OVERVIEW: Malaysia — Tax Treatment for Debt Waiver
Unprecedentedly, the Covid-19 pandemic has had a significant impact on businesses across many industries in Malaysia. With the Malaysian Restriction of Movement Order (RMO) extended twice and the relaxed conditional movement control order that followed effective May 4, 2020, companies are faced with market downturns that may affect marketplaces. financial performance, as well as concerns about a looming global recession.
Many companies, in some industries more than others, are suffering from the ripple effects of Covid-19 and ongoing IR, as evidenced by their inability to continue in business, stifled cash flow, and difficulties in insuring the service of their debts.
This article highlights a key area that may be of interest to taxpayers in these difficult times, namely whether: (i) a lender is allowed to claim a tax deduction for a debt waiver of its borrower; and (ii) the forgiveness of the loan is taxable in the hands of the borrower.
Is debt forgiveness deductible?
Increasingly, companies are making an allowance for bad debts or writing off bad debts for a variety of reasons, for example, in the interest of goodwill, if a debtor is bankrupt / liquidated, or if a disproportionate effort is required. to recover funds. .
Under article 34 of the Income Tax Act 1967 (Law), a taxpayer must meet two conditions to be able to benefit from a tax deduction linked to the exemption:
- first, the debt is reasonably considered bad; and
- second, it was previously treated as gross taxpayer income.
In order to determine what amounts are “reasonably estimated” to be irrevocable, courts will determine whether reasonable efforts have been made to collect the debt. This includes issuing a reminder notice, setting up a debt restructuring plan, or concluding a debt settlement based on sound business considerations. It is inappropriate for the taxpayer to simply state that he is pessimistic about the prospects for debt collection due to an ongoing economic crisis.
Taxpayers are reminded that swift legal action is needed as proof of their good faith intention and genuine efforts to collect the debt. For example, in Sastep Sdn Bhd v. Ketua Pengarah Hasil Dalam Negeri (KPHDN), the High Court found that although the taxpayer sent formal notices to collect the debt, proper legal action was not taken until 13 years later, after prescribed. Since the taxpayer and the debtor were related parties, there were conflicts of interest in the financial management of the two companies, and the decision to delay the debt collection action and the cancellation of the debt did not exist. was considered neither in good faith nor based on commercial considerations.
When appropriate debt collection measures have been taken, the likelihood that a taxpayer will be successful in claiming a deduction increases. In Ireka Corporation Berhad v KPHDN, the Court of Appeal ruled in favor of the taxpayer, allowing a deduction for the difference between the original debt and the settlement amount because the taxpayer had taken steps to negotiate and bring the case to arbitration. This notwithstanding the fact that the arbitration procedure was subsequently abandoned.
In short, the courts will tend to favor taxpayers who can demonstrate a real effort to collect the debt.
Is debt forgiveness taxable?
In general, yes. A beneficiary can be taxed on waiving his debts as income.
Under section 30 (4) of the Act, there are two situations in which a waiver of debts is taxable: namely, if the debts relate to the business of the taxpayer and the taxpayer had:
- has benefited from a tax deduction under article 33 of the law; Where
- claimed a capital deduction under section 42 and Schedule 3 of the Act.
In cases where a taxpayer’s debts do not fall into the above two categories, the general principle should be that a waiver of debts should presumably not result in taxable income, although the legal test is currently lacking. clarity in Malaysian jurisprudence.
The special income tax commissioners (SCIT) in the case of FT Sdn Bhd v. KPHDN (FT case) have considered this issue. Although the intercompany loan waiver granted to a subsidiary by its holding company in this case was not taxable under section 30 (4) of the act, the Inland Revenue Board (IRB) insisted that it was taxable under section 4 (a) of the Act as business income. The SCIT ruled in favor of the IRB and concluded that these sums were “earnings or profits of a business” because they were used by the taxpayer to pay his trade creditors and fulfill his trade obligations. On this basis, it was deemed to be a commercial objective.
