BUSINESS

EXPENDITURE

DEDUCTIONS

A NEW DEFINED BOUNDARY

 

// By Choong Kwai Fatt, PhD

 

Introduction

 

The deductions of a business expenditure are governed by the Income Tax Act 1967 (the Act) in which the pre- requisites are such that expenditure must satisfy the business object that is ‘wholly and exclusively’ incurred in the production of a business income. The degree and extensity of an expenditure that is ‘wholly and exclusively’ incurred is redefined in the recent landmark High Court case of Ketua Pengarah Hasil Dalam Negeri (HDN) v Kompleks Tanjong Malim Sdn Bhd (and Another Appeal) [2019] 1 AMR 393.

 

This article attempts to analyse the legal principles propounded and quantified the essential tax consequences arising from this new defined boundary.

 

The legislations

 

The deduction of business expenditures is provided in s.33 read together with s.39 of the Act. S.33(1) provides: 

 

“Subject to this Act, the adjusted income of a person from a source for the basis period for a year of assessment shall be an amount ascertained by deducting from the gross income of that person from that source for that period all outgoings and expenses wholly and exclusively incurred during that period by person in the production of gross income from that source, including …”

 

The Court of Appeal in Exxon Chemical (Malaysia) Sdn Bhd v Ketua Pengarah HDN [2003-2005] AMTC 371 refers to the deduction test that comprises of ‘wholly and exclusively’, ‘incurred’, and ‘in the production of income’ as ‘the basket’ in s.33; the basket being expenditure wholly and exclusively incurred in the production of income.

 

In Margaret Luping & 2 Ors v Ketua Pengarah HDN [1997- 2002] AMTC 2177, the Court of Appeal laid down the legal principles that any expenditure to be deducted as a business expenditure needs to concurrently satisfy both s.33 read together with s.39 of the Act. S.39 provides a list of expenses that are not allowed for deduction even though such expenditures satisfy the ‘wholly and exclusively’ test in s.33 together with s.39 of the Act. S.39 provides a list of expenses that are not allowed for deduction, even though such expenditures satisfy the ‘wholly and exclusively’ test in s.33.

 

Mokhtar Sidin JCA held on p 2181:

 

“In our view, for a taxpayer to qualify for deduction of any payment or expenditure incurred by him, he must first of all place the payment or expenditure as allowable under s 33 of the Act. He has to justify that the payment or the expenditure incurred by him is an allowable deduction under s 33 of the Act. In the present appeal it is sub-s (1) of that section. If the payment or expenditure is not allowed under s 33(1) of the Act then it would not be allowed as a deduction. On the other hand, if it is allowed as a deduction under s 33(1) of the Act, one has to proceed to the next step to ascertain whether the payment is caught under s 39(1) of the Act. If it is caught under s 39 (1) of the Act, then it would not be allowed as a deduction though it is allowable under s 33(1) of the Act.”

 

The Court of Appeal laid down the two-fold test as follows:

 

  1. First, examine the expenditure that satisfies the basket of s.33; then
  2. further make certain that such expenditure does not fall into the prohibition list in s.39.

 

‘The ‘wholly and exclusively’ element

 

In Ketua Pengarah HDN v Kompleks Tanjong Malim Sdn Bhd (and Another Appeal) [2019] 1 AMR 393, the High Court was asked to ascertain whether the revised quit rent assessment imposed by the State Government under the commercial title incurred on a plantation company passed the ‘wholly and exclusively’ test as stipulated in s.33 of the Act. The High Court referred to the dictionary as guidance and concluded that the word ‘wholly’ means ‘entirely or completely’ whilst ‘exclusively’ means ‘solely or completely’. Therefore, the deduction is only applicable to the outgoing expenses where the said expenses are entirely and solely incurred in the production of gross income from that business source.

In Syarikat Pukin Ladang Kelapa Sawit Sdn Bhd v Ketua Pengarah HDN [2012] AMTC 192, the High Court held that for the deduction in s.33, the expenses must fulfil the following two elements and they must be read conjunctively:

 

  1. The expenses must be wholly and exclusively incurred in that basis year; and
  2. the expenses must be wholly and exclusively incurred in the production of gross income.

