(Tax Update) Interest-Free Loans – Are You at Risk?

Dear Valued Clients,

Are you providing interest-free loans between your companies? If so, it's time to take a closer look! The Malaysian Inland Revenue Board (IRB) has ramped up its scrutiny on these transactions, and they’re not playing around.

What’s Happening?

The IRB is closely examining interest-free loans between related parties, including those from directors to their companies. Even if no interest is charged, the IRB considers these loans as generating "deemed interest income," which is taxable.

This could result in an unexpected tax bill, plus a 5% surcharge tax penalty for what the IRB views as unpaid interest.

Why Now?

Although the rules have been in place for years, the IRB is now strictly enforcing them. Under Section 140B of the Income Tax Act 1967 and Public Ruling No. 8/2015 Loan or Advances to Director by a Company, the IRB has the power to retroactively tax interest income on these loans, with a look-back period of up to seven years.

This means you could be liable for back taxes on past transactions.

Legal and Compliance Risks

If you haven't been reporting these loans or justifying their interest-free nature, you could face penalties. The IRB argues that interest-free loans violate the arm's length principle—meaning they're not conducted on terms that independent parties would agree to.

There is also no guarantee that a company making a payment under such a loan will receive a corresponding tax deduction. Deductions are only allowed if the payment meets the 'wholly and exclusively for the production of income' rule.

But it doesn't stop at loans.

The IRB’s scrutiny also covers other financial arrangements such as cash advances, payments on behalf of related parties, long-outstanding trade debts, financial support, and guarantee fees. It’s essential to determine whether these are genuine loans or could be seen as equity instruments.

IRB’s Active Enforcement

The IRB is actively enforcing these rules, sending letters to taxpayers requesting explanations for their interest-free loan arrangements.

If the IRB isn't satisfied with your explanations or documentation, you could face hefty fines and back taxes.

Recent Tax Cases

Multimedia Super Corridor (MSC) Case: In this case, the taxpayer provided an interest-free loan to its subsidiary. The IRB argued that the loan should have been made on an arm's length basis, with interest being charged. The court sided with the IRB, agreeing that the absence of interest did not adhere to the arm's length principle, and deemed that the interest income should be taxed. This case highlights the IRB's stance that even related party transactions, such as interest-free loans, must be conducted as if the parties were unrelated, meaning they should charge market rates of interest.

Malaysian Airline System Bhd v Ketua Pengarah Hasil Dalam Negeri (2011): This case involved transfer pricing adjustments where the taxpayer did not follow the arm's length principle in its transactions with related parties. The IRB argued for adjustments to be made based on deemed interest income, and the court upheld this view. The judgment emphasized that transactions between related parties should reflect an arm's length transaction to ensure fair tax treatment.

Metacorp Development Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (2015): This case involved a company that had given interest-free loans to its subsidiaries. The IRB treated these loans as generating deemed interest income, arguing that the loans should have been at market interest rates. The court agreed with the IRB, affirming that the absence of interest does not exempt a loan from being taxed on a deemed interest basis. This case supports the IRB’s authority to assess tax on deemed interest income for loans provided by a company to related entities.

Petronas Gas Bhd v Ketua Pengarah Hasil Dalam Negeri (2012): In this case, the IRB made transfer pricing adjustments due to non-arm's length pricing between related parties. The court supported the IRB’s position that transactions, including loans and other financial arrangements, between related entities must adhere to arm's length principles to ensure fair and equitable tax treatment. The court also emphasized the need for clear documentation and justifications for any deviations from standard market practices.

What Should You Do? Best Practices to Follow

To protect your business from these risks, it’s crucial to:

Keep Proper Documentation
Always have loan agreements in place and maintain clear records justifying any interest-free loans.
Review Your Financial Arrangements
Conduct a thorough review of all transactions to ensure they are properly classified and reported.
Seek Professional Guidance
Engage with tax professionals to help navigate these complex rules and ensure your compliance with all tax regulations.

Transfer Pricing and Tax Evasion

Remember, transfer pricing—pricing transactions between related entities to minimize taxes—is a primary method of tax avoidance that the IRB is targeting. Make sure your transactions are compliant with Malaysian laws to avoid being flagged for tax evasion.

Conclusion

With the IRB’s increased scrutiny, it’s more important than ever to ensure your financial practices are in line with current tax laws. Don’t wait until it’s too late—take action now to review your interest-free loans and related transactions to avoid any surprises.

Stay informed, stay compliant, and reach out to us at KTP if you need any assistance navigating these changes.

Thank you for reading our weekly newsletter!

Best regards,

KTP Team

Credit : 'Interest-Free Loans Blitz Is Now Haunting Taxpayers,' as reported by Thannees.com."

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