Is Interest-free
Intragroup Financing
Acceptable?
Audit / Tax / Advisory Smart decisions. Lasting value.
Introduction
As a CEO or CFO of your companies, you often juggle with the resources available with the
view of managing them efficiently, especially idle funds. One of the major decisions you need
to make from time to time is that of shifting around sums of cash between these companies to
meet their respective financial needs. Accounting-wise, inter-company balances would be
created in the books of both the lender and the borrower companies. Have you ever wondered
about these inter-company balances from the tax lens?
Intragroup financing (“IGF”) arrangements are common phenomena in almost every group of
companies. Whilst the IGF may have their commercial basis, IGF related tax issues have
gradually morphed into a high risk area in the eyes of tax authorities in recent years. With
planning, IGF could be deployed as a tool by taxpayers to achieve favorable tax results for
them, which unfortunately, become tax leakages for the tax authorities. To counteract base
erosion and profit shifting (“BEPS”) issues, tax administrators around the world have stepped
up their efforts to counter the act of profit shifting using IGF.
At the global level, the Organization for Economic Co-operation and Development (“OECD”)
formulated various anti-BEPS measures in the BEPS Actions 1 to 15. Specifically relevant to
IGF are Action 4 (Limit base erosion involving interest deductions and other financial
payments), Action 3 (Strengthen controlled foreign company rules), Action 2 (Neutralise the
effects of hybrid mismatch arrangements), and Actions 8-10 (Aligning transfer pricing outcome
with value creation). Those new developments have made IGF one of the most technically
complex areas in the modern tax system.
What is IGF?
In the Malaysian context, IGF transactions are defined as financial assistance between
associated persons that could include loans, interest bearing trade credits, advances or debt
and the provision of any security and guarantee (Chapter IX of the Malaysian Transfer Pricing
Guidelines 2012 as revised in July 2017).
Financial assistance between associated persons involves a taxpayer that acts as a lender
within either a multinational group or a domestic group of companies. The lender proceeds to
extend financial assistance, using funds sourced internally or externally, to other members of
the group for several commercial purposes. In such a transaction, the person receiving the
financial assistance or the borrower is responsible for ensuring that all obligations pertaining to
the financial assistance (e.g. the schedule of repayment, collateral provided and quality of any
guarantee) are met on a timely basis.
It is imperative for taxpayers to be aware that the term “financial assistance” has a rather
broad definition from the perspective of the Inland Revenue Board of Malaysia (“IRBM”). For
example, a simple trade credit facility between associated persons, or one person acting as a
guarantor on behalf of an associated person, payment of expenses made on behalf, etc. could
potentially be labeled as “financial assistance” and therefore the requirements under Section
140A must be observed in those cases.
2
Evaluation criteria – The Arm’s Length Principle
The arm’s length principle remains the global standard in determining the prices (in this case,
interest rates) for any controlled transaction. As IGF transactions fall within the scope of
transfer pricing provisions under Section 140A of the Malaysian Income Tax Act 1967, the
lender and the borrower are required to observe the arm’s length principle. The application of
the arm’s length principle involves the assessments of the lender and the borrower party, and
making reference to the market place for similar financial arrangements. The end result is an
arm’s length interest rate, which is arguably the interest rate that would have been adopted
had the entity been dealing entirely with third parties.
Under the application of the Comparable Uncontrolled Price (“CUP”) method, the arm’s length
interest rate consists of two components, i.e. a reference rate which is used as a base, and a
credit spread or “margin” to compensate the lender for the assumption of risk in the provision of
financial assistance. The determination of an appropriate spread requires an assessment of
various comparability factors. An analysis of these factors would enable the taxpayer to
determine the risks involved within the transaction and aim to recover these risks via an
appropriate spread. Once the spread is determined, adjustments are then made to the chosen
base / reference rate in order to arrive at the arm’s length outcome. An illustration of the
application of the interest rate and comparability factors is outlined below:
Lender Borrower
(Interest charged) Arm’s Length Interest Rate (Interest paid)
Credit Comparability Factors:
Base /
spread
reference rate What is the nature of the IGF and
applied
its purpose?
What is the amount, duration and
terms of the IGF?
Common base / Require
reference rates benchmarking study What type of interest rate is being
include: based on external applied? (e.g. fixed or floating rate)
Average lending comparable data.
Are there any embedded options?
rate
Base lending rate Key determinants of Is there a guarantee involved?
KL Interbank the margin / credit
Offered Rate spread are the Is there any collateral involved?
London Interbank various comparability What is the creditworthiness of the
Offered Rate factors. borrower?
Interest rate on
bank borrowing Where is the location of the
charged to lender borrower and the lender?
