IT IS very common for a group of companies to provide loans to one another. The primary reason is to utilise the internal funds before going to external sources because inevitably it will be cheaper. The opportunity cost to the lender will be the key consideration.
If the lender has surplus funds, the return it could earn by placing those funds in relatively risk-free investments, such as fixed deposits or government securities, would normally be lower than the interest rate the borrower would have to pay if it obtained loans from an external lender.
Another common reason for using intra-group loans is that the borrower may not be able to obtain loan from the external market due to its financial track record.
Debt versus equity
It is extremely important to look at the underlying characteristics for every intra-group loan. The factors to be considered will include legal obligation to repay, maturity, expected return, liquidation ranking, management participation, enforceability and accounting and tax treatment. The intention of the parties is also relevant.
The above factors will determine whether a debt can be recharacterised into equity. The consequence of that is the interest paid by the borrower will not be tax deductible. Other than the deductibility of interest issue by the borrower, the most common problem we have with the Inland Revenue Board (IRB) of Malaysia is whether the interest free loans should be regarded as equity.
The starting point in most cases with the IRB is the attempt to impose interest on loans that should be characterised as equity. On the reverse side, it will be much better for the taxpayers to defend their position if they acknowledged it is an equity or it is a quasi-equity in the financial statements and the legal documents accordingly reflect this fact.
Determining the arm’s length interest rate
Determining the transfer prices for financial transactions is similar to any intra-group transactions. The basis will be the transactions undertaken within the group should be comparable or reflect what happens between two independent third parties in an open marketplace.
The uniqueness of intra-group financing transactions lies in the need to evaluate the borrower’s creditworthiness. Any third-party lender would take the borrower’s creditworthiness into account when pricing the transaction. The cost of financing is closely correlated to the level of risk involved. The higher the risk, the higher the cost of borrowing.
The factors taken into account in determining the creditworthiness are borrower’s financial position, repayment capacity, credit rating and the impact of being part of the group.
The most common method used in pricing intra-group loans is the adoption of rates between third parties available in the marketplace. Normally, the technical term in transfer pricing is called “comparable uncontrolled price”.
A one-size-fits-all approach should not be adopted when determining creditworthiness. For SMEs, CTOS and CCRIS may be adequate sources of credit information. However, where the borrower is an MNE or the financing exceeds RM50 million, reliance on established rating sources such as RAM, Moody’s and S&P would generally provide greater comfort and a more defensible basis for the credit assessment. The trade-off, however, is that access to such databases can be costly.
The simplified method
Eligible taxpayers may use designated interest rates published by Bank Negara Malaysia without carrying out a detailed comparability analysis.
However, conditions apply. These include the taxpayer not being in the borrowing and lending business, interest being taxable under paragraph 4(c) of the Income Tax Act 1967, funding coming from internal funds, the loan being denominated in ringgit and the relevant threshold not being exceeded.
For Malaysian resident associated persons, the threshold identified is RM50 million.
The simplified method is not available where capital has been borrowed and subsequently transferred to the ultimate borrower.
Documentation
The transfer pricing documentation for this type of transaction is absolutely important to avoid long drawn audits. This should include a formal agreement and all analysis relating to the transaction and circumstances of the lender and the borrower. The objective is to make sure that when the IRB initiates an audit, there is enough explanation and documentation to support the arm’s length nature of the transaction. In the event any adjustments are made by the IRB, the penalties and surcharge are significant.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
