The Court of Appeal in Hong Kong delivered its judgment in Zeta Estates Ltd v Commissioner of Inland Revenue on 6 March 2006. Although the taxpayer in this case failed in its appeal, the comments made by Tang JA are interesting. Where a taxpayer retained profits, which were required to produce further profits and the taxpayer then chose to declare its retained profits as dividends and subsequently borrowed money for its business, would the interest on the borrowing be tax deductible? The answer from Tang JA in the Zeta Estates case is yes.
In the Zeta Estates case, the taxpayer’s business was the letting and sale of property. Its business was initially funded by shareholders’ loans of approximately HK$400 million. In February 1998, the taxpayer retained profits of about HK$407 million. In July 1998, an interim dividend of HK$396 million was declared. A final dividend of HK$594,000 was declared in February 1999. The declared dividends were not paid over in cash but were credited to the accounts of the shareholders as loans with interest charged thereon (the "New Shareholders’ Loans").
The case concerns section 16(1)(a) of the Inland Revenue Ordinance (Cap.112) (the "IRO") and turns on whether the New Shareholders’ Loans were borrowed for the purpose of producing profits. If they were, the interest on such loans would be deductible.
The Court’s Decision
The taxpayer failed in the appeal as it failed to prove that the New Shareholders’ Loans were required for its business as working capital. Noting that this was sufficient to dispose of the appeal, Tang JA went on to examine the following issue, namely, if the New Shareholders’ Loans were indeed required as working capital, whether the fact that had the taxpayer not chosen to declare and pay a dividend, its requirement for working capital would have been satisfied by the retained earnings meant that the interest incurred could not be said to have been incurred "in the production of profits" under section 16(1)(a) of the IRO.
On one hand, there is a decision of the Federal Court of Australia providing that if the funds to be withdrawn were employed in the business, the borrowing replacing those funds and the interest incurred on the borrowing will be deductible.
On the other hand, a decision of the Supreme Court of Appeal in South Africa held that if the loan was not needed for the taxpayer’s income-producing activities and that the intention was to increase the shareholder’s income but not of the taxpayer, the liability for the interest was accordingly not incurred in the production of the taxpayer’s income and therefore was not deductible.
Tang JA preferred the Australian approach as he thought that the South African approach was likely to produce highly artificial results. He said, "I am of the view that under section 16(1)(a), the answer depended on whether the borrowing was necessary for the business of the taxpayer. In other words, if the retained earnings in respect of which the dividend was declared was surplus to the business requirement of the company and the subsequent borrowing was similarly surplus to the requirement of the company, the interest paid on the borrowing would not be deductible. But if the retained profits were required by the business of the company (that however would not prevent the declaration and payment of dividend, if the company remained on a sound financial footing afterwards), interest on shareholders’ loans made to replace the retained profits would be deductible."
In conclusion, we agree with the comments made by Tang JA in the Zeta Estates case, as section 16(1)(a) of the IRO does not require one to enquire as to why there is a borrowing. If the interest on any money borrowed by the taxpayer is for the purpose of producing assessable income, it is tax deductible. This case will probably be further appealled to the Court of Final Appeal. We will keep our clients informed about the decision of the Court of Final Appeal.
Experienced lawyers in our Corporate Commercial Department advise on a wide range of corporate finance as well as tax issues for both Hong Kong listed and private companies. Please contact us if you have any queries.
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