I t is common for a holding company to grant its own stock options or share awards to cover the employees of its subsidiaries and

then recharge the subsidiaries a certain amount. While the accounting treatment of these recharges is clear, the tax treatment of the same has been controversial.

Example 1 Under a group employee share-based incentive scheme, company A, as parent, grants some employees of its subsidiary, company B, options (unlisted) at a nominal consideration.

Each option entitles an employee of company B to subscribe for a certain number of shares in company A at a certain price (normally below the then market price of the shares) at the end of his or her third year of employment, provided the employee has remained for the three-year period.

Company A will issue its own new shares to discharge its obligations under the group scheme. Furthermore, at the outset of the group scheme, pursuant to a recharge agreement, company B agrees to pay company A the fair value of the options involved at the end of each year when the relevant expenses are charged to its income statement in accordance with Hong Kong Financial Reporting Standard 2. The options involved on the 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 even spread of the costs involved.

Prior stanceDespite there being contractual and legal liabilities assumed by company B to pay company A under the recharge agreement, the IRD’s prior stance was to disallow company B the tax deduction for the expense of HK$600,000 payable for each of the three years concerned.

The IRD’s prior stance was presumably taken on the basis that such recharges only represented a recharge of the “economic opportunity or notional cost” suffered by company A for issuing its own new shares at less than their full market value. The IRD then took the position that such recharges were not tax deductible as they did not represent a recharge of the actual out-of-pocket costs suffered by company A.

In a single company situation, the case-law authority in Lowry v. Consolidated African Selection Trust Ltd. [1940] 23 TC 259 lends support to the IRD’s disallowance of share-based expenses recognized under HKFRS 2 when the company issues its own new shares at below market value to its employees under an incentive scheme.

However, this concerned only a single-company situation but the IRD apparently attempted to extend it to cover a group recharge situation.

The IRD’s prior stance was that it is only when company A discharged its

obligations under the group scheme by incurring actual costs for acquiring its own shares from the market (as treasury stock) that company B would be allowed a tax deduction for the recharge.

Many taxpayers have been disputing the IRD’s prior stance, which simply looked at whether the group as a whole had incurred actual out-of-pocket costs for acquiring the shares from the market for the group scheme.

Such taxpayers contend that the IRD should respect that a parent and a subsidiary are separate legal entities and that for Hong Kong tax purposes, the IRD should look at the position of the paying company only. As such, they contend that company B in example 1, having assumed contractual liabilities to pay company A, should be allowed a tax deduction for the recharge.

New stance On 6 March the IRD announced that a tax deduction for a recharge would be allowed regardless of whether the shares involved are from a new issue or are acquired from the market by another group company. However, the timing for the tax deduction might not necessarily be when the liabilities are contractually due or recognized in the accounts, but when the relevant options are exercised or shares vested.

Furthermore, the amount claimed for tax deduction must not be excessive. For example, this must not be more than the

New treatment of share-based payments needs clarificationThe Inland Revenue Department has taken a new stance on deductions for share-based payments in group-recharge situations. Tracy Ho and Patrick Kwong explain

Hong Kong tax

44 May 2012

Tracy Ho is the Hong Kong and Macau tax location leader and Patrick Kwong is executive director of Ernst & Young.

open-market value of the shares at the time the options are exercised or shares vested, less the consideration for the shares paid by the relevant employees.

Issues arising While taxpayers generally welcome the new stance taken by the IRD on group-recharge situations, the IRD may need to clarify certain issues arising from its 6 March announcement.

Example 2 The facts are the same as in example 1, except that company A is now discharging its obligations under the group scheme by acquiring its own shares from the market (as treasury stock) in year one, incurring actual costs of HK$2 million.

Assume now that the employees of company B exercise, in year four, all the options previously granted to them and that the difference between the market value of the shares involved on the date of the exercise and the exercise price of the options is HK$2.5 million.

Although the actual costs incurred by company A for acquiring its own shares

from the market in year one is HK$2 million, the total amount recharged by company A to company B (i.e., a recharge of HK$600,000 each payable at the end of year one, year two and year three) is HK$1.8 million. The market value of shares involved on the date of the exercise less the exercise price of the shares paid by the employees in year four (according to the IRD’s announcement on 6 March) is HK$2.5 million.

It does not appear to be clear from the IRD announcement whether the tax deduction for company B in year four should be HK$2 million or HK$1.8 million or HK$2.5 million (i.e., whether any one or more of these figures would be regarded as excessive under the new stance). And if the amount allowed for tax deduction cannot in any case exceed the amount actually recharged (i.e., HK$1.8 million in example 2), what would be the tax position of company B if company A only incurred HK$1.5 million to acquire the shares involved from the market? Would the tax deduction for company B then be restricted to HK$1.5 million, despite HK$1.8 million being actually recharged?

Furthermore, while deviating from the accounting treatment, the IRD’s announcement has not stated the legal basis for its disallowing company B a tax deduction of HK$600,000 for each of the three years concerned at the time the amount was recharged according to the recharge agreement.

Instead of allowing company B a tax deduction of HK$600,000 each for year one, year two and year three, company B in example two would, under the IRD’s new stance, probably be granted a tax deduction in year four of HK$2 million, HK$1.8 million or HK$2.5 million when the options are exercised by the employees of company B.

In addition to the uncertainty about the legal basis and the exact amount being allowed for tax deduction in year four, it also appears unclear whether taxpayers who have previously conceded on their claims for tax deduction can now benefit from the IRD’s new stance.

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