The Judicial Committee of the Privy Council Decisions

Privy Council Appeal No. 10 of 1997

 

The Commissioner of Inland Revenue Appellant

v.

Cosmotron Manufacturing Company Limited Respondent

 

FROM

 

THE COURT OF APPEAL OF HONG KONG

 

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REASONS FOR REPORT OF THE LORDS OF THE

JUDICIAL COMMITTEE OF THE PRIVY COUNCIL

OF THE 23rd June 1997, Delivered the

28th July 1997

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Present at the hearing:-

Lord Browne-Wilkinson

Lord Lloyd of Berwick

Lord Nolan

Lord Hoffmann

Lord Clyde

  ·[Delivered by Lord Nolan]

 

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On 19th May 1997 their Lordships heard the arguments of the parties to this appeal.  Subsequently, their Lordships humbly advised Her Majesty that the appeal should be dismissed.  They now give their reasons for that advice.

 

1. In 1968 Cosmotron Manufacturing Company Limited ("Cosmotron") began to carry on the business of manufacturing metal products from a factory in Hong Kong.  In March 1991 Cosmotron closed the factory, ceased its business, and thereby made its employees redundant.

 

2. Although Cosmotron continued to take on some new employees until shortly before the cessation of its business, the majority of its work force had been with the company for more than ten years, and some for more than twenty years.  In  these  circumstances,  Cosmotron was obliged under the terms of the Employment Ordinance to make substantial severance payments to all but a few of its redundant employees.  Under section 31B of that Ordinance, a severance payment falls to be made to any employee who has been employed under a continuous contract for at least two years, and who is dismissed by reason of redundancy or is laid off.  Under section 31G the severance payment is calculated by allowing two-thirds of the employee's last month's wages or eighteen days' wages out of the last thirty normal working days, for every year (pro rata as respects an incomplete year) of employment, subject to a maximum equal to the total wages earned in the last twelve months.

 

3. During its basis period for the year of assessment 1990/91 the severance payments made by Cosmotron to 117 of its redundant employees came to a total of HK$2,937,981.  The appellant, the Commissioner of Inland Revenue, decided that these payments should be disallowed in computing the assessable profits of Cosmotron.  The Board of Review, Findlay J. and (by a majority) the Court of Appeal rejected the view taken by the Commissioner, and held that the severance payments were a properly deductible expense.  The Commissioner appealed to their Lordships' Board.

 

4. The relevant provisions of the Inland Revenue Ordinance (Cap. 112) are section 16(1) and section 17(1)(b).

 

5. Section 16(1) provides that:-

"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 ..."

 

6. Section 17(1) provides that:-

"For the purpose of ascertaining profits in respect of which a person is chargeable to tax under this Part no deduction shall be allowed in respect of ...

 

(b)any disbursements or expenses not being money expended for the purpose of producing such profits; ..."

 

7. There are, of course, cases in which an expense which is prima facie deductible under section 16 ceases to be deductible because it falls within one of the prohibitions in section 17, but no such difficulty arises in the present case.  The relevant provisions of the two sections are complementary.  All that needs to be noted is that the deductibility of a particular expense in a given basis period does not depend upon its having been incurred in the production of profits in that same period: it is sufficient that the expenditure was incurred in the production of profits "for any period", be it the current period or an earlier period or a later period, in respect of which tax is chargeable.

 

8. The point at issue between the parties may be simply stated.  Cosmotron contends that the severance payments are deductible because its obligation to make them arose from the terms upon which the employees had been engaged and had remained in employment.  The obligation had thus been incurred, together with the other obligations of Cosmotron towards its employees, for the purpose of producing profits throughout the period of their employment.  The Commissioner, on the other hand, contends that the severance payments were not made for the purpose of producing profits: they were made for the purpose of discharging the employees and closing the business down.

 

9. Counsel for the Commissioner contended that the purpose for which the payments were made must be judged at the time when Cosmotron's liability to make them accrued.  Until that time, they represented merely a contingent liability for which no deduction or provision could be made in computing taxable profits.  When the actual liability accrued, it did so as a result of the decision by Cosmotron to put an end to its business.  It is well established that a payment made for the purpose of closing down a business cannot be deducted in computing taxable profits.

 

10. For this last proposition there is ample authority, in decisions of both the Hong Kong and the United Kingdom courts.  The long standing rule for the deductibility of payments under United Kingdom law, now set out in section 74 of the Income and Corporation Taxes Act 1988, is  that  the payments, in order to be deductible, must be laid out wholly and exclusively for the purposes of the trade, but in the context of the present case their Lordships can see no material difference between this test and the test laid down in section 16(1) and section 17(1)(b) of the Hong Kong Ordinance.

 

In Commissioners of Inland Revenue v. The Anglo Brewing Co. Ltd. (1925) 12 T.C. 803, which was concerned with ex gratia payments made to employees on the closing down of a business, Rowlatt J. concisely expressed the principle upon which the Commissioner relies when he said, at pages 812-3:-

"Now I cannot conceive how, under those circumstances, there can be any evidence at all that the payments were made for the purpose of the trade, because that must mean for the purpose of keeping the trade going, and of making it pay.  There was not any such purpose at all.  The purpose was to wind it up ..."

