Advance Ruling Case No. 28

1. The provisions of the Ordinance

This ruling applies in respect of sections 14(1), 16(1), 16(1)(ga), 16F(1), 16G(1), 18F(1), 33A(1), 34(1), 34(2), 39B(1) and 39B(2) of the Inland Revenue Ordinance ("IRO").

2. Background

(a)

X and Y are related companies dealing with each other on an arm's length basis. X is a manufacturer and Y is a distributor.

(b)

Y is X's sole customer and purchases all of X's production under a long term contract.

(c)

Both companies consider the long-term contract is only a contract for Y's purchase of X's production. Under the current accounting standards, Y's purchases are a deductible expense and X is assessable on its sales income.

(d)

Manufacturing assets owned by X are recorded in its books. X claims the depreciation allowances and other capital expenditure deductions allowable under the IRO.

(e)

The long-term contract does not contain any option or provision for the purchase by, or transfer to, Y of X's fixed assets. The companies have no intention to transfer the substantive ownership of the fixed assets from X to Y and X will remain the legal owner of the assets.

(f)

Notwithstanding the accounting treatment dictated by HKFRS-Int 4 and HKAS 17, X and Y have never had any intention to regard X's fixed assets as being under finance leases to Y.

3. The arrangement

(a)

HKFRS-Int 4 has been issued by the Hong Kong Institute of Certified Public Accountants and is effective for accounting periods beginning on or after 1 January 2006. It provides guidance for determining whether a transaction (or a series of related transactions) which do not take the legal form of a lease but conveys a right to use an asset in return for a payment or series of payments are, or contain, leases that should be accounted for in accordance with HKAS 17. HKFRS-Int 4 also provides guidelines on how payments made for such leases should be separated from payments for other elements contained within the arrangement.

(b)

"Take-or-pay" contracts fall within the scope of HKFRS-Int 4. "Take-or-pay" contracts are defined as contracts where the purchaser takes all, or substantially all, of the output or other utility of the underlying asset. X and Y have determined that their long-term contract contains leases with service elements and is subject to HKAS 17.

(c)

The revised accounting standard will result in the long-term contract being treated as a lease by Y of X's fixed assets. For accounting purposes -

Ownership of the assets and the claimant of depreciation will become Y, not X;

ii.

There will not be any changes in the long-term contract nor any sale or transfer of manufacturing assets from X to Y. Legal ownership of all manufacturing fixed assets will remain with X;

iii.

The long-term contract will, from a legal perspective, remain an agreement between X and Y for the sale and purchase of production.

(d)

Under HKAS 17, the lease and the service elements are accounted for separately, as follows -

Lease element - evaluated to determine whether they are finance or operating leases. Due to the unspecified tenure of the long-term contract, the lease of the manufacturing plant and associated assets is a finance lease under HKAS 17,

ii.

Service element - cost for services such as fuel, insurance, maintenance and other general administrative costs;

(e)

Under finance lease accounting -

Y will be regarded as a lessee and manufacturing fixed assets previously recorded in X's accounts will be accounted for as Y's fixed assets under a finance lease,

ii.

New production facilities still under construction will be held in X's books. Upon commissioning, they will be de-recognised in X's books and recognised as assets under finance leases in Y's accounts,

iii.

Y will allocate the price paid to X under the long term contract to -

(A)

the minimum lease payment for the finance lease, which will then be further allocated between the reduction of the finance lease obligation in the balance sheet and finance charges charged to the profit and loss account; and

(B)

service/lease rental payments, which will be charged to the profit and loss account,

iv.

X will become the lessor of the manufacturing assets. Operational fixed assets hitherto recorded in its books will be de-recognised and corresponding finance lease receivables recognised in the balance sheet,

X will allocate the price received under the long term contract to -

(A)

the minimum lease payment for the finance lease, which is then further allocated between the reduction of the finance lease receivables in the balance sheet and finance lease income in the profit and loss account, and

(B)

other service/lease rental elements, which will be recognised as income in the profit and loss account.

4. The ruling

(a)

The legal form of a transaction determines its treatment for the purposes of the IRO. If the application of an accounting standard or interpretation is inconsistent with the form of a transaction, the form of the transaction will prevail.

(b)

Sums received by X from the sale of its production pursuant to the long-term contract will be subject to profits tax under section 14(1).

(c)

X, in respect of machinery, plant and buildings used by it in producing products for sale to Y under the long term contract, will continue to be, pursuant to -

sections 34(1), 34(2) and 18F(1) of the IRO, eligible to claim initial and annual allowances in respect of capital expenditure incurred by it on the construction of industrial buildings and structures,

ii.

sections 33A(1) and 18F(1) of the IRO, eligible to claim annual allowances in respect of capital expenditure incurred by it on the construction of commercial buildings and structures,

iii.

sections 39B(1), 39B(2) and 18F(1) of the IRO, eligible to claim initial and annual allowances in respect of capital expenditure incurred by it on machinery and plant,

iv.

sections 16F(1) and 16(1)(ga) of the IRO, eligible to claim deductions in respect of capital expenditure incurred by it on the renovation or refurbishment of buildings and structures (other than domestic buildings and structures),

sections 16G(1) and 16(1)(ga) of the IRO, eligible to claim deductions in respect of capital expenditure incurred by it on prescribed fixed assets.

(d)

Y will -

pursuant to section 16(1) of the IRO, be entitled to a deduction for the cost of the production purchased from X under the long term contract;

ii.

not be eligible to claim deductions or allowances, as the case may be, under sections 16(1)(ga), 16F(1), 16G(1), 18F(1), 33A(1), 34(1), 34(2), 39B(1) and 39B(2) in respect of any capital expenditure incurred by X in respect of any prescribed fixed assets, machinery and plant, industrial buildings and structures and commercial buildings and structures owned by X, including capital expenditure incurred on the renovation or refurbishment of such industrial or commercial buildings or structures.

5. The period for which the ruling applies

This ruling will apply for the year of assessment 2006/2007 and all subsequent years of assessment.

6. The material assumptions in respect of a future event or any other matter made by the Commissioner

In making this ruling the Commissioner assumed that -

(a)

Legal ownership of the operational fixed assets will remain with X;

(b)

The terms of the long-term contract will remain unaltered.

7 . Date of ruling issued

31 August 2006.

8. Commentary

The Department's established position, where a conflict arises between the form of a transaction and its economic substance, is that for taxation purposes form will always prevail. This position applies equally to the application of accounting standards. In any situation where a disparity of treatment arises between the interpretation and/or application of an accounting standard and the interpretation and/or application of the true legal form of a transaction, the strict legal position and not the economic position dictated by the relevant accounting standard will prevail.

(This commentary is not a legally binding statement and it does not form part of the Ruling.)