Insight - Directors’ remuneration: The tax reflex

Kasturi Nathan is partner and head of governance & sustainability, KPMG in Malaysia

WHEN asked to respond on a maze of tax queries, Albert Einstein, whose theory of relativity is supposedly understood by only seven persons in the world, replied, “this is a question too difficult for a mathematician, it should be asked of a philosopher”.

Indeed, the late great Albert Einstein once admitted that figuring out tax computation was beyond him.

The aforementioned quip serves to underscore the consensus that tax issues are intricate and such intricacies will end up becoming more pronounced after every round of revision or reform.

The nuanced aspect of taxation system is in fact an inherent feature given the need for authorities to promote traceability and enforceability while addressing economic circumstances and competing interests. In the context of taxes on remuneration of non-executive directors, the delicate nature is evidently discernible as such individuals are at the helm of the company and the incentives which drive their actions would have systemic consequences.

For starters, non-executive directors represent individuals who are independent from management and they render services to companies by way of a contract for service.

To this end, the remuneration accorded to them by companies is deemed as a consideration for professional services which gives rise to sales and service tax implications.

Krishman Varges is associate director, governance & sustainability, KPMG Management & Risk Consulting Sdn BhdKrishman Varges is associate director, governance & sustainability, KPMG Management & Risk Consulting Sdn Bhd

The remuneration package of non-executive directors is conventionally made up of director fees (board and board committee fees), meeting allowance and benefits in kind for which the recently released Guide on Professional Services by Royal Malaysia Customs Department (Oct 6,2020) stipulates that only fees will now be subjected to sales and service tax while the latter two remuneration components are free from sales and service tax.

To further contextualise, fees for non-executive directors represent a retainer sum that is anchored on bases such as reposed responsibilities, anticipated time commitment, expertise and experience as well as board performance.

Meeting allowance or sitting allowance meanwhile represents a payment on a per-meeting basis that serves as a consideration for time taken to attend the meeting while benefits in kind are perquisites that act as added incentives for directors with the common examples being insurance and medical coverage.

It should be noted that the sales and service tax for the remuneration rendered to non-executive directors is usually borne by the company enlisting their services rather than the non-executive directors themselves.

Given that around 80% of a typical non-executive director’s remuneration package is currently composed of fees, the changes in tax stipulation may intuitively represent a window of opportunity for companies to capitalise on tax savings.

Against this backdrop and in an anemic operating environment, companies may have the predilection to tinker with the proposition of engaging in an undue redistribution of the fee component to meeting allowance and benefits-in-kind so as to reap tax benefits.

However, any out-of-whack recalibration in remuneration packages of non-executive directors solely for the purpose of cashing in on tax savings and without taking into account the corporate governance context may result in unintended consequences. Simply put, misaligned incentives drive incongruent actions.

For example, a heavy tilt towards meeting allowance as a remuneration component, if not managed well, could bring about polarising outcomes of densely packed meeting agendas or alternatively, fragmentation of meeting agendas.

To add a veneer of clarity, companies may seek to bludgeon their board or board committee meetings with a jam-packed agenda in order to vindicate the high meeting allowance rate for each sitting.

In another extreme, companies may seek to highly fragment their meeting agenda so as to increase meeting frequency and compensate directors with a high overall quantum of meeting allowance in lieu of the lower director fee.

In both cases, the end result is not desirable from a corporate governance perspective as meetings are not optimised to harness the contribution of directors in a strategic and integrated manner.

As an alternative example, an excessive concentration of business related benefits in kind such as petrol allowance, outfit allowance, handphone bill payments, security services and inordinate provision of office utilities for non-executive directors may represent a misallocation of resources and incongruously encourage them to be operationally-minded.

The trickle-down consequences in this regard could be deleterious especially given that corporate Malaysia is not devoid of examples involving exercise of executive powers by non-executive directors.

Operational focus and micromanagement by non-executive directors would invariably disrupt workflow and the inherent check and balance process in the company.

Needless to say, when a non-executive director starts to “go down to the dungeon”, such an individual may also be exporting risks of assuming management function to other board members as directors are jointly and severally liable for breach of fiduciary and statutory responsibilities.

Looking further down the line, due cognisance should be given to the “new normal” conditions precipitated by the Covid-19 pandemic which have resulted in the need for boards to supplement leadership capacity and exercise more intimate oversight on strategy and risk implementation through more frequent and informal engagement sessions with management.

Many companies have also instituted special-purpose board committees or hybrid board-management committees to address these newfound conditions.

Such changes point towards the increasing importance of board and board committee fee as a mode of remuneration to non-executive directors in view of the added heft in responsibilities and transcension beyond formal meetings.

As a corollary, during the heat of the Covid-19 pandemic and recognising the heightened frequency of meetings as well as engagement sessions, some companies have moved to ramp up director fees and correspondingly scrap meeting allowance, reduce its rate or cap the disbursement of meeting allowance based on a maximum number of meetings in a month.

All in all, as companies operate in an increasingly uncertain environment, remuneration can become more decisive to attract, retain and motivate non-executive directors in tandem with the company’s long-term value creation journey.

Companies should therefore not lose sight on the fundamentals of remuneration design when undertaking a review. One should be mindful that a company’s action of allowing taxes to primarily drive the remuneration schemes of non-executive directors would be the case of “putting the cart before the horse”.

Therefore, instead of engaging in a race to solely maximise incremental tax benefits on the remuneration of non-executive directors, companies should remain focused on the underlying philosophy that relate to the variables of responsibilities, risk, business complexity and performance.

In short, never abandon the principle of promoting congruence between remuneration and value creation. While it is often said that nothing is certain in this world except for death and taxes, one should also be cognisant of another constant in life, namely, principles.

As the famous educator, Stephen Covey puts it, “the consequences that flow from one’s actions are controlled by principles”.

Kasturi Nathan is partner and head of governance & sustainability, KPMG in Malaysia, while Krishman Varges is associate director, governance & sustainability, KPMG Management & Risk Consulting Sdn Bhd.The views expressed here are the writers’ own.

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