The Inland Revenue Board of Malaysia has been disallowing employee share option scheme (ESOS) expenditure as deductions and has issued Public Ruling No. 11/2012 on Employee Share Scheme Benefit (PR 11/2012) to the effect that such an expenditure is not deductible.
In the case of Ketua Pengarah Hasil Dalam Negeri v Asia Energy Services Sdn Bhd, the Court of Appeal ruled that expenses paid by a taxpayer to its ultimate holding company in return for the grant of share options to the taxpayer’s employees are deductible for income tax purposes.
This article briefly examines the nature of ESOS expenses, and highlights the facts of Ketua Pengarah Hasil Dalam Negeri v Asia Energy Services Sdn Bhd and the key takeaways from that case.
Brief Analysis
ESOS expenses are revenue in nature
It is a trite taxing principle that where sums of money are incurred for the purpose of enabling the conduct of a business on a profitable basis, then the expenditure is expenditure incurred in producing income and is hence deductible. The expenditure may not be necessary but if it was incurred for commercial expediency and to facilitate the carrying on of the business, it is considered as wholly and exclusively incurred in the production of income.
In so far as expenses relating to employees’ reward / compensation for services rendered are concerned, it is well-established that such expenses are deductible to employers as the employees’ services are rendered to produce income for the employers. The Courts have always accepted that whether the compensation is in cash or in kind, it is equally deductible.
ESOS is recognised under the Malaysian Income Tax Act, 1967 (the “Act”) to be a form of non-monetary compensation, in particular, a perquisite. Although the granting of ESOS to employees is recognised under the Act, the issue of deductibility of costs incurred by employers has not been thoroughly considered by the Malaysian Courts until the case Ketua Pengarah Hasil Dalam Negeri v Asia Energy Services Sdn Bhd. There are nevertheless robust case law authorities in foreign jurisdictions with regards to the deductibility of ESOS expenses:
1. One highly persuasive authority is the English Court of Appeal case of Heather (H M Inspector of Taxes) v P-E Consulting Group Ltd [1973] 1 All ER 8.
In this case, the taxpayer company carried on a management consultancy business and had a number of professional staff. There was upheaval in the management, causing the senior professional staff to be disgruntled, and the taxpayer company risked losing their senior professional staff. As such, the taxpayer company introduced a scheme to enable the employees to obtain control of the taxpayer company. A trust fund was set up to enable the trustee to acquire shares of the taxpayer’s company or its holding company, which were then held on trust for the benefit of the employees. The taxpayer company made annual payments to the trustee to enable the trustee to purchase the shares.
One of the issues that arose was whether the payments made to the trustee were wholly and exclusively incurred for the purposes of the taxpayer company’s trade. In deciding that the payments were wholly and exclusively incurred for the purposes of the taxpayer company’s trade and hence deductible, the Court of Appeal held that because the taxpayer company was dependent on professional men and that the object of the scheme was to keep their goodwill, the payments were therefore wholly and exclusively incurred for the purposes of the taxpayer company’s trade.
2. The decision in the P-E Consulting Group Ltd case was followed by the First Tier Tribunal (Tax) in the case of J T Dove Limited TC00893.
In this case, the Tribunal was considering, amongst others, the issue of whether a £3 million payment, which was made by the taxpayer company to the trustee of an employee benefit scheme to enable it to purchase the taxpayer company’s shares, was made wholly and exclusively for the purposes of the taxpayer company’s trade. The taxpayer company’s shares held by the trustee was for the benefit of the taxpayer’s former and present employees and defined family members.
In deciding that the payment made was made wholly and exclusively for purposes of the taxpayer’s trade, the First Tier Tribunal (Tax) held that the purpose when the taxpayer company made the £3 million payment was to “secure a contented and loyal workforce, and the underlying reason for that was in order to earn profits in its trade”. For the purposes of its trade, the taxpayer company had made the payment to preserve the goodwill of the workforce as a whole, irrespective of rank and status.
3. Further, in the case of NCL Investments Limited; Smith & Williamson Corporate Services Limited [2017] UKFTT 495 (TC), again, a similar issue was raised, that is, whether certain expenses relating to the grant of share options to the taxpayer company’s employees were expenses incurred wholly and exclusively for the purposes of the taxpayer company’s trade and hence deductible.
The First-Tier Tribunal (Tax) agreed that the expenses were wholly and exclusively incurred for the purposes of the taxpayer company’s trade and took a similar view that the taxpayer company’s business’ success depended on the availability of skilled and motivated professionals and the grant of share options to employees was part of their remuneration package. Further, the First-Tier Tribunal acknowledged that the taxpayer company was obtaining a benefit from the grant of options to employees. Such expenses were therefore incurred wholly and exclusively for purposes of its trade.
