Upfront lump sum spectrum utilization fees held as capital in nature and not deductible

Gwenda Ho, Fergus Wong and Anita Tsang

Examining the Court of First Instance judgment

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Gwenda Ho, Fergus Wong and Anita Tsang


The Court of First Instance (CFI) handed down its judgment in China Mobile Hong Kong Company Limited v. Commissioner of Inland Revenue (CIR) in July. The key issue in this case is whether the upfront lump sum spectrum utilization fees (upfront SUFs) paid by the taxpayer to the Telecommunications Authority (TA) were capital in nature and not deductible. 

The CFI dismissed the taxpayer’s appeal and upheld the Board of Review’s (board) decision that the upfront SUFs were capital in nature and not deductible.

This article summarizes the relevant facts of the case, highlights the key findings of the CFI and discusses our comments on the industry-wide “black hole expenditures” issue.

Background of the case

Below is a summary of the key facts of the case:

  • The taxpayer is a mobile telecommunications and related services provider in Hong Kong. Since 1996, the taxpayer has paid annual spectrum utilization fees (annual SUFs) to the government for the use of 2nd Generation (2G) frequency bands assigned to it for its operations.
  • In 2007, the TA recommended to the government that the future 4th Generation (4G) spectra would be allocated by auction and the SUF would be in the form of an upfront lump sum payment. The auction of 4G spectra was completed early 2009 and the taxpayer was the successful bidder of one of the frequency bands. The taxpayer paid a one-off lump sum SUF in the amount of HK$494.7 million in March 2009.
  • In 2008, the TA proposed to the government to make certain unallocated 2G frequency bands available to the existing 2G licensees by auction. In addition to the annual SUFs, a successful bidder was required to pay a one-off lump sum SUF. The taxpayer was the successful bidder of two frequency bands in the auction held in June 2009 and made total lump sum payments of HK$15.1 million.
  • In its audited financial statements, the taxpayer classified the upfront SUFs as non-current intangible assets and amortized them on a straight-line basis over the relevant licence periods.
  • The taxpayer sought to deduct the annual SUFs and amortization of the upfront SUFs in its profits tax computations for years of assessment 2009/10 to 2011/12. The assessor raised assessments for these years of assessment in accordance with the returns.
  • Subsequently, the assessor raised additional assessments disallowing the deduction of the amortization of the upfront SUFs on the basis that such fees were capital in nature. These assessments were confirmed by the determination of the Deputy CIR.
  • The taxpayer appealed against the assessments to the board, which dismissed the appeal and held that the upfront SUFs were capital in nature and not deductible.
  • The taxpayer then lodged an appeal against the board’s decision to the CFI.

The CFI’s judgment 

In the appeal before the CFI, the taxpayer sought to draw a distinction between (1) a payment for the “right to use” radio spectrum (which is capital in nature) and (2) a payment for the “use of” such spectrum (which is revenue in nature). The taxpayer’s key argument, based on the various provisions of the Telecommunications Ordinance (TO), was that the upfront SUFs were paid for the use of, as opposed to the right to use, the 2G and 4G frequency bands and therefore were revenue in nature and deductible.

The CFI dismissed the taxpayer’s appeal and upheld the board’s decision that the upfront SUFs were capital in nature and non-deductible. Below is a summary of the CFI’s analyses in its judgment.

“Right to use” vs. “actual use of” the radio spectrum

  • It is not necessary in every case to draw a distinction between a payment for the “right to use” and a payment for the “use of” an asset for the purpose of determining whether the payment is capital or revenue. It is, in the judge’s view, wrong in principle to treat such distinction as being decisive of determining the nature of a payment.
  • Upon a consideration of the legislative regime under the TO and looking at the matter from a practical, business and common sense point of view, there is no reason to believe that the legislature had the above distinction in mind. There is nothing in the TO suggesting that the obligation to pay the upfront SUFs would only arise upon actual use of the assigned spectrum.
  • The upfront SUFs were the considerations which the taxpayer had to pay in order to be able to use (i.e. for the right to use) the designated spectrum. They were payable by the taxpayer regardless of whether it actually used, or made use of, the spectrum, and regardless of the extent of its use of the spectrum.
  • The notices of terms and conditions issued by the TA relating to the 2G and 4G auctions specified the “right to use” the specified frequency bands.

