If you borrow money, you need to repay the principal with interest. Interest is therefore a compensation to the lender for the loss of use of the money.
Inter-company financing has been an international tax planning tool for decades. A classical example is where the lender and borrower are located in a low tax and high tax jurisdictions respectively resulting in a tax arbitrage.
The OECD and G20 are aware of this and hence, the advent of Action 4 (Limiting Base Erosion Involving Interest Deductions and Other Financial Payments) as part of the 15 action plans under the Anti-Base Erosion and Profit Shifting (BEPS) package.
While Malaysia is neither a member of OECD nor G20, it has joined BEPS Inclusive Framework. Although Action 4 is not mandatory, Malaysia takes cognisance of its importance in protecting the nation’s revenue base. Action 4 is aimed at, among others, limiting base erosion through the use of interest expense to achieve excessive interest deductions.
Even without Action 4, Malaysia already has robust tax rules on interest deduction. The borrowing that gives rise to interest must be utilised as working capital or for the purchase of assets that are used to produce income.
Where the borrowing is utilised for business and non-business purpose, interest restriction kicks in. Moreover, the interest expense must be “due to be paid”. The interest expense charged must be at “arm’s length”. Where interest is paid to non-resident, withholding tax and the late payment penalty, if applicable, must be dealt with.
Now, if one thinks that these rules are onerous, there is another rule that kicked in on 1 July 2019, namely the Earning Stripping Rules (ESR). ERS is not a new term to the international tax fraternity as it has been or will be introduced in various jurisdictions such as Japan, the UK, Germany and the Netherlands.
To recap, in 2016, the European Union adopted the Anti-Tax Avoidance Directive to combat “aggressive tax planning” as part of the Anti-Tax Avoidance Package, which includes an Interest Limitation Rule based on the recommendations set forth in Action 4. Similarly, the Malaysian-styled ESR is a modification of Action 4 concept taking into account the local tax legislations and domestic circumstances.
Firstly, how does the Malaysian ESR work? Apart from having a need to meet all conditions explained above, deduction for interest is restricted to a ‘maximum amount of interest’ being 20% of the tax-earnings before interest, taxes, depreciation and amortisation (EBITDA).
Tax-EBITDA is computed based on the special formula that “normalises” the adjusted business income. The De Minimis threshold is RM500,000. A company is allowed to carry forward the interest expense which is in excess of the maximum amount of interest subject to the substantial shareholding test. In other words, it is a matter of time before the excess of interest can be fully utilised.
The ESR will apply to business interest expense and other payments which are economically equivalent to interest. There is no grandfathering provision and it simply means that ESR will also apply to financial assistance obtained prior to 1 July 2019.
Also, ESR only applies to controlled transactions and hence the clarification is required on whether inter-company borrowings should be evaluated separately from third party borrowings when computing interest restriction under the existing rule.
Secondly, who would be affected? Based on the rules which are law, it appears that the ESR applies to not only cross-border financial assistance, but also domestic financial assistance. If so, many local corporate groups are likely to be affected as intra-group financing is extremely common. The tax authorities should be commended for issuing guidelines to clarify that ESR is applicable to, amongst others, a person within the charge to tax under the Malaysian income tax regime and a person carrying on business having interest expenses from financial assistance which is paid or payable to its associated person outside Malaysia.
Given this, the Malaysian corporate groups with solely domestic borrowings would have some breathing space for now. Borrowers who are carrying out property development, construction, banking, insurance etc and individuals are excluded.
Clarification will be required on the non-inclusion of a person enjoying special tax holiday in the guide whilst the rules do include. Policy may change and hence being vigilant will be key.
Malaysian subsidiaries or branches of foreign-based MNCs with related party foreign financing will be affected. For Malaysian-based MNCs, ESR could also apply if the Malaysian subsidiaries pay interest to the cash-rich related parties outside Malaysia.
Non-Malaysian bank financing would also be affected if it is guaranteed by a person within the group regardless of the guarantor’s tax residency. The tax authorities should also be commended as the rules would not apply to a person with the basis period commencing prior to 1 July 2019.
This is an equitable policy. One question arises on the validity of the guide as it is not a law whereas the rules are. In this regard, clearly there is a legitimate expectation that the guide will be respected.
In light of ESR, CFOs need to revisit the group’s international financing structures. Any additional tax costs must be taken into account. Where it involves foreign external financing, due care must be given on the guarantee arrangement.
Domestic financing may work better coupled with the withholding tax saving. Broadly speaking, the tax authorities around the world have strong preference of ESR over the traditional thin capitalisation rules and it appears that there are limited tax planning for ESR. OECD’s Anti-BEPS package, which includes Action 4 is the most significant international tax reform in the history.
Action 4, coupled with other Anti-BEPS standards that deal with areas of harmful tax practices, tax treaty-abuse, country-by-country reporting requirements for transfer pricing and permanent establishment would likely lead to the end of international tax planning. The emphasis these days would be on compliance.
Tan Hooi Beng is deputy tax leader and international tax leader of Deloitte Malaysia. The views expressed here are solely the opinion of the writer.
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