The above cases demonstrate that having a loyal and dedicated workforce is directly related to the profitability of an employer, to ensure that employees are contented and are willing to continue working for the employer. As such, expenses incurred on ESOS would be expenditure wholly and exclusively incurred in the production of gross income.
ESOS expenses are not capital in nature
In many of the above cases, the tax authorities tried to argue that payments made by employers for purposes of granting ESOS to their employees created an asset for the employers as well.
First of all, in determining whether or not an expense is capital or revenue in nature, one would usually see if the payment was a one-off payment or of a recurrent nature and also, if it was a one-off payment, whether it brought into an existence an asset or an advantage for the enduring benefit of the trade. ESOS expenses are typically not one-off but instead, they are recurrent.
Further, generally, employers never acquire any asset or advantage for the enduring benefit of their businesses. Whilst it is acknowledged that shares are assets and an expenditure to acquire stocks or shares may be capital in nature, we must not lose sight of the fact that in general, the shares or share options are not acquired by the employers. The employers are typically never the owner of the share or share options. The employees acquire assets while the employers are merely the payers.
Public Rulings on ESOS
Public Ruling No. 11/2012 on Employee Share Scheme Benefit (PR 11/2012) states that where a company offers its employees newly issued shares by its holding company under an employee share scheme, the costs for the shares cannot be claimed by the employer for deduction.
Public Rulings are not law and cannot lawfully form the basis for the disallowance of the ESOS expenses. The issue of deductibility depends on the law. Public Rulings are mere interpretations of the Director General of Inland Revenue (the “DGIR”). Case laws have decided as such.
PR 11/2012 is also fundamentally flawed. There is cost involved when issuing new shares. Case laws have established that there is cost attached to any shares or share options offered. Moreover, when an employer offers shares of its holding company to its employees. The employer would have to pay for the shares. In fact, isn’t the charge by the holding company to the employer company in line with section 140A of the Act, which requires such dealings to be at arm’s length basis?
Also, Public Ruling No. 2/2013 on Perquisites from Employment (PR 2/2013) states that employers who incur any expense in respect of perquisites paid to employees are eligible for deduction under section 33(1) of the Act and shares granted to employees are perquisites. Whilst public rulings are not law, they are binding on the DGIR if a taxpayer applies that public ruling, as per section 138A(3) of the Act.
We now analyse the case of Ketua Pengarah Hasil Dalam Negeri v Asia Energy Services Sdn Bhd and highlight the key takeaways from that case.
Ketua Pengarah Hasil Dalam Negeri v Asia Energy Services Sdn Bhd
Background
The taxpayer company, as part of its employee remuneration structure, grants to its employees shares and stocks and options to purchase shares and stocks in its parent company (the “Employee Stock Based Compensation”).
The taxpayer company provides management services to its group companies, which are involved in the oil and gas industry. As part of the group’s global human resource policy, the group introduced stock-based compensation for employees in its group, which forms part of each of the group companies’ overall remuneration package. The purpose of offering this is to incentivise and provide reward opportunities to employees in the group. The stocks offered are stocks in the ultimate holding company.
The ultimate holding company cannot issue shares to employees of other companies without receiving full value for it. There is a cost to the taxpayer. That is the expenses the taxpayer company deducted. The shares and stocks and options to purchase shares and stocks are employment benefits to the taxpayer company’s employees. In order for the taxpayer company to provide an employment benefit to its employees, the taxpayer company has to incur and pay these expenses. The expenses are ordinary employment expenses. Employers get a deduction for employment expenses and employees need to bring employment benefits to tax.
The DGIR however disallowed the deduction of the expenses that the taxpayer company incurred in order to give employment benefits to its employees.
DGIR’s Position
The position taken by the DGIR is that the expenses are not deductible under section 33(1) of Act as the expenses are not wholly and exclusively incurred in the production of income, and are capital in nature. The expenses are therefore caught by section 39(1)(c) of the Act. According to DGIR:
1. The issuance of new shares does not involve any cost or expenditure to the company that issued the new share.
2. The Employee Stock Based Compensation is not part of the employment contract and therefore, not remuneration. Employees do not have an automatic right to the Employee Stock Based Compensation.
3. The Employee Stock Based Compensation is to maintain the employees in the company. Employees are the company’s assets. An expenditure on company assets is a capital expenditure.
4. The Employee Stock Based Compensation is a form of equity and is the taxpayer company’s capital. The payment made by the taxpayer company to the parent company is therefore a capital expenditure for equity contribution by the ultimate holding company.
The DGIR also attempted to rely on PR 11/2012, which states that where a company offers its employees newly issued shares by its holding company under an employee share scheme, the costs for the shares cannot be claimed by the employer for deduction.
Taxpayer Company’s Position
All businesses need to employ employees so as to produce income. Naturally, remuneration would need to be paid. It is settled law that a deduction would be available for payments made to employees relating to services rendered by the employees, as the employees’ services are rendered to produce income.