Whilst the above methodology in determining the appropriate arm’s length interest rate is one
that is prescribed in the Malaysian Transfer Pricing Guidelines and is a common approach
adopted around the world, the underlying analysis to arrive at an arm’s length interest rate is a
complex one, making the determination of an arm’s length interest rate a time consuming
process and with unguaranteed results.
3
Evaluation criteria – The Earning Stripping Rules (“ESR”)
Section 140A is not the only legislation in place on IGF. In line with Malaysia’s commitment to
fulfill the BEPS Action 4 and address the issue of excessive interest, the Earning Stripping
Rules (“ESR”) has been codified through the introduction of Section 140C of the Malaysian
Income Tax Act 1967. Despite lacking in details, ESR is effective on 1 January 2019. This
provision essentially limits tax deductions on interest expense in the borrower company arising
from IGF. Under the ESR, it has been suggested that the interest deduction on IGF be limited
to a ratio of between 10% and 30% of the borrowers’ earnings. Essentially, ESR is a simplified
rule to ensure that an entity’s interest deductions are directly linked to its profits generated
from its economic activities, and excessive interest over the profitability will be penalised.
Reading both Section 140A and Section 140C together, while Section 140A does not prevent
a borrower entity from claiming an interest deduction on IGF to the extent that the arm’s length
test is met, the ESR under Section 140C creates another hurdle for tax deduction in
circumstances the borrower’s profits are relatively lower vis-à-vis the interest costs.
Do interest-free loans meet the evaluation criteria?
Now, you ask the question: ‘what about interest-free loans and do they meet the criteria?’.
These are logical questions because you do not find benefits of going through the trouble of
finding an answer for arm’s length interest rates. To the taxpayer, it is a matter of putting the
money from the right pocket to the left pocket, and vice versa.
In the past, many taxpayers had resorted to not acting on the IGF and adopted the interest-
free approach. This is in part due to the fact that much of the IGF transactions in domestic
groups relate to movement of internally generated funds (e.g. funds from profits, owners,
directors or shareholders). The tax authorities had been rather considerate on IGF in the past,
as they probably focused on other types of controlled transactions. However, this is now
history. The tax risk of interest-free IGF escalates day-by-day and the tax authorities are
increasing scrutiny on IGF to ensure that IGF is not a tool to gain tax advantages, especially
among multinational enterprises attempting to shift profit between jurisdictions. Therefore,
interest-free loans rank on top of their wanted list and they will not hesitate to make the tax
adjustment where circumstances warrant them to do so. In particular, when the tax adjustment
is imposed at one of the parties, it will entail potential penalties and cash flow impact towards
that entity, and a potential risk for an audit at the counter party in case the counter party
wishes to gain tax deduction from the corresponding tax adjustment.
4
How to treat Quasi-Equity?
As mentioned above, taxpayers (particularly domestic groups)
often utilize internally generated funds in their day-to-day
business. This may involve entities within the domestic group
seeking to lend money to other entities for various commercial
purposes.
Hence, there are arguments by taxpayers that such movement
of funds is not a form of financing, but rather potentially equity in
nature. This question is somewhat addressed in the OECD’s
Model Tax Convention. Commentary paragraph 3(b) of Article 9
states that “not only in determining whether the rate of interest
provided for in a loan contract is an arm’s length rate, but also
whether a prima facie loan can be regarded as a loan or should
be regarded as some other kind of payment, in particular a
contribution to equity capital.”
From the OECD perspective, prima facie loans within a group of
companies have the potential to be considered as equity based
contributions to a particular entity. In such a scenario, these
movement of funds might be considered as being equity in
nature and therefore, may fall outside the scope of being
treated as an IGF for Malaysian transfer pricing purposes.
Given the complexities surrounding characterizing the
movement of funds, proper assessment of each individual
transaction is necessary before treating such transactions as
being equity in nature.
These complexities are compounded by the fact that the IRBM has not provided clear
guidance on the differences between equity and loans from a transfer pricing perspective. In
this regard, taxpayers should follow the guidance of the OECD and the comparability factors
addressed on the previous page in ensuring that these transactions are appropriately
analysed and characterized before adopting an interest-free approach. This is to mitigate the
risks that the IRBM may view the movement of funds as being akin to financing and seek to
impute an arm’s length interest rate in accordance with the prevailing Malaysian Transfer
Pricing Guidelines.
How prevalent is this issue regionally?
It is reported in Action Plan 4 released in December 2016 that “the use of third party and
related party interest is perhaps one of the most simple of profit-shifting techniques available
in international tax planning”. BEPS risks on IGF had prompted the speedier implementation
of more stringent rules in order to plug tax leakages.
