THE The Inland Revenue Board (IRB) is now focusing on interest-free loans between associated companies in all branches and is retrospectively collecting interest income from the lender on the grounds that interest-free loans are not granted on arm’s length terms.

To make matters worse, a surcharge of up to 5% of gross interest is added to the tax bill.

If the interest-free loan is between two domestic entities, there is no guarantee that the division of the IRB collecting the tax on the income side will ensure that the relevant deduction is granted on the deemed interest payment, which may be dealt with by another division of the IRB. There is no specific law requiring the IRB to grant the deduction to the counterparty, but in reality, the IRB has created an artificial source of income from another related party included in the tax net. In such a case, the payer should not be denied a deduction provided he satisfies the “entirely and exclusively of earning income” rule.

Bigger problems lie ahead

The problem is not limited to interest-free loans. Loans are generally defined as advances of money with an unconditional promise of repayment. This problem extends beyond loans to advances of money, payments on behalf of related parties, unpaid commercial debts over a long period of time that become a loan, etc.

This issue of arm’s length pricing in the provision of direct or indirect financing support between related parties will extend to any guarantees or security given by an related party on behalf of another related party to a third party such as a bank (e.g. bank guarantees, performance bonds, letters of compliance, etc.). Fees for providing such guarantees will be largely based on the cost of the funds and other factors. The IRB will also address these matters in addition to the interest rate charged between related parties.

What is the position of taxpayers?

Taxpayers should consider whether the loan is actually a loan or whether it is some kind of hybrid equity instrument. There are no clear rules to distinguish between equity and loans. The deciding factor depends 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 to be repaid on demand without notice and without underlying collateral. Typically, transactions between completely unrelated third parties are not conducted in this way.

There is a fundamental problem: in the context of the comparability analysis that is at the heart of transfer pricing, such interest-free loans could be completely disregarded by the tax authorities on the grounds that such transactions do not reflect the economic and commercial reality of the market. This would be detrimental to taxpayers.

However, there is a saving grace for taxpayers. Taxpayers must now thoroughly review these transactions and determine whether the interest-free loan is still a loan or whether it is a form of capital financing for the related party. Such transactions are likely to be 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 to take a stand on this important matter.

Final advice

This is a serious matter affecting thousands of companies in Malaysia conducting domestic and international transactions. The affected taxpayers must prepare to face the IRB, which is currently actively seeking taxpayers who may be under-declaring their taxes.

This article was contributed by SM Thanneermalai, Managing Director of Thannees Tax Consulting Services Sdn Bhd (www.thannees.com).