This article serves as reference material for candidates preparing for the ATX-MYS, Advanced Taxation – Malaysia variant exam from the December 2023 session onwards. The laws referred to are those in force at 31 March 2023. This article is based on current legislation relating to the anti-avoidance provision of interest restriction under the earnings stripping rules and excludes any reference to subject matters (such as financial services, insurance, Islamic financing, property development and construction), which are not included in the ATX-MYS syllabus.
Malaysia has always actively pursued foreign direct investments (FDIs) as part of its strategy to industrialise the economy. When a foreign investor contemplates investing into Malaysia, one of the strategic decisions to be made relates to the relative proportion of equity capital and debt capital. While equity capital produces dividends, which are below the line, i.e. after tax, debt capital generates interest, which is above the line, i.e. a deduction may be taken before net profits and therefore before tax. Hence, interest deductions have the effect of stripping profits.
As an anti-avoidance measure to combat profit-shifting base-erosion (BEPS), the rationale of the earnings stripping rules (ESR) is to restrict the amount of interest deductions on borrowings/debt from non-resident related parties, in a year of assessment, to a fixed ratio to reduce the earnings stripping effect.
The premise underlying the fixed ratio is that an enterprise should be able to deduct interest expenses up to a specified portion of the earnings before interest, tax, depreciation and amortisation (EBITDA), ensuring that a portion of an enterprise’s profit remains subject to tax in a tax jurisdiction. The excess interest is allowed to be carried forward. Thus, the fixed ratio provides a country with a level of protection against BEPS, and it is relatively simple to apply.
Malaysia is an early adopter of ESR, after the US, UK, Japan and the EU member states.
With effect from 1 January 2019, a new section 140C ‘Restriction on deductibility of interest’ was introduced to the Income Tax Act 1967.
This enabling legislative provision was followed by the gazette order 175 of 2019 (as amended by gazette order 27 of 2022) to spell out the details. Please refer to the examiner’s guidance notes, included in examinable documents, for further information (see 'Related Links’). The rules came into operation on 1 July 2019 and apply for basis periods beginning on or after 1 July 2019 (see Illustration 1 below).
The Inland Revenue Board (IRB) also published guidelines and frequently asked questions to provide further clarifications.
The main points of section 140C and the rules, as clarified by the IRB guidelines, are as follows:
The first year of assessment (YA) for which the ESR applies is YA 2020, as seen in Illustration 1 below.
Illustration 1
ABC Sdn Bhd closes its accounts annually to 30 June. The basis period that began on 1 July 2019 ended on 30 June 2020. Therefore YA 2020 is the first YA in which the ESR applied to ABC Sdn Bhd, provided the other requisite conditions are satisfied.
The ESR only applies to a person who has been granted any financial assistance in a controlled transaction, and the total amount of interest expense for all such financial assistance exceeds RM500,000 in the basis period for a YA. In calculating this de minimis threshold, according to the IRB guidelines, the interest expenses from all businesses carried out by the company are included, although the application of ESR is source by source.
Financial assistance includes loans, interest-bearing trade credit, advances, debt or the provision of any security or guarantee.
Controlled transaction is financial assistance between persons one of whom has control over the other; or between persons both of whom are controlled by some other person (referred to as a third person). The IRB guidelines have since clarified that only borrowings from outside Malaysia are included. The IRB further clarified that domestic borrowings are not caught under the ESR.
Control means holding 20% or more of the share capital AND any one of the following:
a. the person’s business operations depend on the proprietary rights (such as patents, non-patented technological know-how, trademarks or copyrights) provided by the other person or third person, or
b. the business activities of the person (such as purchases, sales, receipt of services, provision of services) are specified by the other person, and pricing and supply conditions are influenced by the other person or third person, or
c. where one or more board members are appointed by the other person or third person.
Interest expense means interest on all forms of debt, or payments economically equivalent to interest, but excludes expenses incurred in connection with the raising of finance.
