IT IS not uncommon for companies within a group to provide financial assistance to one another in the form of loans, advances or trade credits. The normal expectation is such financial help will be given at a cost, and it is unlikely to be provided free of charge as the saying goes, “nothing in this world is free”.
Transactions of this nature between unconnected third parties would generally attract interest, as there is an inherent cost to money. A lender who chooses not to advance funds can still earn a return by placing the money in interest-bearing deposits.
Likewise, a borrower seeking funds in the open market would not be able to obtain financing without offering some form of consideration, typically in the form of interest or another form of compensation. In short, there is always a cost attached to borrowing in an independent setting.
From a tax perspective if the loans between related parties carry interest, then the issue will be whether the interest meets the arm’s length test which is equivalent to the price that will be charged between independent parties in the open market.
The more challenging issue arises when loans are extended between related parties on an interest-free basis. The starting position of the Inland Revenue Board (IRB) on this issue is that interest should be charged at market rates for transactions between related parties. This is provided for in the transfer pricing legislation and the rules.
Currently, IRB is scrutinising such cases and imposing tax on the deemed interest income on the grounds that the transaction between related parties is not at arm’s length.
Is there a case for providing interest-free loans?
There is no provision in the law that prevents parties from providing interest free loans to one another. It is not uncommon in real life for friends and family to provide friendly loans without interest. It is legally acceptable to undertake such transactions.
When it comes to the corporate sector, interest-free loans are provided as a form of contribution to capital and usually the tenor of the loan will be long term. The underlying reason for providing a loan as opposed to injecting share capital is the flexibility to recover the money lent with minimum administrative burden. Recovering share capital is much more cumbersome and it may involve getting permission from the court in the case of capital reduction.
Interest-free loans are often provided as a form of capital injection, particularly where the borrower is unable to secure financing from independent lenders due to poor creditworthiness. This typically involves factors such as an insufficient ability to repay, weak liquidity, negative historical results and unfavourable projected cash flows. In such circumstances, an external lender would not advance funds without compensation or may decline the loan altogether.
Proper analysis and documentation are essential to support this position, demonstrating that the economic reality aligns more closely with a capital contribution than a short-term financing arrangement.
What do you do now?
Taxpayers with such arrangements must be prepared to show IRB in the event of an audit or investigation that the interest-free loan is commercially justifiable and relevant to their business. There is no golden rule that says interest-free loans are not permitted. There is significant literature in the transfer pricing arena, and you can find them in the Organisation for Economic Cooperation and Development and the United Nations publications, and the arguments are centered around whether such loans can be categorised as equity.
The current climate is such that you must be ready to take these matters to court to defend your position if you believe that the interest-free loan is justifiable.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
