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 tomay bein the past,the underlying principles andconceptscovered in the articleare 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 arepreparing 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.
Interest income
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:
- overdue trade debts
- normal credit period
- extended credit period, such as easy payment scheme
- client account
- fixed deposits necessarily placed as trade security
- loans to employees
- term deposits of excess cash from working capital
- short-term deposits in money market
- outstanding loans after the death of the money lender, and
- a group treasury business [other than a Treasury Management Centre (TMC)]
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
- employed in or laid out on assets used in or held for the production of any gross income of that person derived from Malaysia or
- the debt in respect of which the interest is paid is secured by any property or asset situated in Malaysia, or
(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:
