Global Tax Alert | 31 January 2014

Hong Kong IRD clarifies deductibility of amounts recharged for equity-based compensation expenses in a group context

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Executive summary

The Hong Kong Inland Revenue Department (IRD) has recently further clarified its views on the deductibility of a recharge of equity-based compensation expenses made by one group company to another, including the timing and amount of deduction and taxability of the recharge payment received by the holding company.

These latest views of the IRD, and discussed in this Alert, are contained in the IRD’s replies to four new frequently asked questions1 (FAQs) posted on the IRD’s website in January 2014.

Detailed discussion

Under a group equity-based compensation plan, the employer entity may enter into an agreement with another group company under which the other group company will grant its own shares to the employees of the employer entity covered by the plan.

In consideration of its employees being granted shares upon their fulfillment of certain specified conditions, e.g., serving out a vesting period, the employer entity may agree to be recharged certain amounts by the other group company.

In the FAQs, the IRD clarified that for the purposes of a deduction claim, despite what may have been agreed between the parties as regards the timing of the payment for a recharge, such a recharge would only be deductible in the year when the relevant share awards vest to the employees concerned (or in the case of stock options, the options are exercised by the employees concerned). It was the IRD’s stance that the employer entity would only be liable, or have a definite liability for the expenses in connection with the granting of shares under the plan, upon vesting of the shares.

Furthermore, the amount of the recharge that would be deductible may be the lower of the amount agreed to be recharged or the market value of the relevant shares on the date of vesting. In the reply posted on its website, the IRD stated that: “The deductible amount would generally be the amount of recharge provided that it is not excessive in the circumstances. It is expected that adjustment of the recharged amount to account for the market circumstances should be provided under the terms of a commercially realistic recharged agreement.” In addition, the IRD appears to be indicating that fixing the amount of recharge may not be acceptable for tax purposes if the market value of the relevant shares on the date of vesting is lower than the amount agreed to be recharged.

On the other hand, the IRD also provided that where the holding company acquired the shares from the market solely for the purpose of discharging the obligations under the plan, the IRD would not generally regard the recharge as a trading receipt arising from trading in the shares and therefore taxable.

Implications

Under the assessing practice discussed above, the manner in which the IRD disregards the terms of a recharge agreement, which may be commercially justifiable and convenient for the parties concerned, appears somewhat controversial.

Nonetheless, in its 2013 annual meeting with the Hong Kong Institute of Certified Public Accountants (HKICPA), the IRD justified its assessing practice by noting that the practice had already resolved a substantial number of objection cases and disputes.

Endnote

1 Questions 10-13 of the FAQs under Group Recharge Arrangement accessible via the link: http://www.ird.gov.hk/eng/faq/sbpt.htm.

For additional information with respect to this Alert, please contact the following:

Ernst & Young Tax Services Limited, Hong Kong
  • Tracy Ho
    +852 2846 9065
    tracy.ho@hk.ey.com
  • Florence Chan (Financial Services)
    + 852 2849 9228
    florence.chan@hk.ey.com

Ernst & Young LLP, New York
  • Connie Chan
    +1 212 773 2661
    conniehf.chan@ey.com

Ernst & Young LLP, Asia Pacific Business Group, New York
  • Chris Finnerty
    +1 212 773 7479
    chris.finnerty@ey.com
  • Jeff Hongo
    +1 212 773 6143
    jeff.hongo@ey.com
  • Kaz Parsch
    +1 212 773 7201
    kazuyo.parsch@ey.com
  • Bee-Khun Yap
    +1 212 773 1816
    bee-khun.yap@ey.com

EYG no. CM4151