Tax deductibility of business expenses
Khoo Chuan Keat, Tax Leader, PwC Malaysia
One of the basic principles that any taxpayer needs to know is that one is not allowed to deduct all of one's expenses from income one earns when computing the tax chargeable. The reasons some expenses are allowed as deductions while others are not, form one of the fundamental principles that must be grasped by anyone who wishes to gain a basic understanding of income tax rules.
In any tax jurisdiction, there are legislations that prescribe the conditions for expenses to qualify for tax deduction. In Malaysia, the deductibility of expenses is governed by Section 33 of the Income Tax Act, 1967 (ITA) and the general rule for deduction of an expense is contained in Subsection 1, which states:
"Subject to this Act, the adjusted income of a person from a source for the basis period of 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 that person in the production of gross income from that source, …."
Expenses wholly and exclusively incurred in the production of gross income
The phrase "expenses wholly and exclusively incurred… in the production of gross income" incorporates the basic rule which spells out the conditions for allowing a tax deduction. For an expense that is incurred in the course of operating a business to be allowed as a deduction from income of the business, it must be:
(b) Wholly and exclusively; and
(c) In the production of gross income (from the business).
Underlying each of these conditions is a comprehensive library of case laws, which defines the meaning of the words and delineates the boundaries for their applications. Some guiding principles established in cases brought before the courts include:
(a) Only "revenue" expenses are deductible while "capital" expenditures are not. The following statement from the case of Sun Newspapers Ltd and Associated Newspapers Ltd versus CIT (1938) 61 CLR 337 is often quoted to illustrate the distinction between revenue and capital expenditures:
"The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay…"
(b) In general, an expense has been "incurred" when a legal liability has arisen for the sum to be paid (for example, when goods have been delivered to the purchaser and an invoice issued for the price of the goods delivered). Hence, an expense is deductible even though the bill has not been paid, so long as the debt is due to be paid. But an expected expenditure, or one that is contingent on the occurrence of certain events in the future, is not deductible; no matter how certain one is that the money will have to be spent in time to come.
(c) An expense must be incurred for the sole purpose (exclusively) of producing income from the business. A dual-purpose expenditure is one which is incurred for more than one reason. Expenses incurred for both a business and private purpose would fail the 'exclusively incurred' test. However, if an incidental personal benefit arises as a result of an expense incurred to achieve a business objective, it does not mean that the expense is disallowed simply because of the personal benefit.
(d) "Wholly" refers to the quantum of the expense. If a definite proportion of an expense was laid out wholly and exclusively in the production of income from the business, that proportion should not be disallowed merely because the expense was not entirely laid out wholly and exclusively in producing income from that source.
(e) There must be a nexus between the expenditure and income which is assessed, so that the expenditure is "incidental and relevant" (Ronpibon Tin NL versus CIT(1949) 78 CLR 47) to producing the income that is assessed. In other words, it is not sufficient for the expense to be incurred for any business related purpose, but it must be incurred for the purpose of producing income from that business. A connection must be established between the expenditure and the process of earning income.
Expenses necessarily incurred but not deductible
Section 33 of the ITA is essentially a replication of Section 14 of the repealed Income Tax Ordinance 1947, which applied to the States of Malaya before the formation of Malaysia. Therefore, the law relating to the deductibility of expenses in Malaysia has not changed for the last six decades. In a nutshell, while the Malaysian economy in the new millennium has progressed and developed beyond any resemblance to the structure that prevailed in the last century, the tax system, in particular its rules on tax deductibility, has changed little to cope with the increasing complexities in business operations within the changing economy.
The law that applied in an era when small businesses were probably the norm and the business operations were less complicated and less regulated than they are now, is likely to be outdated in its application to the present day business environment, which transcends national boundaries and are subjected to a host of statutory and other regulations, sometimes in more than one tax jurisdiction.
The application of the rules embodied in Section 33(1) means that many expenses that are incurred in operating a business will not be allowed for tax deduction even though these expenses may be compulsorily, or necessarily, incurred as a consequence of carrying on the business. Many kinds of business expenses, not envisaged when the law was enacted, may fail one or more of the deductibility tests. Included among non-deductible expenses are those which have to be incurred to comply with the law and regulations governing their operation. Some examples of such business expenses are:
Undoubtedly, these are expenses incurred in the course of carrying on the business of a company. However, they are not regarded as deductible expenses on the grounds that there is no nexus between the expense and the income-earning process. It has also been often and strenuously argued that these expenses are not incurred for the purpose of producing income, but are only incurred after the income has been earned.
- Expenses to comply with requirements under corporate law, such as audit and secretarial fees, including annual filing of accounts with the Companies Commission of Malaysia;
- Expenses on matters relating to shareholders (also in compliance with the law), such as cost of holding annual general meetings and related expenses including printing cost of annual financial statements, registrar's fees, and so on;
- Expenses related to complying with tax legislation (for example, fees for tax advisory services of tax consultants and tax agent's fees for annual tax filing).
