THE Inland Revenue Board (IRB) across all branches is now focusing on interest-free loans between related parties and imposing retrospectively deemed interest income on the lender on the grounds that interest-free loans are not being provided on an arm’s length basis.
To add salt to the wound, a surcharge of up to 5% of the gross interest is added to the tax bill.
If the interest-free loan is between two domestic companies, there is no guarantee that the section of the IRB that raises the tax on the income side will ensure that the corresponding deduction is given on the deemed interest payment which may be dealt with by a different section of the IRB. There is no specific law that requires the IRB to provide the opposite side the deduction, but in reality the IRB has created an artificial source of income from another related party which is within the tax net. In such a case, the payer should not be denied a deduction provided the payer meets the “wholly and exclusively in the production of income” rule.
Bigger problems are looming ahead
The problem will not be confined only to interest-free loans. Loans are defined in general as advances of money with an absolute promise to repay. This problem will extend beyond loans to advances of money, payments on behalf of related parties, unpaid trade debts over a long term that becomes a loan, etc.
This problem of arm’s length pricing for providing direct or indirect financing support between related companies will extend to any guarantees or securities given by one related company on behalf of another related company to a third party such as a bank (e.g. bankers guarantee, performance guarantees, letters of conform, etc.). The charges for the provision of such guarantees will be largely based on the cost of monies and other factors. The IRB will also be looking into these matters in addition to the interest rate charged between related parties.
What is the position of taxpayers?
Taxpayers should examine whether the loan is really a loan or is it some form of a hybrid equity instrument. There are no clear rules to distinguish between equity and loan. The deciding factor will be dependent on the legal arrangement, the economic substance of the arrangement, and the actual conduct of the taxpayers. Most interest-free loans between related parties state that the loan is repayable on demand without a time limit and without any underlying security. Normally transactions between entirely independent third parties will not be conducted in this manner.
There is a fundamental problem here that under the comparability analysis which is the “heart” of transfer pricing, such interest-free loans could be entirely disregarded by the tax authorities on the basis that such transactions do not reflect the economic and commercial reality that goes on in the marketplace. This will be detrimental to taxpayers.
However, there is a saving grace for taxpayers. Taxpayers need to now re-examine these transactions thoroughly and determine whether the interest-free loan remains a loan or is it some form of capital funding to the related party. It is likely that such transactions are sitting in “no man’s land”. The taxpayers concerned must take a position based on the law, their conduct, the accounting treatment, and the underlying economics in making a stand on this important matter.
Final advice
This is a serious matter affecting thousands of companies within Malaysia undertaking domestic and international transactions. The affected taxpayers must prepare themselves to face the IRB which is now actively looking for taxpayers who may be underdeclaring their taxes.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