Further, the SCIT rejected the taxpayer’s argument that the loan was a “grant”. The SCIT considered that the amounts received under the loan were clearly used to settle its trade and business debts of the taxpayer. When it was waived, it became income in the hands of the taxpayer.
Section 4 (a) is the general tax provision for income from a source of activity, such as income from the sale of goods / provision of services. It was unusual for the SCIT to equate the renunciation of loans granted to a subsidiary with the income received in the course of its activity, without applying section 30 (4) of the law to the facts of the case.
The ruling, rightly or wrongly, has not been overturned and the FT case ratio remains binding on all taxpayers, unless and until a similar fact case is brought to court. superior.
Conversely, however, the Court of Appeal in KPHDN v. Bandar Nusajaya Development Sdn Bhd (Bandar Nusajaya) took a clearer position and made it clear that Article 30 (4) is the only provision that the tax authorities can rely on to recover a debt release.
Here the taxpayer got a loan from the holding company. The taxpayer claimed a tax deduction for the interest payable on the loan against two different sources of income: business income and non-commercial interest income. Subsequently, the holding company waived the interest due. The taxpayer taxed only the part of the business income in accordance with Article 30 (4), but did not impose the non-commercial interest income waiver on the grounds that it did not fall under Article 30 (4).
The IRB imposed an additional assessment on the taxpayer to impose the waiver of interest payable on loans made by the holding company to the subsidiary under section 22 (2) (a) of the Act, as income from non-commercial sources. More specifically, the IRB sought to rely on the word “otherwise” in paragraph 22 (2) (a) on the basis that it should be interpreted broadly and not be given a meaning that is. ejusdem generis with “insurance, indemnity, recovery, recovery, reimbursement”.
In Bandar Nusajaya, the Court of Appeal agreed with the High Court judge, among others, that:
- By applying the ejusdem generis as a general rule, the word “otherwise” should have the same gender as the preceding words. Therefore, the waiver of interest due should not be treated as amounts receivable or deemed to have been received into the hands of the taxpayer for the purposes of Article 22 (2) (a).
- The maxim generalibus specialia derogant requires that, where there is a specific provision on a point of law, this provision takes precedence over a general provision. In this case, Article 30 (4) is a specific or special provision allowing the tax authorities to recover a debt relief from a commercial source to tax. Therefore, Article 30 (4) should be applied.
- Article 30 (4) contemplates the discharge of a debt which is to be subject to tax in limited circumstances, that is, when it comes to income from a business. Since the waiver of interest payable arose in the context of the taxpayer’s non-business income, it was not taxable.
We note with interest that the High Court of Bandar Nusajaya referred to the equivalent legal provision in England of our Section 30 (4), and observed that it was created to enforce the waiver of debts incurred to derive income. the sale of goods or the provision of services. .
Unfortunately, the Court of Appeal’s decision was overturned by a subsequent appeal to the Federal Court, albeit on other technical grounds. Nonetheless, the written reasons of the Court of Appeal remain useful in providing guidance on how Article 30 (4) should be applied in cases relating to the imposition of waivers of debt.
While the current Covid-19 pandemic presents significant challenges for businesses, businesses must act with great caution when dealing with debt cancellation. In future tax audits / investigations, taxpayers may need to deal with the IRB’s scrutiny of business decisions made during or as a result of the Covid-19 pandemic.
As such, businesses should be aware of the prerequisites for claiming write-off deductions, especially for business-to-business loans. Taxpayers should assess the soundness of each claim and ensure that there are good and compelling reasons for claiming a deduction. Any deduction made must be supported by sufficient and appropriate documentation. A simple assertion of poor economic conditions without substantial evidence is unlikely to support the taxpayer’s case for a deduction.
Likewise, debtors whose debts have been canceled should take into account the ambiguity of the law relating to Article 4 (a) vis-à-vis Article 30 (4), assess, consult their tax advisers and determine s • It is taxable under the law to avoid additional assessments and penalties.
Adeline Wong is a partner, Jason Liang is a partner, Kellie Allison Yap is a senior partner and Sophia Choy is a student at Wong & Partners, Malaysia.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.