 

In this case, the High Court held that advance rental is not deductible simply because it satisfies (b) but not (a). Advance rental, in its true essence, is the expenses incurred in the future for the production of gross future income and not the current year income. In any year of assessment, only rental relating to the current year fulfils the ‘wholly and exclusively’ test. In the upshot, advance rental is not deductible notwithstanding it has been paid, which fulfils the ‘incurred’ test to the land owner.

 

Rohana Yusuf J held on p 199:

 

“Advance rental cannot be taken in any circumstances to be expenses exclusive and wholly incurred for that basis year because although they are paid in advance, they are actually expenses to be incurred in the future for the production of gross future income. In other words, for the production of the gross income for the basis year in question, the only required rental to be paid is an annual rental. Advanced rental is not required for the purposes of the production of gross income in that basis period and hence cannot be expenses wholly and exclusively for the purpose of the production of gross income in that period.”

 

These decisions pointed to an irresistible conclusion that in order for the expenses to be deductible, it has to be related to the current year with the sole purpose of production of business income. These are the essence and spirit of the ‘wholly and exclusively’ test.

 

Apportionment rule

 

It is a settled principle that in s.33, ‘wholly and exclusively’ means an all or none basis, i.e. the expenses are either fully deductible or non-deductible at all. Apportionment of expenditure is never permitted.

 

In Director General of Inland Revenue v Kok Fai Yin Co Sdn Bhd (2014) MSTC 30-076, the tax authorities attempted to apportion the director’s fee paid by the company as the IRB was of the opinion that such excessive director’s fee did not fulfil the ‘wholly and exclusively’ test. The High Court held that the apportionment of the director’s fee was not permitted. S.33 operates on an ‘all or none’ basis. S.33 does not empower the IRB to exercise its discretion in determining what amounts to reasonable director’s fees which should have been paid to the directors, and to disallow the excess from deduction under s.33. The director’s fee remains as a business decision and any director’s fee paid must be accepted as fulfilling the business decision and any director’s fee paid must be accepted as fulfilling the business object being ‘wholly and exclusive incurred’ and thus fully deductible.

 

In summary, the IRB’s action and discretion with regards to the amount paid to each director as director’s fee was unreasonably excessive, and having proceeded to deduct a certain portion from the amount and adding the deducted amount back to the gross income of the company is ultra vires in the spirit of s.33.

 

Tan Sri Dato’ Hj Mohd Eusoff b Chin held on p 7927:

 

“My finding is that s.33 of the Act does not empower the appellant (IRB) to consider and determine what reasonable fees should have been paid to the directors by the respondent (company), and to disallow the excess from deduction under that section.”

 

Practical applications

 

In Ketua Pengarah HDN v Kompleks Tanjong Malim Sdn Bhd (and Another Appeal) [2019] 1 AMR 393, the crux of the disputes is on the deduction of the quit rent in relation to a plantation income. The company conducted the business of oil palm plantation, deriving its plantation income from the sale of fresh fruit bunches planted on the freehold land, Ladang Kompleks Tanjong Malim, which is situated in Mukim Hulu Bernam, Daerah Hulu Selangor.

 

The company, of its own accord, applied to the land administrator of Daerah Hulu Selangor to convert the land from being an agricultural land to a commercial land with the intention to enhance its land value. This has resulted in a substantial increase in quit rent assessment and the increase in value was tabulated as follows:

 

YA 
Increased quit rent (RM)
2006  1,057,244
2007  1,056,804
2011  1,015,157

 

The company claimed that the entire amount of quit rent was an amount which was wholly and exclusively incurred in the production of its plantation income. However, the IRB only allowed the amount of quit rent as previously deducted based on its agricultural land status. In summary, the increase in the quit rent due to the change of land status was not allowed as it has no relevance to the plantation of oil palm. A penalty of incorrect return was levied on the tax undercharged.

 

Aggrieved, the company appealed before the Special Commissioners of Income Tax (SCIT) and contended that the IRB has no power to apportion the expenditure between its agricultural use and commercial use because the entire value had been, in fact and in law, incurred and paid by the company to the land administration of Daerah Hulu Selangor.

