Tax issues – Interest-free loans under scrutiny

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MANY taxpayers have taken a simplistic position that whenever they lend money to each other within the group, it can be loaned interest free since they have full control over the borrowers. The common statement we hear from majority shareholders is: “After all, this is our business. Why should we charge interest? »

What does the Inland Revenue Board (IRB) do?

Taxpayer scrutiny of interest-free loans within groups began with one or two branches of the IRB, but is now expanding to other branches across the country. The IRB assesses taxpayers retrospectively by applying the interest rates in effect in the respective years. Sanctions are also imposed on the beneficiary of the interest.

What is the basis?

The additional assessment is based on the fact that the transaction was not at arm’s length, which is provided for in the transfer pricing provision under section 140A of the Tax Act 1967. income tax (ITA).

The arm’s length principle requires that transactions between related parties be made on the same terms/conditions and under the same circumstances that would have been comparable to similar transactions made between unrelated/unrelated parties.

Related parties are those where one person controls the other or both persons are under the control of a third party or persons related to each other.

Commercial rationality

The key question is: will a third party give an interest-free loan to an unconnected person? If we accept the principle adopted in our tax legislation that each taxable person is treated as a separate entity entirely independent of each other, it will not be possible on the market to obtain interest-free loans with or without collateral. The use of money always has a cost.

Are there exceptions?

Yes, there are exceptions where shareholders provide capital to their related companies. In the event that the loan should not be repaid for a very long time, this financing takes on the character of equity. There are other arguments to defend such a challenge by the IRB and it will depend on the qualification and the intention/facts surrounding the transaction.

Interest-free loans between corporate directors and shareholder directors

Interest-free loans and advances made by a company to its shareholder directors who hold more than 20% of the ordinary share capital of the company and who participate in the management of the company will automatically trigger interest income for the company, which is clearly stated in the ITA.

Conversely, when the shareholder grants interest-free loans to the company, the IRB has remained silent on such transactions. However, reading the law strictly, the IRB could come back at any time and impose an arm’s length interest rate on such transactions.

Promote good relations with taxpayers

The interest-free loan issue is not new and has existed for a long time and the tax authorities are aware of this problem. The majority of taxpayers have operated on the basis that since the IRB has remained silent, there has been a tacit approval of interest-free loans.

The 2022 taxpayer review and retrospective taxpayer assessment may not promote goodwill, although the law broadly supports the position taken by the IRB. It may be desirable for the IRB to consider some form of taxpayer relief. This could take the form of a waiver of penalties accompanied by the reasonable imposition of an interest rate which may be established according to criteria agreed between the taxpayer groups and the IRB.

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

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