Relevant to ATX-MYS
This article is relevant to candidates preparing for the ATX-MYS, Advanced Taxation exam. The article is based on the prevailing laws as at 31 March 2017. Candidates are presumed to already have a basic understanding of the subject matter. Although some dates referred to may be in the past, the underlying principles and concepts covered in the article are still examinable and remain relevant for current candidates. Candidates are advised to read this article in conjunction with the syllabus and study guide and examinable documents that are relevant for the exam session they are preparing for.
This article collates and discusses the provisions in the Income Tax Act 1967 (the Act) to assist candidates with understanding the more intricate issues relating to interest income and interest expense. While reading this article, candidates are expected to refer where necessary to the relevant provisions of the Act and the Public Ruling 9 of 2015.
This article is being provided as a result of the amendments made to the provisions of the Act relating to the taxation of interest income and the deduction of interest expense in the past few years. The changes are partly in response to several relevant judicial decisions and partly anti-avoidance in nature. The tax authorities' strategy appears to be to synchronise the timing of the taxation of the interest income with the deduction of the interest expense in respect of loans between related parties.
Definition of interest
There is no technical definition of ‘interest’. Interest is generally taken to be passive investment income, being payment for the use of money or for indebtedness by reference to time.
Apart from obvious sources like interest on loans and borrowings, interest may also include late payment penalties, forbearance of debt-collection, credit period, inter-company indebtedness, etc.
In contrast, case law has established that a discount is not equal to interest although it may be calculated by reference to prevailing interest rates. A discount is said to arise upon maturity or fulfilment of any pre-condition, whereas interest accrues evenly over time.
Classification of interest income
Interest is classified as income under s4(c) of the Act together with dividends and discounts. However, interest is also capable of being classified as business income under s4(a). A succession of cases went to the courts in Malaysia involving this interest-per-se-or-business-income issue. Judicial pronouncements have generally determined that, where interest income is derived other than purely from investment transactions, or when the placement of deposits is incidental to trade or dictated by trade, the interest should be treated as part of business income.
With effect from year of assessment (YA) 2013, a new s4B was introduced to the Act to the effect that ‘... gains and profits from a business shall not include interest.... other than interest...’ from the business of financial services, including banks, licensed money lenders, insurance companies and treasury management centres (TMC).
This means that interest income, for instance, from:
is, as from YA 2013, specified by law to be interest income per se, and cannot be treated as business income.
This represents a significant development in the treatment of interest and withholding tax (as discussed below) and candidates should make sure that they are aware of this.
Derivation rule of interest income and withholding provisions
The determination of the source of interest income is significant as only interest derived from Malaysia is taxable in Malaysia. Foreign-sourced interest income is specifically tax exempt.
Additionally, where interest is paid to a non-resident, the interest derived or deemed derived from Malaysia is subject to withholding provisions. A failure to comply will lead to punitive penalties.
It is pertinent to bear in mind however that although the interest is treated as income derived in Malaysia, it cannot be taxed by way of withholding provisions.
The withholding provisions under s109 apply only when a person pays interest derived in Malaysia to any other person ‘not known to him to be resident in Malaysia. The payer is ‘a person’ while the recipient is ‘any other person’ – ie two separate entities are involved. Therefore, withholding tax is not applicable if the payer and the recipient are one and the same person, as in the case of a branch paying interest to the head office.
Withholding tax also does not apply if the interest income is attributable to a business – ie a branch, permanent establishment, etc, carried out by the non-resident in Malaysia.
Non-application of withholding tax provisions in the two scenarios above does not mean non-assessability of the amounts: it merely means that the mechanism of payment by withholding does not apply.
The derivation rule for interest income is embodied in s15 of the Act captioned ‘Derivation of interest and royalty income in certain cases’.
It states, inter alia, that:
Gross income in respect of interest ... shall be deemed to be derived from Malaysia -
(a) if responsibility for payment of interest... lies with the Government, a State Government or a local authority; or
(b)
(i) if responsibility for payment of the interest ... in the basis year for a year of assessment... lies with a person who is resident for that basis year; and
(ii) in the case of interest it is payable in respect of money borrowed by that person and
(c) if the interest ... is charged as an outgoing or expense against any income accruing in or derived from Malaysia.