 

The SCIT concurred with the company’s contention and allowed the company’s appeal. The SCIT held that the IRB is debarred from apportioning the expenditure, relying on the legal principles propounded by Mohd Eusoff b Chin in Director General of Inland Revenue v Kok Fai Yin Co Sdn Bhd (2014) MSTC 30-076. In effect, the IRB appealed to the High Court for adjudication.

 

The High Court found that the SCIT had misdirected itself in law based on its findings of the primary facts. The admitted fact by the SCIT was that the purpose of the conversion was to increase the capital value of the land. Therefore, such increase in value for the quit rent cannot be said to have satisfied the ‘wholly and exclusively’ test as the conversion of the land to commercial land by the company has nothing to do with palm oil production.

 

Aziziah Nawawi J held on p 403:

 

“Therefore, the conversion of the land to commercial land by the company has nothing to do with the palm oil production, as the conversion of the land category is to enhance the capital value of the land. As the purpose of the conversion to commercial land has nothing to do with the palm oil production, then it cannot be said that the payments of the quit rent premised on commercial land is wholly and exclusively incurred for the palm oil production…”

 

In reading the words ‘wholly and exclusively incurred’, the judge adopted the pragmatic approach that the amount of quit rent incurred based on agricultural basis is deductible even though the sum is paid entirely for the commercial land. The learned judge opined that the IRB was legally right not to allow the full deduction on the quit rent based on commercial land status as it was clearly contrary to the spirit of s.33(1) of the Act. On the same ground, the IRB cannot disallow the entire sum as the company did pay the quit rent for the said land as entitled to deduction under s.33(1). In the upshot, the amount of deduction is restricted to the quit rent based on its agricultural land status.

 

The High Court in this case propounded the divisible test in applying the meaning of ‘wholly and exclusively’ and not its rigid interpretation of ‘all or none’ basis. The factual matrix reveals that the company had incurred a sum for the quit rent on commercial land, nonetheless, a clear sum is divisible between the quit rent on agricultural land and commercial land. The company is only allowed deduction on an amount paid on the agricultural land being an amount wholly and exclusively incurred for the production of plantation income. In carrying out the business of plantation, there is no necessity to convert the land to commercial use.

 

This decision is entirely in line with the decision of Director General of Inland Revenue v Kok Fai Yin Co Sdn Bhd (2014) MSTC 30-076. In Kok Fai Yin, the director’s fees are paid to the directors and they are not divisible in any manner. The director’s fee of a company is determined by the shareholders’ discretion: a judgmental value which varies from company to company. It can never be objectively determined what amount is considered reasonable

 

The court should not interfere in a business decision and best leave it for the shareholders to decide. The IRB, which is empowered by the Act for a smooth administration and collection of tax, is equally refrained from apportioning the director’s fee that is subjective in nature. The payment of the director’s fee has to be by reference to the services rendered by the director; and to remain a subjective test where apportionment is never available.

 

Therefore, it would continue to operate as an ‘all or none’ basis.

 

However, the amount of quit rent collected by the State Government can be objectively determined and measured. The company which has been conducting its plantation business has been consistently paying quit rent based on agricultural land basis and is debarred from claiming quit rent as deduction based on commercial land. In the event the company voluntarily converted the land of its own accord, any increased amount of expenditure would fail to fulfil the ‘wholly and exclusively’ test as stipulated in s.33.

 

Conclusion

 

The ‘wholly and exclusively’ test in s.33 needs to apply with reference to the business intent and object. To be deductible, it has to be objectively determined. The division of business expenditure is only allowed in a situation where such division can be objectively ascertained as seen in Ketua Pengarah HDN v Kompleks Tanjong Malim Sdn Bhd (and Another Appeal) [2019] 1 AMR 393. In the event it involves subjective ascertainment, such as the director’s fee as seen in Director General of Inland Revenue v Kok Fai Yin Co Sdn Bhd (2014) MSTC 30-076, then it would be operated on an ‘all or none’ basis.