Malaysia has jumped onto the bandwagon. Nearer to us, there have been numerous
developments in recent years. In 2017, the Inland Revenue Authority of Singapore introduced
an indicative margin that should be applied to an appropriate reference rate for selected
cross-border IGF transactions thus indirectly highlighting to taxpayers the need for a spread to
be applied. At the same period, Vietnam introduced its version of ESR by limiting the interest
deduction at a rate of 20% of a company’s earnings. In addition, Cambodia recently
introduced new statutory forms that require the disclosure of related party loans.
5
What should you do as a taxpayer?
With the increased scrutiny by the IRBM on IGF, taxpayers can no longer afford to ignore the
tax implications under Sections 140A and 140C of the Income Tax Act 1967. Ignorance of the
law is not a defense and taxpayers must start taking proactive measures to ensure that IGF is
not interest-free, and the interest rate on the IGF can withstand the arm’s length test.
To mitigate such tax risks on IGF including, among others, interest-free loans and quasi-
equity, taxpayers may consider the following actions:
• Performing a risk assessment to ascertain the tax positions of both the lender and
borrower;
• Run a scenario analysis to determine the overall tax impact on both lender and borrower
companies within the same group if the IRBM were to impute an arm’s length interest rate;
• Ensuring proper transfer pricing documentation is put in place as a defence of the IGF
practice being adopted within the group. This should include a proper analysis of the
transaction including characterization of whether the transaction is a form of financing or
equity contribution and the appropriate interest rate to be adopted.
Aside from the above, ESR considerations should also be contemplated. Given that ESR is
another pitfall, taxpayers should review the need for inter-company loans on a more regular
basis, comparing interest expense under the IGF vis-à-vis their earnings to minimize the tax
impact thereof.
It is only with diligence and careful planning that taxpayers can avoid unwanted shocks to
their business through costly tax adjustments and be better positioned to defend themselves
in the event of any scrutiny from tax administrators within and beyond Malaysia.
6
References
OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 -
2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD
Publishing, Paris.
OECD (2018), Base Erosion Profit Shifting (BEPS) Public Discussion Draft BEPS Actions
8-10 Financial Transactions.
OECD (2019), Harmful Tax Practices - 2018 Progress Report on Preferential Regimes:
Inclusive Framework on BEPS: Action 5, OECD/G20 Base Erosion and Profit Shifting
Project, OECD Publishing, Paris.
OECD (2017), Limiting Base Erosion Involving Interest Deductions and Other Financial
Payments, Action 4 - 2016 Update: Inclusive Framework on BEPS, OECD/G20 Base
Erosion and Profit Shifting Project, OECD Publishing, Paris.
OECD (2017), Model Tax Convention on Income and on Capital: Condensed Version 2017,
OECD Publishing.
Disclaimer: Aside from those mentioned above, where applicable, references have also
been made to applicable legislations, regulations and guidelines thereunder with respect to
the tax jurisdictions mentioned in this article.
7
Contact Us About Us
Crowe KL Tax Sdn Bhd About Crowe Malaysia PLT
C15-5, Level 15, Tower C Crowe Malaysia PLT is the 5th largest accounting firm in
Megan Avenue 2 Malaysia and an independent member of Crowe Global. The firm
12, Jalan Yap Kwan Seng in Malaysia has 13 offices, employs over 1,200 staff, serves mid-
50450 Kuala Lumpur to-large companies that are privately-owned, publicly-listed and
Malaysia multinational entities, and is registered with the Audit Oversight
Board in Malaysia and the Public Company Accounting
Foo Meng Huei Oversight Board in the US.
Executive Director
About Crowe Global
[email protected]
Ranked 8th largest accounting network in the world, Crowe
Tel: +603 2788 9898 ext: 2501
Global has over 250 independent accounting and advisory firms
in 130 countries. For almost 100 years, Crowe has made smart
Song Sylvia decisions for multinational clients working across borders. Our
Director leaders work with governments, regulatory bodies and industry
[email protected] groups to shape the future of the profession worldwide. Their
Tel: +603 2788 9898 ext: 2514 exceptional knowledge of business, local laws and customs
provide lasting value to clients undertaking international projects.
Becky Nguyen
Director
[email protected]
Tel: +603 2788 9898 ext: 2626
Kishenjeet Dhillon
Manager
[email protected]
Tel: +603 2788 9898 ext: 2552
www.crowe.my
Crowe Malaysia PLT is a member of Crowe Global, a Swiss verein. Each member firm of Crowe is a separate and independent legal entity. Crowe Malaysia PLT and its
affiliates are not responsible or liable for any acts or omissions of Crowe or any other member of Crowe and specifically disclaim any and all responsibility or liability for
acts or omissions of Crowe or any other Crowe member.
© 2019 Crowe Malaysia PLT