The IRB guidelines have specified that the ESR applies to a person who has incurred tax deductible interest expenses, relating to financial assistance, payable to:
a. an associate person outside Malaysia, or
b. an associate person outside Malaysia which operates through a permanent establishment in Malaysia, or
c. a third party outside Malaysia where the financial assistance is guaranteed by its holding company or any other member of the same multi-national group (regardless of the tax residence country of the guarantor).
It can therefore be concluded that only debt or borrowing between cross-border related parties (as defined) are caught under the ESR. Debt and borrowing involving independent parties e.g. financial institutions or non-related third parties, or financial assistance involving only Malaysian parties, are not caught under these rules.
The ESR does not apply to various persons, listed a) through to k) in the legislation, including financial services, insurance, Islamic financing, property development and construction.
For the purposes of candidates preparing for the ATX-MYS exam, only items (a) and (k) in the list are relevant, as the other items are not included in the syllabus. Therefore, for ATX-MYS purposes, the ESR does not apply to:
a) an individual
k) a person who has been granted an exemption under section 127(3)(b) or 127(3A) of the Income Tax Act 1967.
For ease of reference, reproduced below are the provisions in item (k):
| Section 127(3)(b) | (3) The Minister may by statutory order: (a) ….. (b) exempt any class of persons from all or any of the provisions of this Act, either generally or in respect of any income of a particular kind; |
| Section 127(3A) | (3A) The Minister may, in any particular case, exempt any person from all or any of the provisions of this Act, either generally or in respect of any income of a particular kind or any class of income of a particular kind. |
Malaysia has determined the fixed ratio to be 20% of tax-EBITDA. This means that interest expenses payable by the Malaysian entity on the total cross-border controlled financial assistance (i.e. between related parties) is restricted to 20% of tax-EBITDA (as defined) for each YA.
Tax-EBITDA, as determined under Rule 5 of the PU(A) 175 of 2019 as amended by PU(A) 27 of 2022, may be summarised as
A + B + C where
A is the adjusted income of a person from a business source before the s.140C ESR is applied;
B is the total amount of ‘qualifying deductions’ allowed in arriving at the adjusted income (i.e. A). This refers to any special deduction [e.g. under section 34(6)], further deduction [e.g. promotion of exports deduction where a second deduction is given in addition to the first round under section 33(1)] or double deduction (e.g. deduction for approved research and development (R&D) under section 34A) allowable in arriving at A; and
C is the total amount of interest expense from cross-border controlled financial assistance transactions in respect of a business source in a YA.
Having restricted the deduction of interest expenses to 20% of tax-EBITDA, any excess unabsorbed amount may be carried forward to subsequent YAs to be deducted in arriving at the adjusted income of the same business source until the whole amount has been utilised.
The 20% of tax-EBITDA will similarly apply in those subsequent YAs, notwithstanding that the person may not incur any interest expenses relating to any cross-border controlled financial assistance in those YAs.
If the person is a company, the carry forward of any unabsorbed interest expenses will be subject to the satisfaction of shareholder continuity rules, i.e., there is no substantial change (more than 50%) in ordinary shareholding on the first day and the last day of the basis period in the ensuing YAs of absorption.
The three-step approach may help us to navigate through the ESR:
How the ESR works is best demonstrated by a worked illustration, as seen below:
Illustration 2
Scenario
XYZ Sdn Bhd (XYZ), is a Malaysian resident company involved in manufacturing. In the financial statements for the year ended 30 June 2023, XYZ charged interest expense as follows to the statement of profit or loss:
| RM’000 | |
|---|---|
| Interest on loan from UK parent company | 402 |
| Interest on loan from Malaysian commercial bank to acquire patent to produce royalty income | 12 |
| Interest on amount owing to fellow subsidiary in Singapore | 313 |
| Interest on overdue trade account to fellow subsidiary in Malaysia | 174 |
| Total interest expense charged | 901 |
After deducting all the expenses charged, including the interest expense, depreciation and amortisation, the profit before tax is RM1 million.
Written by a member of the ATX-MYS examining team