 

11. In the present case the payments were not, of course, made ex gratia, but counsel for the Commissioner submits that this makes no difference because the obligation to make them resulted, and resulted solely, from the decision of Cosmotron to close its business.  The severance payments, it was submitted, were fundamentally different from the long service payments to which an employee would become statutorily entitled on normal retirement and which were accepted as deductible expenses.  The two types of payment were calculated in broadly the same way, that is by reference to length of service, but the latter were to be distinguished from severance payments because the obligation to make them was unconnected with the closure of the business: it was simply a reward for long continuing and unbroken service.

 

12. The Board of Review were unimpressed with this distinction.  In the course of their decision they said:-

"In the present case the employees worked for the Taxpayer and earned a prospective entitlement to severance pay or long service pay.  Under the Employment Ordinance this entitlement to severance or long service pay would crystallize and the sum become payable upon certain future events.  One of the future events would be the closure of the factory which occurred in the case before us.  At that moment in time the employer is required to make immediate payment of entitlements  which  have  accrued over a number of years on a contingent basis.  In such circumstances it would appear to us quite clear that the expenses are monies which have been expended for the purpose of producing past profits."

 

13. In their Lordships' view, in saying this the Board of Review correctly refused to distinguish severance payments from long service payments on the ground that the former represented a merely contingent liability until the occasion for that payment arose.  It might equally be said that long service pay represented only a contingent liability because by virtue of section 31R it would only be received if the employee retired in the ordinary way and did not become entitled to a severance payment.  The question nevertheless remains whether the Board of Review were right in holding that both types of payment were equally deductible, notwithstanding that the severance payments were inseparably linked to the decision to close down the business.

 

14. Counsel for the Commissioner relied in this connection upon the decision of the United Kingdom Court of Appeal in Godden v. A. Wilson's Stores (Holdings) Ltd. (1962) 40 T.C. 161.  The respondent company in that case carried on the trade of rubber planters.  The manager of the company's estates was employed under a contract terminable by six months' notice to be given on 31st March or 30th September in any year.  On 15th March 1958, the company entered into an agreement to sell its estates, and the sale was completed on 31st March 1958, on which date the trade of the company was discontinued.  By a letter dated 27th February 1958 the manager was given notice of the termination of his employment, and on 28th March 1958 was paid the sum of ,1,900 representing the salary due to him for the six months to 30th September 1958, and the estimated commission which he would have earned in that period.

 

15. The Special Commissioners upheld the Company's appeal.  The basis upon which they did so appears from paragraph 6 of the stated case, which includes the following passage at page 164:-

"In the letter of 27th February, 1958, written by the Company's secretary to Mr. Paton, the proposed payment of ,1,900 was described in the following words:

 

`A payment should be made to you of $1,900, being six months' remuneration in lieu of notice as under your agreement you are entitled to full remuneration up to the 30th September, 1958.'

 

16. It was clear from the letter of 27th February, 1958, that Mr. Paton was aware that the Company was proposing to sell the Malayan estates with effect from 31st March.  The directors exercised control in London and perforce they had to rely on Mr. Paton's services in Malaya until the purchasers took possession.  Understandably, therefore, the directors did not wait until 31st March to give notice to terminate Mr. Paton's employment and to make known to him the proposals summarised in the letter of 27th February.  As we saw it, the directors decided to break a service agreement with their manager which they had entered into in the course of their trade.  They decided in February, 1958, to break the agreement, and in that same month they notified their manager and told him that they would pay him ,1,900, being six months' remuneration in lieu of notice.  We held that the payment of ,1,900 should be regarded as expenditure incurred on revenue account during the period ending 31st March, 1958, to break a trading obligation.  It was, therefore, an allowable deduction in computing the Company's profits."

 

17. Thus the Special Commissioners appear to have regarded the payment as representing, in effect, additional remuneration paid to the manager in order to keep him in his post during the final period of trading.  If that had been its true character, their Lordships see no reason to doubt that the payment would have been properly deductible.

 

18. In the light of the view taken by the Special Commissioners, it is understandable that counsel for the company defended their decision on this basis in the High Court and the Court of Appeal.  At page 173 of the report Upjohn L.J. at page 173 said:-

"Mr. Borneman has submitted that, in truth and in fact, this sum of ,1,900 was in reality paid to keep Mr. Paton working hard in the interests of his employers until the hand-over on 31st March, 1958 - for, as I have already pointed out, it was essential that the estates should at all times be kept in a first-class and efficient condition.  Therefore,  he  submits  that  this is, in effect, additional remuneration paid to him for keeping on until 31st March."

