CHARGING below market interest gets you in trouble with the taxman or the law against money-lending.
“Neither a borrower nor a lender be”.
This advice by Polonius, the King's adviser to his son in Shakespeare's Hamlet remains good advice today.
But good advice, it is said, is least heeded when most needed.
Lending money gives rise to risk of default, a stark reminder of today's global phenomenon.
At a personal level, it can lead to the loss of a friend, a relative remaining one only by virtue of blood ties.
The term “relative” is defined in our tax law to include a wide network of family members including a nephew, a niece, a cousin and somewhat incredibly “an ancestor or lineal descendant.”
How the latter is to be determined, the law has not made clear, leaving the conundrum perhaps to the wisdom of the courts.
In many cases, loans between family members are below-market loans.
By this is meant that the lender charges either no interest or a rate that is less than the “market rate” also known as the “arm's length” rate.
This is in breach of the tax law, which requires a loan to a related party including a relative to be at the market rate of interest.
This requirement has been made clear by a recent Government Gazette setting out rules on transfer pricing as the rules do not state that such loans must be in the context of carrying on a business or must be used in a business.
Thus when you make a below market loan to a relative, driven entirely by altruistic reasons and devoid of any business considerations, the tax law treats you as having derived imputed' income from your borrower and would proceed to levy tax on that imputed income.
This phantom income on which tax is levied equals the market rate you should have charged less the interest you actually charged.
This means that you must report the imputed interest as taxable income in your tax return failing which you will be in default of the tax law.
If you were to consider avoiding this unfavourable tax outcome by being somewhat hard-hearted and charged interest to your relative, then you are in breach of the Moneylenders Act.
The law here precludes the charging of any interest since you are not a licensed moneylender.
A moneylender under this law is any person who “lends a sum of money to a borrower in consideration of a larger sum being repaid to him”.
So this puts you, the lender, setting out to help a financially distressed relative, on the proverbial “horns of a dilemma”.
You are in the untenable position of breaking one or the other law.
This state of affairs seems to run counter to any coherent tax policy objective.
In the United States, the lending of money below market rate historically occurred without tax consequences.
Through a series of court cases over several years culminating in a case in 1984, the court held that the lender's right to receive interest is a “valuable property right” and where such a right is transferred by way of an interest-free loan, it is in the nature of a gift subject to “gift tax”.
But the point here is that the taxing of the interest-free loan is because of the existence of a gift tax.
We do not have such a tax in Malaysia and taxing imputed interest, as this measure is generally known, between related individuals not conducting business transactions, is a retrograde step.
We had long repealed a similar imputed income provision, which treated a person owning an unoccupied house as having an income source, even where no income exist.
Business related loans follow similar concepts, but here the law is entirely understandable and justified where the intent is to avoid tax.
If company A makes an interest-free loan to its subsidiary which is a tax exempt pioneer company, then this leads to tax results which are not reflective of transactions between commercial parties.
Not charging interest inflates the subsidiary's tax exempt profits enhancing its capacity to pay tax exempt dividends, without a corresponding tax liability on the lending parent had interest been charged.
Here the existence of a “tax shelter” where one entity has either tax exempt status or a tax loss position, can lead to tax leakage, the reason for the arm's length rule.
Interest-free business lending between related companies can also lead to anomalous results.
This is a consequence of the divergence between the tax treatment and the new accounting standards for public listed companies.
The taxman will require tax to be imposed on the lender on the imputed market rate interest.
Whereas if such a company lends RM100,000 to its subsidiary interest - free to be repaid in equal instalment over five years and the market interest rate is 10%, the accounts will reflect the lender as having a debt of RM75,816, which is the discounted amount at the inception of the loan.
Over the period of the loan, the borrower will be shown as having paid interest of RM 24,184 which will equal the discount.
Thus the books of both companies will be recorded as if interest had been paid as shown in the table.
Since these are book entries and there are no costs incurred or income earned, they have no tax consequence.
This reflects the economic substance of the loan transaction as distinct from the strict legal substance, the mainstay for tax.
This fundamental difference in concept tends to make attempts at convergence between the accounting and tax treatments particularly problematic.
The more pressing issue is doing away with the taxing of imputed interest on non-business lending between relatives, a measure which seems unjustified.
Kang Beng Hoe is an executive director of TAXAND MALAYSIA Sdn Bhd, a member firm of TAXAND, the first global organisation of independent tax firms. The views expressed do not necessarily represent those of the firm. Readers should seek specific professional advice before acting on the views. Beng Hoe can be contacted at kbh@taxand.com.my
“Neither a borrower nor a lender be”.
