High Court Allows Tax Deduction For ESOS Expenses
Recently, the High Court held that the Employee Share Option Scheme expenses incurred by a taxpayer company to be deductible under Section 33(1) of the Income Tax Act 1967.
Our tax associate, Yap Wen Hui discusses the key points of the appeal before the High Court in this alert.
Recently, the Kuching High Court in CI v Ketua Pengarah Hasil Dalam Negeri ruled that employee share option schemes (ESOS) expenses are tax deductible expenses pursuant to Section 33(1) of the Income Tax Act 1967 (ITA).
Our Tax, SST & Customs partner, S. Saravana Kumar and associate, Yap Wen Hui, were engaged by the taxpayer to work with their local solicitors to develop the legal strategy for the tax appeal.
The taxpayer is a part of the CSB group of companies (the Group). Since June 2010, the CSB had introduced the CSB Group ESOS scheme for its employees as part of its remuneration structure. Under this scheme, CSB’s share options would be granted to the eligible employees as part of the overall remuneration package with the sole purpose of incentivizing and rewarding the employees in the Group.
The taxpayer incurred a substantial expenditure in making available the ESOS scheme to its employees. However, the Director General of Inland Revenue’s (DGIR) position was that the ESOS scheme expenses are not tax deductible as it is regarded as a capital expenditure. The IRB’s position on this matter is reflected in its Public Ruling No. 11/2012. Accordingly, the taxpayer decided not to claim the ESOS expenses but proceeded to lodge an appeal to the Special Commissioners of Income Tax (SCIT).
The Revenue’s Submission
The DGIR alleged that the taxpayer had failed to fulfil the requirement under Section 33(1) of the ITA, where the crux of the DGIR’s submission is summarised as follows:
(i) Paragraph 10 of Public Ruling 11/2012 was applicable whereby in accordance with the ITA and Financial Reporting Standard / Malaysia Financial Reporting Standard the ESOS expenses are treated as the cost issuance of new shares and as such it is a capital expenditure.
(ii) The ESOS expenses enabled the taxpayer’s employees to obtain the shares of the Group, which becomes a benefit to the employees.
(iii) The main purpose of the ESOS was to bestow an enduring benefit to the employees of the taxpayer.
The Taxpayer’s Submission
The taxpayer’s position was that the ESOS expenses are eligible for tax deduction under Section 33(1) for the following reasons:
(i) The expenses were revenue in nature as the ESOS was part of the remuneration for the taxpayer’s employees. As such, it does not give rise to an enduring benefit to the taxpayer.
(ii) Public ruling has no application in the appeal as our courts have consistently held that internal rulings and guidelines of the DGIR have no force of law. Secondly, a public ruling cannot override the statutory provision of Section 33(1) which in turn was legislated by Parliament.
(iii) In Heather (H M Inspector of Taxes) v P-E Consulting Group Ltd  1 All ER 8, the taxpayer introduced a scheme to enable its employees to obtain control by setting up a trust fund. Under the said scheme, the trustee was able to acquire the taxpayer’s or its holding company’s shares which will then be held on trust for the benefit of the employees. The English Court of Appeal held that the annual payments made by the taxpayer to the trustee were wholly and exclusively incurred for the purpose of the taxpayer’s trade.
In the present matter, the taxpayer was in the business of providing management services where it has employed certain key qualified personnel to run the business. It is an undisputed fact that the taxpayer’s income was derived from the activities carried out by these employees.
(iv) The ESOS expenses were not capital in nature as it was recurrent and not a one-off payment.
The SCIT’s Decision
The SCIT disallowed the taxpayer’s appeal and held that the ESOS expenses incurred by the taxpayer were not deductible under Section 33(1) of the ITA.
Being dissatisfied with the SCIT’s decision, the taxpayer appealed to the High Court. The taxpayer maintained its position that the ESOS expenses were deductible. The High Court in allowing the appeal considered the following key points submitted by the taxpayer:
(i) The SCIT had misinterpreted Section 33(1) by applying the test of whether the ESOS expenses were incurred for promoting business and earning profits. The proper test for determining the deductibility of expense should have been whether it had been incurred “for the production of income”.
(ii) The SCIT had failed to consider that the ESOS expenses played a role in the retainment of good talents within the taxpayer’s company which led to a continued growth of the taxpayer’s business and profitability.
This decision reiterates that the fact that ESOS expenses are tax deductible under Section 33(1) and perhaps, it is time for the DGIR to review its stance on this matter in light of the High Court’s decision.
Authored by Yap Wen Hui, associate with the firm’s Tax, SST & Custom practice.
25 MARCH 2022