The expenses are incurred to ensure that employees are contented and are willing to continue working. Having a loyal and dedicated workforce is directly related to the profitability of a company. Moreso here where the taxpayer company is a services company and its income is derived from the activities carried out by employees. The taxpayer company is highly dependent on its employees and it is crucial for the taxpayer company to retain its employees.
The Employee Stock Based Compensation is not a gift. It is part of the employment package. There is a real cost incurred by the taxpayer company. The stock offered is not the taxpayer company’s stock but instead, the ultimate holding company’s stock. The expenses are arrived at an arm’s length basis, are actually settled and are not mere accounting entries.
The expenses are also not capital in nature. The expenses are not one-off but instead, they are recurrent. The taxpayer company also never acquired any asset or advantage for the enduring benefit of its business. If the retention of employees is taken to be an asset or an advantage of enduring benefit, this would mean that any expenditure a company incurs to remunerate or reward its employees would be capital expenditure. This would include bonuses and even ordinary wages and salaries. This would be in direct contradiction with case law authorities.
Further, although employees do not have an automatic right to the Employee Stock Based Compensation, this does not mean that the Employee Stock Based Compensation is not part of the remuneration given to the employees. Generally, employees do not have an automatic right to bonus. It is an additional remuneration granted by employers based on their discretion.
If the DGIR were correct to in saying that any payment incurred to retain employees is capital in nature, this would mean any expenditure incurred by employers to remunerate or reward their employees would be a capital expenditure. This would include bonuses and even ordinary wages and salaries. This point does not warrant further commentary.
The matter can also be resolved by reference to the Inland Revenue Board’s own public rulings. Public Ruling No. 2/2013 on Perquisites From Employment (PR 2/2013) states that employers who incur any expenses in respect of perquisites paid to employees are eligible for deduction under section 33(1) of the Act. PR2/2013 shows that shares granted to employees are perquisites. Whilst public rulings are not law, they are binding on the Inland Revenue Board if a taxpayer applies that public ruling, as per section 138A(3) of the Act.
Decisions of the Courts
The Special Commissioners of Income Tax and High Court decided in favour of the taxpayer company.
The High Court ruled that it was not in dispute that the purpose of the Employee Stock Based Compensation is to provide incentives and rewards to the employees in the group, including the taxpayer company. The Employee Stock Based Compensation is part of the employment package. Through the giving of incentives and rewards to its employees, this will facilitate the taxpayer company’s business to be performed more efficiently. This is because the taxpayer is principally engaged in the provision of regional management services to the group, and the good performance of the employees is directly related to the performance of the taxpayer company. Having a loyal and dedicated workforce is important to the taxpayer to enhance the profitable growth of the taxpayer company over the long term.
Therefore, the Employee Stock Based Compensation is the reward given to the employees for the services that they have rendered to facilitate the taxpayer’s business to be performed more efficiently. The taxpayer company has to pay its ultimate holding company in order to enhance the services rendered by the employees. As such, the expenses for the Employee Stock Based Compensation, which have been incurred so that the taxpayer company’s business is performed more efficiently, are expenses that are wholly and exclusively incurred in the production of the taxpayer company’s income
Where a compensation is given by an employer to its employees as a reward for services rendered, the value of the compensation is a cost to the employer.
The Court of Appeal agreed with the Special Commissioners of Income Tax and the High Court that expenses paid by the taxpayer company to its ultimate holding company in return for the grant of shares and stocks and options to purchase shares and stocks to the taxpayer company’s employees are deductible for income tax purposes.
Summary
Given the Court of Appeal’s decision in favour of Asia Energy Services Sdn Bhd, expenses paid by employers in return for the grant of shares and stocks and options to purchase shares and stock to employees should be deductible for income tax purposes
This case relied heavily on the fact that the taxpayer company is a management services company and hence its employees are therefore directly involved in the production of income of the taxpayer company. This decision should similarly apply to any company that has an ESOS in place. Employees are one of the key drivers for any company’s profitability and any cost incurred to reward employees should be tax deductible.
Expenses in return for the grant of shares and stocks and options to purchase shares and stock would be incurred by employers in almost every case where there is an ESOS in place. The decision has a wide-reaching effect. This case sets a binding precedent on the deductibility of expenses paid by employers in return for the grant of shares and stocks and options to purchase shares and stock to employees.
The Inland Revenue Board of Malaysia’s public ruling appears to be without basis with the Court of Appeal’s decision, and the case acts as a reminder that public rulings of the Inland Revenue Board of Malaysia do not have the force of law and, hence, can be challenged.
This article was originally published in the Chartered Tax Institute of Malaysia’s Tax Guardian Vol. 15/No.3/2022/Q3.
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