This advice by Polonius, the King's adviser to his son in Shakespeare's Hamlet remains good advice today.
But good advice, it is said, is least heeded when most needed.
Lending money gives rise to risk of default, a stark reminder of today's global phenomenon.
At a personal level, it can lead to the loss of a friend, a relative remaining one only by virtue of blood ties.
The term “relative” is defined in our tax law to include a wide network of family members including a nephew, a niece, a cousin and somewhat incredibly “an ancestor or lineal descendant.”
How the latter is to be determined, the law has not made clear, leaving the conundrum perhaps to the wisdom of the courts.
In many cases, loans between family members are below-market loans.
By this is meant that the lender charges either no interest or a rate that is less than the “market rate” also known as the “arm's length” rate.
This is in breach of the tax law, which requires a loan to a related party including a relative to be at the market rate of interest.
This requirement has been made clear by a recent Government Gazette setting out rules on transfer pricing as the rules do not state that such loans must be in the context of carrying on a business or must be used in a business.
Thus when you make a below market loan to a relative, driven entirely by altruistic reasons and devoid of any business considerations, the tax law treats you as having derived imputed' income from your borrower and would proceed to levy tax on that imputed income.
This phantom income on which tax is levied equals the market rate you should have charged less the interest you actually charged.
This means that you must report the imputed interest as taxable income in your tax return failing which you will be in default of the tax law.
If you were to consider avoiding this unfavourable tax outcome by being somewhat hard-hearted and charged interest to your relative, then you are in breach of the Moneylenders Act.
The law here precludes the charging of any interest since you are not a licensed moneylender.
A moneylender under this law is any person who “lends a sum of money to a borrower in consideration of a larger sum being repaid to him”.
So this puts you, the lender, setting out to help a financially distressed relative, on the proverbial “horns of a dilemma”.
You are in the untenable position of breaking one or the other law.
This state of affairs seems to run counter to any coherent tax policy objective.
In the United States, the lending of money below market rate historically occurred without tax consequences.
Through a series of court cases over several years culminating in a case in 1984, the court held that the lender's right to receive interest is a “valuable property right” and where such a right is transferred by way of an interest-free loan, it is in the nature of a gift subject to “gift tax”.
But the point here is that the taxing of the interest-free loan is because of the existence of a gift tax.
We do not have such a tax in Malaysia and taxing imputed interest, as this measure is generally known, between related individuals not conducting business transactions, is a retrograde step.
We had long repealed a similar imputed income provision, which treated a person owning an unoccupied house as having an income source, even where no income exist.
Business related loans follow similar concepts, but here the law is entirely understandable and justified where the intent is to avoid tax.
If company A makes an interest-free loan to its subsidiary which is a tax exempt pioneer company, then this leads to tax results which are not reflective of transactions between commercial parties.
Not charging interest inflates the subsidiary's tax exempt profits enhancing its capacity to pay tax exempt dividends, without a corresponding tax liability on the lending parent had interest been charged.
Here the existence of a “tax shelter” where one entity has either tax exempt status or a tax loss position, can lead to tax leakage, the reason for the arm's length rule.
Interest-free business lending between related companies can also lead to anomalous results.
This is a consequence of the divergence between the tax treatment and the new accounting standards for public listed companies.
The taxman will require tax to be imposed on the lender on the imputed market rate interest.
Whereas if such a company lends RM100,000 to its subsidiary interest - free to be repaid in equal instalment over five years and the market interest rate is 10%, the accounts will reflect the lender as having a debt of RM75,816, which is the discounted amount at the inception of the loan.
Over the period of the loan, the borrower will be shown as having paid interest of RM 24,184 which will equal the discount.
Thus the books of both companies will be recorded as if interest had been paid as shown in the table.
Since these are book entries and there are no costs incurred or income earned, they have no tax consequence.
This reflects the economic substance of the loan transaction as distinct from the strict legal substance, the mainstay for tax.
This fundamental difference in concept tends to make attempts at convergence between the accounting and tax treatments particularly problematic.
The more pressing issue is doing away with the taxing of imputed interest on non-business lending between relatives, a measure which seems unjustified.
Kang Beng Hoe is an executive director of TAXAND MALAYSIA Sdn Bhd, a member firm of TAXAND, the first global organisation of independent tax firms. The views expressed do not necessarily represent those of the firm. Readers should seek specific professional advice before acting on the views. Beng Hoe can be contacted at kbh@taxand.com.my 