 

19. Upjohn L.J. went on to reject the argument, however, because it did not accord with the legal character which the payment bore.  At page 174 Upjohn L.J. continued:-

"It is perfectly true that this payment might have been so devised that the Company might have been entitled to claim this as a deductible expense, as being the remuneration of Mr. Paton during this period; but, in fact, it was not so devised. ...  What the parties were intending to do was to give Mr. Paton ,1,900 in lieu of notice, which is as common a transaction as one can possibly have.  In other words, they were paying him compensation for the fact that they were not going to employ him for the full time for which they were bound so to employ him: and, for that and other reasons, Mr. Paton was happy and willing to accept that arrangement.  To my way of thinking, that payment cannot possibly be described as a payment for the purposes of trade.  It was made because the Company was not going on to trade, and they were left with the possibility of an action for damages against them for breach of the agreement of employment.  I accept Mr. Borneman's submission that, though it was made on the occasion of discontinuance, it was not because of that, and it was not to enable them to discontinue business: they were going to do that anyway.  But this payment was not made for the purposes of the trade they were going to carry on: it was to get rid of a possible law suit after discontinuance."

 

20. Counsel for the Commissioner relied upon this decision as authority for the proposition that a payment does not qualify for deductibility merely on the grounds that it stems from an obligation entered into as part of the contract of employment: to be deductible, it must be made for the purpose of continuing the trade.  Counsel for Cosmotron sought to distinguish the Godden case on the ground that the payment there, unlike the severance payments in the present case, was expressly related to the period after the cessation of trading.

 

21. Their Lordships have no difficulty in accepting the reasons  why  the Court of Appeal rejected the argument put

forward by counsel for the company.  The payment simply was not made by way of additional remuneration for the period to 31st March.  Nor would their Lordships accept the submission of counsel for Cosmotron that the Godden decision can be distinguished merely on the ground that the payment was related, at any rate as a matter of calculation, to a period after the end of trading.  Their Lordships have difficulty in seeing, however, why the payment should not have been deductible simply because it discharged an obligation entered into by the company as an ordinary incident of its contract of employment with the manager.  The obligation to give six months' notice or pay damages in lieu had been a term of the contract since its inception.  It was not suggested in that case, nor in this, that there could be any question of the payment being regarded as capital expenditure.  In their Lordships' judgment the matter was well put by Findlay J. in the following passage from his judgment in the present case:-

"It is, in my view, quite wrong to say that the liability to pay the expense of severance payments is incurred for the purpose of closing up a business.  It is not a businessman's aim to close up his undertaking.  It may be a consequence of the closing of the business that the employees become redundant, and, therefore, the liability crystallises.  The employer has always had a potential liability as an unavoidable part of conducting his business; that potential is realised by the closing of the business, but liability was not incurred for the purpose of closing the business.  The employer does not undertake the obligation in order to close up his business; he undertakes it because he wishes to employ people in order to make things, so that he can sell them and make a profit.  It is true that the event which triggers the payment to the employee is the dismissal by reason of redundancy because the business is shut down, but that is not the purpose for which the expense was incurred."

 

22. The view thus taken by Findlay J. was upheld in the Court of Appeal by both Nazareth V.-P. and Bokhary J.A.  Liu J.A., on the other hand, in his dissenting judgment, was unable to accept that in the circumstances of the present case the severance payments could be regarded as having been incurred in the production of profits as envisaged by section 16(1).  He regarded the words "in the production of profits" as  having  a  much  narrower  ambit  than the words "for the purposes of the trade" which appear in the United Kingdom Income and Corporation Taxes Act 1988.

 

23. The difference in language is undeniable, but the phrase used in the United Kingdom legislation has generally been interpreted by the courts in a manner consistent with that of the Hong Kong Ordinance.  Thus in Strong & Co. of Romsey Ltd. v. Woodifield [1906] AC 448 Lord Davey said, at page 453:-

"I think that the payment of these damages was not money expended `for the purposes of the trade'.  These words are used in other rules, and appear to me to mean for the purpose of enabling a person to carry on and earn profits in the trade etc.  I think the disbursements permitted are such as are made for that purpose.  It is not enough that the disbursement is made in the course of, or arises out of, or is connected with, the trade, or is made out of the profits of the trade.  It must be made for the purpose of earning the profits."

 

24. In their Lordships' view, the severance payments in the present case were properly accepted by the Board of Review, by Findlay J., and by the majority of the Court of Appeal as representing expenditure both for the purpose of producing profits and in the production of profits.  The obligation to make them was contingent, like many of the employer's other contractual or statutory obligations, but was nonetheless incurred as a necessary condition of retaining the services of the employees concerned.  The argument advanced by Cosmotron in the present case was not put to the Court of Appeal in Godden, and the reception which it would have received must be a matter for speculation.  The point does not appear to have been explored in the later cases in which Godden has been cited, and which have helpfully been brought to their Lordships' notice in a joint note prepared by counsel for the parties.  In the opinion of their Lordships the reasoning of the Court of Appeal in Godden should not be applied in the present case.

 

25. These, then, are the reasons why their Lordships humbly advised Her Majesty that the appeal should be dismissed and directed that the appellant should pay the respondent's costs before their Lordships' Board.

 

© CROWN COPYRIGHT as at the date of judgment.