Previously, we warned readers that the Inland Revenue Board’s (IRB) scrutiny of interest-free related party loans is imminent, and now it’s a reality. The IRB challenges interest-free loans and attempts to charge arm’s length interest rates.
The IRB’s position is that third parties will not lend money without charging interest. It issues retrospective valuations for previous years and it could be up to seven years when the right to increase valuations on transfer pricing adjustments is permitted under the Income Tax Act 1967.
What is happening?
The IRB attempts to impose an arm’s length interest rate under the transfer pricing regime without resorting to the specific provisions of Section 140A. Instead, it attempts to use the interest provisions of section 29 to make those adjustments.
It is difficult to understand the reasoning adopted by the IRB since the provisions of Article 29 do not address the arm’s length issue surrounding transfer pricing issues relating to intercompany loans.
Are interest-free loans allowed?
In certain circumstances, interest free loans should be allowed as they can be seen as an alternative to capital provided to a business.
In situations where the borrower does not have the creditworthiness or the ability to borrow in the open market, any loan made by a related company in such a circumstance should be considered capital provided to the company to continue its operations. In any free market situation, lenders will only lend money if the borrower has the capacity to repay the loan.
Any related lender of an interest-free loan will be placed in the same position as a shareholder of the company where the return on their investment will be in the form of dividends or the realization of the value of the investment upon its divestment from. investment rather than being remunerated by interest.
Is there legal support for charging interest on interest free loans?
There appears to be a conflict between the existing provisions of the tax law. Although Section 140A of the transfer pricing legislation allows the IRB to charge interest on interest-free loans, there is no provision to link such deemed interest imposed by the CEO under from Article 140A to the specific provisions of Articles 27 and 29 which deal with the timing of the taxation of interest income.
Under section 27, interest is taxed only when received. Section 29 is an anti-avoidance section that prevents taxpayers from deferring the taxation of interest income on the grounds that the interest was not collected when in fact the amount could have been received if the lender had made efforts to demand payment of interest and the borrower had the capacity to pay the interest.
There are further provisions in Article 29 relating to related parties where the law was amended in 2014 and 2015 to allow the IRB to tax interest income in the year in which the interest is due. be paid or the following year in which the interest income was first paid. becomes admissible.
Although section 140A creates deemed interest income, it is not interest that is legally owed to the lender and this conflicts with the primary legislation of sections 27 and 29 which deals with the taxation of income from interest on the basis of actual interest received or due. payable, or first becomes admissible.
Where do we go from here?
This is an issue that needs to be resolved quickly as it affects most business groups in Malaysia. Imposing a tax on such matters retrospectively will be extremely onerous for taxpayers who are currently facing severe economic stress as a result of the Covid crisis.
This requires dialogues between the IRB, the Ministry of Finance and the various stakeholders.
This article was written by Managing Director SM Thanneermalai of Thannees Tax Consulting Services Sdn Bhd.