3 November 2014
2014 Issue No. 20
Hong Kong
Tax alert
Tax deductions for share-based payments
further clarified
This tax alert discusses the clarifications provided by the Inland Revenue Department
(IRD) in its 2014 annual meeting with the Hong Kong Institute of Certified Public
Accountants (HKICPA) as regards the deductibility of share-based payments in certain
circumstances.
The issues clarified are summarized in the answers to the three questions posed below.
While not considering that there is an imminent need to issue a Departmental
Interpretation and Practice Note on the captioned subject, the IRD undertook in the
meeting that it would continue to disseminate its views on the subject through the FAQs
or Tax Representatives’ Corner portions of its website.
Determining the tax deduction for share-based payments could in many instances be a
complicated matter. Clients should seek professional tax advice where necessary.
1. Is tax deduction for a share-based payment
necessarily restricted to the lower of the
amount recharged or the market value of the
shares on the date of vesting?
Position taken by the IRD
Company B can only claim a tax deduction in Year 4
when shares vest
This was in fact a follow-up question posed by the HKICPA
given the uncertain effect of the replies provided by the IRD
on the same issue in their 2013 annual meeting.
Scenario posed by the HKICPA
Under a group employee share-based incentive scheme,
Company A, as parent, grants some employees of its
subsidiary, Company B, share awards at a nominal
consideration. The employees of Company B will receive the
share awards at the end of their third year of employment,
provided the employees have remained with Company B for
the 3-year vesting period.
To discharge its obligations under the group scheme,
Company A acquires its own shares from the market (as
treasury stock) in Year 1, incurring actual costs of HK$2
million. Furthermore, from the outset of the group scheme,
pursuant to a recharge agreement, Company B agrees to pay
Company A the fair value of the share awards involved at the
end of each year of the 3-year vesting period. The shares
involved on date of grant are valued at HK$1.8 million.
Therefore, under the recharge agreement, Company B is
liable to pay Company A HK$600,000 at the end of each of
the three years concerned, assuming, for the sake of
simplicity, the costs are evenly recharged over the three
years.
Assume now that the employees of Company B obtain, in
Year 4, all the share awards previously granted to them and
that the market value of the shares involved on the date of
vesting is HK$1.5 million.
The table below summarizes the relevant figures:
HK$
Actual costs incurred by Company A for
acquiring its own shares from the market in
Year 1
2.0 million
Total amount recharged by Company A to
Company B (i.e., a recharge of
$600,000 payable for each year at the end
of Year 1, Year 2 and Year 3)
1.8 million
Market value of shares involved on the date
of the vesting to the
employees in Year 4
1.5 million
Despite the group arrangement that Company B is liable
to pay Company A HK$600,000 at the end of each of the
3-year vesting period under the recharge agreement, the
IRD took the view that Company B would only have a
definite liability to pay Company A at the end of the
vesting period when the shares vest to the employees in
Year 4. As such, the IRD considered that Company B
would not be eligible for a tax deduction of HK$600,000
in each of the 3-year vesting period. Instead, Company B
would only be entitled to a tax deduction in Year 4 when
the shares vest to the employees.
Amount Company B can claim as deductible in Year 4
when shares vest
The IRD indicated in the 2013 annual meeting that the
amount that Company B can claim as deductible in Year 4
may not be HK$1.8 million, i.e., the total amount
Company B is liable to pay Company A in accordance with
the recharge agreement. Instead, the amount that can be
claimed for a tax deduction may have to be restricted to
HK$1.5 million, i.e., the market value of the shares on
the date of vesting.
The IRD stated that Company B could have acquired the
shares from the open market at a cheaper cost of HK$1.5
million in discharging its obligation towards the
employees. To safeguard Company B’s interest, it was
expected that the terms of a commercial realistic
recharge agreement would allow for an adjustment of the
amount of recharge having regard to the market
circumstances. The payment of the recharge of HK$1.8
million by Company B without regard to market
circumstances might indicate a claim for an excessive
deduction.
Position clarified by IRD in 2014 annual meeting
In the 2014 annual meeting, the IRD clarified that the
absence of an adjustment clause in a recharge agreement
did not necessarily mean that the recharge agreement
was commercially unrealistic. This clarification was made
in response to the HKICPA’s argument that parties to a
contract were free to agree on the terms of the contract.
Therefore, so long as the terms struck were arm’s-length,
the amount so agreed should be tax deductible,
regardless of whether there was an adjustment clause in
a recharge agreement.
