construction of the LOU and in the light of the facts as found by the Board, the appellant’s chargeable profits for the assessment year 2002/2003 was $1,122,804 or 20% of $1,757,433.  Save it must be understood that the amounts of $1,122,804 or 20% of $1,757,433 are merely figures of trading receipts or gross profits and may be subject to other just deductions in arriving at the figure of chargeable or assessable profit, I consider that the question posted correctly set out the central issue in this case. 

12.  Although there must have been a lot of people in the same situation as the Appellant, I am told that this is the first case in Hong Kong which has ever gone beyond the stage of the Board of Review.  In the absence of any guiding judicial precedent, I would proceed from first principles.

13.  Section 14 of the Inland Revenue Ordinance provides:

“(1)   Subject to the provisions of this Ordinance, profits tax shall be charged for each year of assessment at the standard rate on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong in respect of his assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business (excluding profits arising from the sale of capital assets) as ascertained with this Part.”

14.  There is no dispute that the receipt of sum of $1,757,433 arose out of the Appellant’s carrying on a trade, profession or business.  The question is whether the whole sum or any particular part thereof should be considered as the Appellant’s trading receipts thus forming the basis for assessable profits for the assessment year of 2002/2003. 

15.  Section 16(1) of the Inland Revenue Ordinance provides:

“(1)   In ascertaining the profits in respect of which a person is chargeable to tax under this Part for any year of assessment there shall be deducted all outgoings and expenses to the extent to which they are incurred during the basis period for that year of assessment by such person in the production of profits in respect of which he is chargeable to tax under this Part for any period, including -….” (emphasis added)

16.  It is clear that the deduction could only be made in respect of expenses incurred during the basis period for the year of assessment.  Hence it may be the case that in order to produce any particular profit in a particular year, the tax payer would have to incur expenses in the years before or after that year of assessment, and yet the deduction permitted is restricted to those incurred “during the basis period for that year of assessment”.  Thus the section envisages that there is a possibility that a certain profit for one year of assessment may be the result of certain expenses incurred in other assessment years.  The corollary is that the fact that expenses may have to be incurred in a number of years does not necessarily mean that the profit resulted from such expenses must be treated as profits for the years when the expenses are incurred. 

17.  In the present case the basis period for the year of assessment is the same as the year of assessment, viz 1 April 2002 to 31 March 2003.

18.  Although the whole amount of $1,757,433 had been advanced to the Appellant on 9 November 2001, I do not think that this is relevant to the issue in the present case.  This is because by the term of the advance, the amount is repayable by way of set off from the amounts payable to him under the LOU.  Hence it is when the amounts became due and payable to the Appellant under the LOU that it could be said that the Appellant had received the Signing Fees or the Monthly bonuses as the case may be.

19.  Under clause 6(a) of the LOU, in the event that had happened the Appellant was entitled to be paid the balance of the Signing Fee in the sum of $585,811 on 1 March 2003.   As on 1 March 2003, this amount of the Balance of Signing Fee would belong to him beneficially and he could use it for whatever purpose he deemed fit.  No doubt under clause 8 of the LOU the Appellant would be liable to repay the whole of the sum if the Contracts between him and AIA were determined before 1 March 2003.  This event did not happen within the year of assessment of 2002/2003.  Hence clause 8 is not relevant.   Under clause 9 the Appellant would be liable to refund 80% of the amount received if the Contracts between him and AIA were terminated between 1 March 2003 and 28 February 2004 (the 2^nd year) and he would be liable to repay other percentages of the amount received if the Contracts were terminated at other time before the end of the 5^th year (i.e. 28 February 2007).  However all these contingencies giving rise to the obligation to refund had not occurred at all during the year of assessment in question (i.e. 1 April 2002 to 31 March 2003).  It has not been contended that the Appellant should be entitled to make certain provisions for the contingent refund liability for the future years. 

20.  Thus the short point in the present case is whether a certain amount received by a tax payer beneficially in the course of his trade could be properly treated as trading receipt on the day of the receipt when there is a possibility that in the future the tax payer may be liable to refund certain part of the amount.  

21.  In Smart v Lincolnshire Sugar Co. Ltd. (1937) 20 T.C. 643 the tax payer was entitled to receive certain subsidy from the Government under the British Sugar (Subsidy) Act 1925 for 10 years.  In 1931, the tax payer was further entitled to receive some money from the Government under The British sugar Industry (Assistance) Act 1931 by way of weekly payments for one year commencing on 1st October 1931.  The payments were described as advances in the 1931 Act.  The 1931 Act provided that in the event of a rise in sugar prices, the advances were repayable, wholly or in part, by deductions from the subsidies received under the 1925 Act in respect of sugar manufactured during the period of 2 years beginning on 1 October 1932, and that in the event of the winding of the up or appointment of a receiver of the recipient of the advances within the period of 3 years beginning on 1 October 1931, the total advances, so far as not already repaid, were to become repayable.  Apart from these provisions, the advances were not repayable.  The question was whether the advances should be treated as trading receipts for the year when they were paid, or should only be treated as trading receipt until the period during which possible repayment might be claimed had expired.   The House of Lords decided that notwithstanding that the amounts were described as advances in truth the payments were not in the nature of loans at all.  The payments were made to the taxpayer in order that the money might be used in its business.  They were supplementary trading receipts bestowed upon the taxpayer by the Government and proper to be taken into computation in arriving at the balance of the taxpayer’s profit and gains for the year in which they were received.  Even though the amounts were repayable upon certain contingencies, they should not be treated as trading receipts only when it could be certain that the repayment was not required. 

22.  In the present case, once the amount of the Balance of Signing Fee was received, the Appellant held the sum beneficially and was entitled to use it for whatever purpose he liked including for his trade and business.  Although there was a possibility that he might have to repay part of the amount received to AIA in the future, on the authority of Smart v Lincolnshire Sugar Co. Ltd, I am of the view that the amount should properly be considered to be part of his trading receipt for the year when the sum was received and accrued to him. 

23.  The same reasoning must likewise apply to the monthly bonuses payable to the Appellant under clause 7 of the LOU.  All the 11 monthly bonus payable to him during the period between 1 April 2002 and 28 February 2003 were money properly accrued to him and would belong to him beneficially.  They should be treated as trading receipts by him in the year of assessment of 2002/2003. 

24.  The position may well be different if the amounts were received by the Appellant as loan or money paid on account or as security to satisfy the liability of the payer (i.e. AIA) in the future. 

25.  To conclude, I am of the view that the Board of Review has come to the correct decision and my answer to the question posted in the Case Stated is that on true construction of the Letter of Undertaking dated 6 November 2001 and in the light of the facts as found by the Board, the sum of $1,122,804 should be treated as trading receipts for the purpose of assessing the Appellant’s assessable profit for the assessment year 2002/2003.  The appeal is dismissed with cost.