Tax Hong Kong Client Alert When Do Enhancement Activities of Real Estate Prove a Change of Intention that Triggers Profits Tax on a Subsequent Sale? The Court of Final Appeal is expected to clarify the circumstances in which enhancement activities, which increase the value of real estate, may serve as evidence supporting a factual conclusion that the property owner held the property for trading, resulting in profits tax on the gain from a subsequent sale. Prior court decisions noted that enhancement activities do not necessarily indicate that a property is held with the intention of trading. However, these decisions did not provide further guidance on the circumstances in which these activities might support this factual determination. Guidance on this issue is very important for property owners, and it may change their behavior as they may refrain from certain enhancement activities if these actions might trigger profits tax on a gain from a subsequent sale. Background In Hong Kong, when one owns land for long term investment, a gain from a subsequent disposal of the land is generally not taxed because Hong Kong does not tax capital gains. However, when one owns land for trading, the proceeds from disposal of the land will be subject to profits tax. Hong Kong courts have ruled that the question of whether land is held for long term investment or trading is a factual question that depends on the intent of the property owner. Intentions may change as the property owner might buy a property for one purpose, such as long term investment, and later change his intention to that of trading. If a change of intention is argued, the court should determine whether the evidence proves a change of intention. One important question is whether a change of intention can be evidenced by enhancement activities taken by the property owner in order to increase the value of the land prior to a subsequent sale. In a prior case (Taylor v Good (Inspector of Taxes)  1 WLR 1249), the court ruled that activities relating to the enhancement of the value of one’s capital assets for the purpose of sale do not necessarily indicate an intention of trading rather than an intention of long term investment. This is called the “enhancement for realization principle.” However, this July 2015 Beijing Suite 3401, China World Office 2 China World Trade Centre 1 Jianguomenwai Dajie Beijing 100004, PRC T: +86 10 6535 3800 F: +86 10 6505 2309 Hong Kong 14/F Hutchison House 10 Harcourt Road Central, Hong Kong T: +852 2846 1888 F: +852 2845 0476 Shanghai Unit 1601, Jin Mao Tower 88 Century Avenue, Pudong Shanghai 200121, PRC T: +86 21 6105 8558 F: +86 21 5047 0020 2 Baker & McKenzie | July 2015 decision provided no guidance on when enhancement activities may prove or support the factual determination of a change of intention. The question regarding the scope of the enhancement for realization principle was raised in a recent case, Church Body of Hong Kong Sheng Kung Hui v Commissioner of Inland Revenue and Another  5 HKLRD 384 (“Sheng Kung Hui”). On July 6 2015, the Court of Final Appeal (“CFA”) granted leave to further review this question. Therefore, we expect that this important question will be further explored and clarified by the CFA. The facts and prior court decisions The taxpayers - two charitable entities - owned land in Tai Po since the 1930s. In 1989, they considered developing the land. In 1998, after several development phases, they sold the developed land with substantial profits. The taxpayers contended that these were capital gains that were not subject to tax because the land was not held for trading. The Inland Revenue Department (“IRD”) issued profits tax assessments for these profits, arguing that the land was held with an intention to trade. The IRD argued that although the taxpayers had originally acquired the properties as a capital asset, there was a change of intention, evidenced by their development actions between 1989 and 1998, so the gain from the property’s subsequent sale should be subject to profits tax. The taxpayers appealed to the Board of Review (the “Board”), that held that the assessments were correct. The Board held that the taxpayers undertook enhancement activities to maximize profits and carried on an enterprise of a “lucrative commercial and trade character.” The taxpayers then appealed to the Court of First Instance (“CFI”), which affirmed the Board’s decision. On further appeal, the Court of Appeal (“COA”) overturned the CFI’s decision, noting that work done on the land for the purpose of maximizing profit in the subsequent sale would not evidence a change of intention from long term investment to trading. Leave was subsequently granted by the CFA on three points,1 the first of which is of particular interest: exactly what “enhancement for realization principle” arises from the authorities cited in the COA and what is its scope? The COA ruled that “activities relating to the enhancement of the value of the property for the purpose of sale would not necessarily point towards a change of intention to one of trading.” In essence, the COA affirmed the position in Taylor whereby enhancement work undertaken in response to the simple desire to realise property at the best possible price is not in itself suggestive of an intention to trade. It is possible that enhancement work undertaken by an owner on its property may not be consistent with the continuation of an intention on their part that the asset be no more than an investment. Equally, however, enhancement may 1 The other two questions were (1) in determining whether a taxpayer has changed his intention regarding an asset from holding it for long term investment to holding it for trading, is the Board required to refer to and apply the “enhancement for realisation principle” (as understood by the COA or otherwise), and if the Board fails to do so, does this justify the appellate court’s interference with the Board’s finding of fact? (2) Does a finding of fact on change of intention based solely on “enhancement activities” necessarily amount to an error of law made by the Board? July 2015 | Baker & McKenzie 3 www.bakermckenzie.com To find out more about how we can add value to your business, please contact: Steven Sieker +852 2846 1048 firstname.lastname@example.org Pierre Chan +852 2846 1560 email@example.com Josephine Chuk +852 2846 1644 firstname.lastname@example.org Noam Noked +852 2846 2116 email@example.com This publication has been prepared for clients and professional associates of Baker & McKenzie. Whilst every effort has been made to ensure accuracy, this publication is not an exhaustive analysis of the area of law discussed. Baker & McKenzie cannot accept responsibility for any loss incurred by any person acting or refraining from action as a result of the material in this publication. If you require any advice concerning individual problems or other expert assistance, we recommend that you consult a competent professional adviser. 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The COA noted that the reason for the change “colors heavily the whole matter.” The court did not express a view on which reasons may evince a change of intention and which may not. Nor, on a more practical level, did the court formulate its own guidelines as to what precise enhancement activities might constitute a change of intention. However, it is interesting that Cheung JA (with whom Yuen JA and Au J agreed) referred with approval and emphasis to the reasoning of the High Court of Australia in a similar case,2 which concerned the realization of land at a profit by a taxpayer whose initial commercial use for that land had since become unproductive. In that case, the court stated that “the facts would have to be very strong” in order for a change of intention to be found to exist, and that this is especially so where “the land which had been acquired [was] used for a purpose which it was no longer business like to carry out. “It is possible that the CFA will pick up on this theme. It could, for example, formulate a rule providing that enhancement will not evince a change of intention where the use for the land disposed of is no longer productive. In summary, the COA has left open the possibility that in certain cases enhancement activities can show a change of intention, without providing specific guidelines as to the circumstances in which this will be so. The importance of clarifying the rules We welcome the opportunity for the CFA to clarify the rules in relation to enhancement activities. The status quo is undesirable because the uncertainty with respect to the rules creates behavioral distortions, more disputes and other social costs. The current uncertainty creates a disincentive for property owners to undertake socially desirable enhancement activities. In addition, this uncertainty results in more disputes between taxpayers and the IRD. Clarifying the rules in relation to enhancement activities would enable property owners to better predict the tax consequences of their actions and reduce disputes. 2 Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation  81 CLR 188 at 195.