A Tale of Two Tax Cases

Sarah Kate Lee examines two recent cases on the deductibility of sales incentives

The issue as to whether sales incentives commonly paid to marketing agents and dealers are fully deductible expenses or are to be treated as entertainment expenses that are subject to separate deductibility rules was considered recently by the Courts in NV Alliance Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2012] 1 MLJ 441 ("NV Alliance Case") and Ketua Pengarah Hasil Dalam Negeri v Khind-Mistral (Borneo) Sdn Bhd and another appeal [Tax Appeal: KCH-14-2-2011] ("Khind Case").

DEDUCTIBILITY AND ENTERTAINMENT EXPENSES

As a general rule, section 33(1) of the Income Tax Act 1967 (“Act”) allows an expense that is wholly and exclusively incurred in the production of gross income to be deducted against gross income when computing taxable income.

On the other hand, an entertainment expense is currently only allowed a 50% deduction against gross income under section 39(1)(l) of the Act unless it is specifically allowed for full deduction under any of the 8 provisos contained in section 39(1)(l).

The word “entertainment” is defined in section 18 of the Act to include: "

  1. the provision of food, drink, recreation or hospitality of any kind; or

  2. the provision of accommodation or travel in connection with or for the purpose of facilitating entertainment of the kind mentioned in paragraph (a),

by a person or an employee of his in connection with a trade or business carried on by that person."

 

THE NV ALLIANCE CASE

Background Facts

NV Alliance Sdn Bhd (“NV”) carries on the business of marketing burial plots, urn compartments and funeral packages. In the course of its business, NV appointed marketing agents who were paid commissions for their work.

To motivate the agents to increase sales, NV introduced incentive schemes whereby the agents who achieved certain set sales targets were paid various types of incentives including cash incentives. These payments were claimed by NV as deductions against its gross income under section 33(1) of the Act.

The Inland Revenue Board (“IRB”) disallowed the deductions on the ground that such expenses were “entertainment” expenses under section 39(1)(l) of the Act which at the relevant time, did not allow such expenses to be deducted.

The Special Commissioners of Income Tax (“Commissioners”) however ruled that the expenses were related to the performance of profit earning operations as they were wholly and exclusively incurred in the production of NV’s gross income pursuant to section 33(1) of the Act and were not disallowed deductions by virtue of section 39(1)(l) of the Act.

On appeal, the High Court overturned the decision of the Commissioners and agreed with the IRB that the incentives were caught under the definition of “entertainment” in section 18 of the Act and therefore were not deductible under section 39(1)(l) of the Act.

NV appealed to the Court of Appeal against the decision of the High Court.

Decision of the Court of Appeal

The Court of Appeal set aside the Order of the High Court and restored the Deciding Order of the Commissioners by holding that the cash incentive payments were not “hospitality” expenses, and hence, were not entertainment expenses under section 39(1)(l) of the Act. Thus, NV was entitled to the deductions claimed in respect of the cash incentive payments.

In arriving at its decision the Court of Appeal held that the noscitur a sociis rule of statutory interpretation was applicable and that the more general words ‘or hospitality of any kind’ in section 18(a) of the Act must be restricted to a sense analogous to that of the less general words, namely, ‘food, drink, recreation’.

The Appellate Court held further that in determining as to whether or not the cash incentive expenses came within the meaning of ‘or hospitality of any kind’, it was necessary to take into account the words preceding that phrase, that is to say, the words ‘food, drink, recreation’.

The Court concluded that the cash incentive expenses clearly could not come within the meaning of the words ‘or hospitality of any kind’ if the meaning to be given to the words ‘or hospitality of any kind’ is limited accordingly.

The Court went on to state that it would arrive at the same conclusion even if it were to apply the ejusdem generis rule where the meaning to be given to the general words ‘or hospitality of any kind’ in section 18(a) must be restricted to the same genus as ‘food, drink, recreation’.

The Court then concluded that if the meaning to the expression, ‘or hospitality of any kind’ is so confined, it would then clearly exclude the cash incentive payments.