Nonetheless, the IRD remarked that whilst the excess (i.e.,
a recharge above market price) arising from the normal
fluctuation of a share price might generally be accepted,
the IRD would reject cases where the recharge was
blatantly above what would be reasonable and
commercial for acquiring the shares in the open market.
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2. Would share-based payments be disallowed twice during vesting period if they are passed on to another
entity?
The following diagram illustrates the question raised by the HKICPA.
Holding Co.
Granted share
awards with a 3year vesting period
(relevant costs
recharged to
Employing Co.)
Provision of services
Operating Co.
Employing Co.
Service fees
(including a dollar-fordollar recharge of the
share-based costs
incurred by Employing Co.)
Senior employees
Employing Co.
Profit and loss account in Year 1
Operating Co.
Profit and loss account in Year 1
HK$
HK$
Service income
100
Turnover
xxxx
Share-based cost, say
100
Service fee paid
100
Tax treatment
Employing Co.
Operating Co.
Each of Year 1, Year 2 and
Year 3, during the vesting period
Disallow HK$100
Also disallow HK$100 (as the service
fee paid also represents the underlying
share-based cost)?
Year 4 – when shares vest
Claim a total deduction of
HK$300 disallowed during the
vesting period)
Also claim a total deduction of HK$300
disallowed during the vesting period?
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In the above scenario, the group may for various commercial
reasons, centralize the employment of certain senior
employees in a group employing company. These senior
employees would however render services to other group
operating companies. Under such an arrangement, a group
employing company would charge an operating company
service fees for its provision of employees, say on a cost
recovery basis.
In reply, the IRD stated that where the shares so acquired
by the company were not required to be cancelled under
the company law of the jurisdiction concerned (e.g., in
the US where the shares so acquired could be treated as
treasury stock), the out-of-pocket costs so incurred would
be allowed as a tax deduction in Hong Kong, provided that
the relevant costs related to the generation of that
company’s chargeable income in Hong Kong.
The question was whether in line with the IRD’s position
discussed above, both the employing company and operating
company would have to disallow the share-based cost of
HK$100 in each year of the 3-year vesting period, and only
be able to obtain a tax deduction of HK$300 in Year 4 when
the shares vest.
The IRD however noted that where the company was a
Hong Kong incorporated company, the shares it bought
back would be treated as cancelled under the Companies
Ordinance. Under such circumstance, as the shares
bought back would be cancelled, the subsequent issue to
its employees in accordance with a share-based scheme
would be treated as a new issue of shares. As such, the
aforesaid UK case-law authority would apply to deny the
tax deduction. This was because any costs recognized in
the accounts for such a share-based payment would be
regarded as being “notional” and not an actual “outgoing”
or “expense” incurred with a view to generating
assessable profits as required under section 16(1) of the
Inland Revenue Ordinance.
In reply, the IRD stated that the disallowance of the sharebased cost during the vesting period would only apply to the
employing company, but not to the operating company. In
other words, the operating company would be able to claim a
deduction of HK$100 in each year of the 3-year vesting
period for the service fee paid to the employing company,
even though it represented a recharge of the share-based
cost incurred by the employing company.
3. Are actual out-of-pocket costs incurred by a
company in acquiring its own shares from the
market to operate a share-based scheme for its
own employees tax deductible?
The background to this question is the IRD’s stated position
(based on the authority of the 1940 UK case Lowry v
Consolidated African Selection Trust Ltd 23 TC 259) that the
notional cost of a company issuing its own new shares at
below market value in order to operate a share-based
scheme is not tax deductible. The HKICPA’s question was:
what if in order to operate a share-based scheme, a company
did not issue its own new shares, but acquired the shares
involved from the market as treasury stock, thereby
incurring actual out-of-pocket costs. In that situation, would
the UK case-law authority then be inapplicable, and the outof-pocket costs so incurred tax deductible?
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Financial Services
Hong Kong office
Rowan Macdonald
Managing Partner, Tax, Asia-Pacific
+852 2629 3088
[email protected]
Principal tax contact
Florence Chan
Partner
+852 2849 9228
[email protected]
Business Tax Services
International Tax Services
Paul Ho
Partner
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James Badenach
Partner
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Director
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Partner
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Director
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Partner
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Director
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Michelle Yan
Director
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Director
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Transfer Pricing Services
Justin Kyte
Partner
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Jonathan Thompson
Partner
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[email protected]
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APAC no. 03001029
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