Complex business regulations, tax laws, financing options and stakeholder protection have necessitated the appointment of lawyers, bankers, accountants and auditors, tax advisers and agents and incurrence of related expenses to ensure strict compliance. The deductibility of such expenses depends strictly on whether they meet the tests of deductibility listed above.
Sometimes, where the authorities have recognised that some such expense is a legitimate business expense that should be allowed as a tax deduction, special legislation had to be enacted to allow for its deduction because it does not fall within the narrow scope of section 33(1). For example, the law providing for deduction of fees for statutory audits was only gazetted in March 2006, although the requirement for statutory audits is as old as the Companies Act, 1965.
The tax authorities have always adhered strictly to the rules of deductibility embodied in Section 33(1) of the ITA, as reflected in some of the public rulings issued by the Inland Revenue Board pertaining to deductibility of certain types of expenses. Some expenses that are treated as not allowable under these rulings include (just to name a few) cost of filing tax returns and tax appeals, secretarial fees and annual general meeting expenses of companies, cost of obtaining a trading licence and premiums on professional indemnity insurance paid by professionals like lawyers, doctors and accountants. (The table sets out some of the more significant business expenses prescribed in the public rulings as non-deductible.)
Although all these expenses would have been incurred for the purpose of operating the business, they are disallowed on grounds that they do not meet the tests of deductibility under Section 33(1) of the ITA.
Widening the bounds of deductibility
Looking at the law in countries like the UK and Australia, which have progressed far in their tax reform programme, we find that not all rules of deduction are as narrowly scoped as ours.
Although Malaysia's law is a heritage of its British colonial administrators, it is interesting to note that current British tax law has departed from the narrow scope of our Section 33(1). Section 34(1) of the Income Tax (Trading and Other Income) Act 2005 (equivalent of Section 74(1) of the Income and Corporation Taxes Act 1988) provides that:
"(1) In calculating the profits of a trade, no deduction is allowed for:
(a) Expenses not incurred wholly and exclusively for the purposes of the trade; or
(b) Losses not connected with or arising out of the trade."
Though the words "wholly and exclusively" are also used, expenses need only to be incurred "for the purposes of the trade" as opposed to the much more stringent requirement in Malaysia that they must be incurred in the production of gross income of the trade or business. This means that the British taxpayer need only to show that the expense (or that an identifiable portion thereof) is incurred for the purpose of the trade.
Australia, which also shares a history of British colonial administration, has also retained elements of the UK law in its own rules for allowing deduction of expenses. Section 8-1(1) of the Income Tax Assessment Act 1997 states:
"You can deduct from your assessable income any loss or outgoing to the extent that:
(a) It is incurred in gaining or producing your assessable income; or
(b) It is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income."
The first condition that an expense must be "incurred in gaining or producing… income" is similar to the Malaysian provision. However, allowance is given (under [b]) for expenses that are "necessarily incurred in carrying on a business" to qualify for deduction as well. Hence, an expense like audit fees would automatically be deductible under this provision.
The use of the words "necessarily incurred" does not mean that the expense must be one which the taxpayer is compelled to incur under a requirement of law, or a contractual or other legal obligation.
The Australian Tax Office has explained (in ATO Interpretative Decision 2005/284):
"Where a taxpayer is carrying on a business for the purpose of gaining or producing assessable income, the commercial and practical implications of the term 'necessarily incurred' imply that voluntary expenditure incurred for business needs may be deductible. It is the taxpayer who decides whether the expenditure is dictated by the business ends to which it is directed."
And it quotes the following statement from the case of Magna Alloys & Research Pty Ltd versus CIT (1980) ATC 4542, to support the above position:
"For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily incurred."
Under ongoing tax reform programmes in both the UK and Australia, the income tax laws of these countries have been made more robust in keeping pace with the increasing complexities of business operations, as a result of which the bounds of deductibility are now very much wider than the restrictive provisions under Malaysian law.
It should be recognised that the complexities of operating a business in today's highly regulated and sophisticated environment makes it necessary for businesses to incur expenses which, although undoubtedly incurred for the purpose of the business, may not be directly connected with the income-earning process. The narrow scope of Section 33(1) of the ITA means that taxpayers are denied deductions for expenses which are clearly and legitimately expended in the course of operating their businesses, thus increasing their tax cost, an extremely important component of business costs. Any law that ignores this commercial reality needs to be updated, in keeping with the government's declared intention of making every effort to foster a business-friendly environment that promotes commerce and entrepreneurship.
One of the principal objectives of any tax reform programme is to reduce business costs. Therefore, a specific review of Section 33(1) to widen the scope for deductibility of expenses, should be given urgent and top priority, if the government is seriously committed to reducing the tax costs of doing business in Malaysia and making Malaysian businesses more competitive in the regional and global market.
This article was first published in The Edge, 30 July 2007