Capital vs. revenue expenditure

  • There are well-established principles for determining whether an expenditure is capital or revenue in nature. As a question of law, there is no single decisive test and the issue has to be approached by applying common sense from a practical and business point of view having regard to all relevant features of the case. Some useful indicia can nevertheless assist in answering the question, namely whether the expenditure (1) is incurred “once and for all” or is “recurring”, (2) is incurred with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade and (3) relates to the costs of creating, acquiring or enlarging the permanent income-producing structure as opposed to performing the income-earning operations.
  • The 4G spectrum and the additional 2G spectrum acquired by the taxpayer were part of the necessary and permanent profit-earning structures required by it to venture into a new line of business (i.e. the provision of 4G services) or expand and strengthen its existing line of business (i.e. the provision of 2G services).
  • The upfront SUFs would bring about enduring benefits to the taxpayer’s business as the taxpayer could provide 4G and additional/enhanced 2G services to its customers for the next 15/12 years respectively.
  • The upfront SUFs were lump sum payments incurred once and for all, instead of periodic payments to meet an ongoing demand for expenditure.
  • The change in the method of fixing and payment of the SUFs from an annual royalty basis to an upfront lump sum basis was driven by economic, business and administrative considerations. The motive or purpose of the recipient (i.e. the TA) in the method of payment is irrelevant in deciding whether the payment is capital or revenue in nature as far as the profits tax position of the payer is concerned. The correct question is what the expenditure is calculated to effect from the payer’s practical and business point of view.
  • There are significant differences between the annual SUFs and the upfront SUFs. In particular, the annual SUFs were made annually and calculated by reference to the network turnover of the taxpayer subject to a minimum amount. These are the relevant factors which support the view that the annual SUFs were revenue in nature (a view that the CFI assumed, without deciding, was correct).

The takeaway

The CFI’s analyses on the nature of the upfront SUFs, based on the agreed facts, are in line with the legal principles established by the judicial precedents in determining whether an expenditure is capital or revenue in nature. It may be worth noting that the judge made a comment in their judgment that a distinction between the “right to use” and the “use of” an asset is not decisive, or even not necessary, in determining the nature of a payment. Arguably, an upfront lump sum payment made to secure the right to use an asset for the next 10 years is different in nature from an upfront lump sum that represents payment made in advance for the annual use of the asset for the next 10 years. Since this distinction formed the crucial argument of the taxpayer, it has yet to be seen whether the taxpayer will further appeal the case to a higher court.

Certain expenditures incurred by telecommunication service providers for acquiring an intangible, such as the upfront SUFs in this case and the payments for acquiring an indefeasible right of use (IRU) of certain capacity of a submarine/optical fibre cable, have been a controversial issue from a business perspective. As decided by the CFI in this case, the upfront SUFs are not tax deductible despite these expenditures were necessarily incurred by the taxpayer in producing its chargeable profits in Hong Kong. These so-called “black hole expenditures” may also exist in other industries such as the catering and retail industries where a lump sum may be incurred to acquire a licence or franchise for running a business.

The non-deductibility of “black hole expenditures” is an industry-wide issue and will hinder the development of Hong Kong as a world-class telecommunication services centre. Therefore, the government should consider expanding the existing scope of tax deduction for capital expenditures incurred for acquiring intangible properties to cover not only patents, trademarks and copyrights, etc. but also other intangibles such as spectra and IRUs as far as they are used in producing profits chargeable to tax in Hong Kong. Similar to granting depreciation allowances to investment in plant and machinery or allowing one-off deduction for computer software under section 16G of the Inland Revenue Ordinance, providing tax deduction to this type of capital expenditures will encourage investments in the relevant business sectors, such as the telecommunication industry.

This article is contributed by Gwenda Ho, Partner, Fergus Wong, Director, and Anita Tsang, Tax Services, Director, of PwC

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