Note: The actual text has been reconfigured and certain parts deemed not relevant to the topic under discussion have been omitted, to facilitate a clearer appreciation of the definition.
While parts (a) and (b) (i) above are relatively straightforward, parts (b)(ii) and (c) are quite complex. Below are some illustrations to help candidates understand these parts:
| Scenario | Derived from Malaysia? Withholding tax applicable? | Why? |
|---|---|---|
A Sdn Bhd is a resident company. It purchased equipment from Taiwan for its manufacturing business in Malaysia. It secured extended credit from the Taiwanese equipment supplier and paid interest. |
Yes, derived from Malaysia.
|
Payer is resident, and borrowed money to acquire an asset used in business carried out in Malaysia.
Paid interest to non-resident. |
B Sdn Bhd is resident in Malaysia. It obtained a loan from Singapore to finance its acquisition of plantation land in Indonesia. It charged its real property in Kuala Lumpur as collateral for the loan. |
Yes, derived from Malaysia.
|
Payer is resident, and borrowed money to acquire an asset in Indonesia.
Loan is secured by real property in Malaysia, paid interest to non-resident. |
C Sdn Bhd (C) is resident in Malaysia. It supplies newsprint and printing materials to the Malaysian branch of a UK publishing company. The branch carries out the printing and packing functions in Malaysia. |
Yes, derived from Malaysia.
No, not subject to withholding tax. The branch of the UK company will have to report the interest income in its annual tax return. |
Payer is resident, and borrowed money to use as working capital of business in Malaysia.
Paid interest to the branch of a non-resident. |
D Pte Ltd is a non-resident company carrying out business in Malaysia. It paid interest to its head office in UK on advances for working capital. |
Yes, derived from Malaysia.
|
Payer is carrying out business in Malaysia, and charged interest against income derived from Malaysia.
Not subject to withholding because branch and head office are not separate persons. |
E Pte Ltd is a non-resident company carrying out business in Malaysia. It paid interest to its fellow subsidiary in Thailand on inter-company indebtedness. |
Yes, interest is derived from Malaysia.
|
Payer is carrying out business in Malaysia, and charged interest against income derived from Malaysia.
Subject to withholding because branch and Thai fellow subsidiary are two separate persons. |
Basis of recognition of interest income
The basis of recognising interest income is on the receipt basis, unlike the accrual basis for a business source of income. This is laid out in s27 and is tabulated below to assist candidates’ understanding.
|
Provision |
Notes |
|---|---|---|
s27(1)
|
• Where interest income first becomes receivable in the relevant period, • it shall when it has been received • be treated as gross income of the relevant person in the relevant period. |
Illustration 1 Interest of RM100 was first receivable in YA 2015;
|
s27(2) and proviso (a) |
• When interest is receivable in respect of a period (overlapping period) which overlaps the relevant period, • that interest, when received, shall be apportioned on time basis, and • so much as is apportioned to the relevant period shall be treated as gross income of the relevant person for the relevant period. |
Illustration 2 Interest of RM100 was receivable in respect of the period 1.12.2015 to
The apportionment is as follows:
2016
|
Proviso (b) |
Where the overlapping period partly elapsed more than 4 years before the day on which the receipt of the interest first became known to the director general (DG), then the interest income shall be deemed to have been receivable in respect of and have accrued evenly over that part of the overlapping period which did not so elapse. |
Illustration 3 Interest of RM420 was receivable for the overlapping period 1.1.2010 - 31.12.2012. Interest was received on 1.10.2015. DG was notified on 31.10.2015.
|
(3) |
Where interest becomes receivable in the relevant year and is in respect of a period after the relevant period or a period which overlaps the relevant period and partly elapsed after the end of the relevant period, then when the interest is received, it shall be treated as income of the relevant person for the relevant period.