THE KHIND CASE

Background Facts

Khind-Mistral (Borneo) Sdn Bhd (“KM”) carries on the business of dealing and trading in electrical products under the brand name ‘Khind’.

KM appointed dealers to sell their products and in 1996 introduced a scheme to motivate and reward dealers who reached their sales target by giving them trips to the local factory and tourist destinations both local and abroad.

These incentives were in addition to the commissions and discounts given to the dealers. For the years of assessment 2000, 2002 and 2003, KM deducted all the expenses for these trips from their gross income when declaring their taxable income under section 33(1) of the Act.

The IRB took the position that these expenses were in fact entertainment under section 18 of the Act and not allowed under section 39(1)(l).

The Commissioners ruled that the incentive trips were expenses deductible under section 33(1) of the Act. The Commissioners also decided that the IRB could not impose a penalty as KM had clearly and correctly described the expenses in the return forms and made full disclosure to the IRB.

Both parties then appealed and cross-appealed to the High Court.

Decision of the High Court

The High Court laid down the principles of statutory interpretation by holding that where the sections are plain and unambiguous, the Court must give effect to the natural and ordinary meaning of words and when interpreting a tax law, the interpretation must be strict.

The High Court then referred to the Court of Appeal decision of Aspac Lubricants (Malaysia) Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2007] 5 CLJ 353 where Gopal Sri Ram JCA held that promotional items which were given away to customers who purchased the taxpayer’s products were not entertainment expenses within section 39(1)(l) of the Act.

The High Court Judge then adopted the guidelines laid down by Gopal Sri Ram JCA (as His Lordship then was) in the Aspac case which are summarised as follows:

  1. The proper approach in determining whether expenses were incurred in the production of income is to examine the true nature of the transaction between the taxpayer and its customers.

  2. Where there is consideration moving from the customer to the taxpayer in the form of payment for the product sold, then the expenses incurred for (in this case) promotional items or gifts for the products are not entertainment expenses under the Act.

  3. Where the sole object of the activity undertaken was “business promotion, the expenditure is not disqualified because the nature of the activity necessarily involves some other result, or the attainment or furtherance of some other objective, since the latter result or objective is necessarily inherent in the act”.

According to the High Court Judge, the ‘business promotion’ aspect of the activity was the material consideration.

The High Court held that the incentive trips were not “entertainment” within the meaning of section 18 of the Act for the following reasons:

  1. the incentive trips were only given to those who achieved their sales target;

  2. achieving the sales target essentially meant that the sales of the company’s product was being boosted and therefore income was increased;

  3. it did not matter the incentive trips were also a reward to the dealers for their performance as the only reason it was given to them was because the sales target was achieved; and

  4. by virtue of the dealer’s achievement of the sales target, there was consideration moving from the customer to KM in the form of payment for the product sold.

The High Court also went on to rule that the trips did not fall within the ambit of “hospitality” as mentioned in section 18 of the Act.

As “hospitality” was not defined in the Act, the Court referred to United Detergent Industries Sdn Bhd v Director General of Inland Revenue [1999] AMR 462 which defined “hospitality” as:-

“the action of entertaining someone without that person having to subscribe towards the cost incurred by the host for the purpose of entertaining that someone”.

The Court held that KM was not being hospitable within the natural and ordinary meaning of the word as the trips were not given to all dealers but only to those who achieved their sales targets. In other words, only the dealers who contributed to and had generated more income for the company were awarded the trips.

 

CONCLUSION

The effect of these decisions is that sales incentives paid or awarded by the taxpayer to its marketing agents or dealers who have achieved sales targets do not constitute entertainment expenses and are deductible expenses under section 33(1) of the Act.

While the Court of Appeal in the NV Alliance Case came to the same decision by looking only at the rules of statutory interpretation, the High Court in the Khind Case provided some helpful guidelines that a taxpayer can follow in the giving of sales incentives so as to ensure that the expenses are fully deductible against its gross income.



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