Note: This involves interest which is receivable in advance.
|
Illustration 4 Interest of RM100 was receivable on 1.8.2015 in respect of the period 1.11.2015 to 31.10.2016.
|
Proviso |
Where the relevant period wholly elapsed more than 4 years before the day the receipt of that interest income first becomes known to the DG, that interest income shall be treated as income of the relevant person for the YA that began 4 years before the beginning of the YA which includes that day. |
Illustration 5 Interest of RM100 is receivable on 1.8.2011 in respect of the period 1.11.2011 - 31.10.2012.
|
Obtainable on demand
In addition to s27, there is s29(1) which states, inter alia, that when interest is obtainable on demand, it is deemed ‘received’ by that person. This means that the interest is taxable even though the interest has not been received yet.
S29(3) was an anti-avoidance provision introduced with effect from YA 2014. This provides that where interest relates to a loan:
the interest is deemed to be obtainable on demand when it is due to be paid.
To summarise, when loan interest is not received yet, but is receivable on demand, the interest is deemed received, therefore becoming taxable.
Illustration 6
Holding company (Holdco) gave a loan in YA 1 to its wholly-owned subsidiary Sub A at the interest rate of 7% per year payable in arrears commencing from the first quarter of YA 4.
As Holdco controls Sub A, Holdco is deemed to be able to obtain the interest on demand when the interest is due to be paid in YA 4. Therefore, if Sub A fails to pay the interest in YA 4, Holdco will be deemed to have received the interest income for YA 1 to YA 3.
The assessments for YA 1 to YA 3 of Holdco will be revised to take into account the interest receivable for each of the YA.
S29(4) concerns, inter alia, interest income (other than loan interest) which relates to transactions between related parties – ie
It states that when the interest income first becomes receivable in the relevant period, it is deemed obtainable on demand in the basis period immediately following the relevant period.
Illustration 7
Holdco (year end 31 December) charges interest on the trade debt owed by its 60%-owned subsidiary Sub B as at 31 December 2016. The interest on the outstanding trade debt is payable on 1 October 2017.
As Holdco controls Sub B, Holdco is deemed to be able to obtain the interest on demand in the basis period immediately following the relevant period of YA 2017. Therefore, Holdco will be deemed to have received the interest income for the outstanding trade debt in the immediately following YA – ie YA 2018.
Interest expense
The provisions relating to the tax treatment of interest expense are:
General deductibility – s33(1)
The five general rules for deduction of expenses apply to interest expense:
| 1. Revenue nature | Outgoings and expenses |
| 2. Quantum and purpose | Wholly and exclusively |
| 3. Actual liability | Incurred |
| 4. Timing | In the basis period |
| 5. In the process | In the course of producing (rather than in order to produce) gross income from that source |
Specific deductibility – s33(1)(a), s33(4)
The five rules above are further augmented by s33(1)(a) which stipulates:
‘any sum payable for that period ... by way of interest upon any money borrowed by that person and
(i) employed in that period in the production of gross income from that source, or
(ii) laid out on assets used in or held in that period for the production of gross income from that source;’
This enables the deductibility of interest where the money borrowed is used to acquire capital assets that are used in the business.
With effect from the YA 2014, the timing of deductibility is spelled out in s33(4):
When interest expense becomes due to be paid, the taxpayer must relate the interest expense to that period for which it was payable.
Compliance requirement
The taxpayer will have to initiate the following process:
Generally, interest income is subject to tax only when it is received, but interest expense is deductible when it is incurred (and which may not be paid).
However, when the loan/indebtedness is between related parties, anti-avoidance provisions have been introduced to pre-empt the timing mismatch between income and expense.
Thus s29 (3) and (4) were put in place to deem that the lender is able to obtain payment on demand when the interest is ‘due to be paid’, and s33(4) is inserted to stipulate that the interest expense is deductible only when the expense is ‘due to be paid’.
This means that the deduction of the interest expense is synchronised with the taxing of the interest income. In the process, it is necessary to revise prior years' assessments.
Written by a member of the P6 (MYS) examining team