By Nithea Nadarajah
Businesses are scrambling to re-evaluate their strategies in the wake of the COVID-19 crisis, and this includes assessing the impacts of direct and indirect taxes of current operations as well as new strategies.
With many companies falling into the red for the 2020 financial year, the Inland Revenue Board of Malaysian (IRBM) should be expected to scrutinise the quantum of losses incurred to prevent gross overstatements as well as looking into transfer pricing activities and the impacts of indirect tax obligations arising from supply chain disruptions.
During a complimentary MIA webinar on COVID-19 business realignment and tax considerations, Thenesh Kannaa, Partner at TraTax advised participants to pay attention to the following issues and their tax repercussions:
Supply chain tax issues can arise both during the lockdown and post-lockdown periods.
In line with the government’s Movement Control Order (MCO) restrictions, the example of a Malaysian factory allowed to operate at 50% of its capacity could end up with an excess of raw materials and components. To maximise capacity utilisation, the business could take temporary measures to move these under-utilised materials and components to factories operating at full capacity.
However, the items in question may have initially qualified for either sales tax or import duty exemptions, known only to the purchaser. Any subsequent transfers may, depending on the commercial arrangement, be tantamount to re-selling, which is likely to be viewed as a breach of conditions by the Customs Department. Therefore, do obtain proper written approvals prior to acting upon planned business measures to avoid tax penalties.
Post-crisis, Thenesh advised companies planning to restructure – which may result in new distribution channels throughout varied jurisdictions – to look into tax matters such as direct tax incentives and supply chain from the planning stage itself. Some matters to consider include:
- the tax efficiency of the ‘new norm’ supply chain
- potential increases in costs
- policies under Free Trade Agreements (FTAs)
- challenges in obtaining the Certificate of Origin, and
- regional value-added ratios to be entitled to the FTA benefits.
TP Issues – Allocation of Profits
Companies entering into related party transactions, whether domestic or cross-border, are expected to adhere to the arm’s length principle and ensure that adequate contemporaneous TP documentation are prepared with annual updates maintained. A transaction is deemed conducted on an arm’s length basis if both parties are acting independently with the transacted price clearly based on fair market value.
However, companies falling below the following thresholds are absolved from such stringent requirements but are still required to prepare adequate documents justifying adherence to the arm’s length principle: –
- gross income exceeding RM25 million and total amount of related party transactions exceeding RM15 million; or
- the provision of financial assistance exceeding RM50 million.
Although Limited Risk Distributors (LRDs) are low risk business ventures, the current crisis warrants a reassessment of such arrangements with the principal entities. Say for example, a UK-based Multinational Company (UK MNC) enters into an LRD arrangement with its Malaysian related party (M Co) to oversee the local distribution of its products in return for a guaranteed margin of, say, 5% annually. At the end of each year, should the margin fall below the 5% threshold, it was agreed that the UK MNC shoulder the risks and responsibilities of raising it up to 5%. In return, the UK MNC will receive entrepreneurial returns which could fluctuate between super profit margins averaging at 20% and unforeseen losses.
“The unprecedented COVID-19 crisis necessitates a revisit of the relevant TP documents in order to determine the business-worthiness of the current arrangement and whether it should remain ‘status quo’, or possibly a lowering of the agreed margin, or maybe even attribution of a certain amount of losses to the local LRD,” said Thenesh.
TP issues relating to toll or contract manufacturing arrangements are somewhat similar to LRDs with foreign principals earning entrepreneurial returns whilst allocating a fixed margin to the local outfits. The same question again arises as to whether there should be any change to the current business arrangement in view of the turbulence caused by this pandemic. There is no standard answer as it goes back to the functional profile and the TP documents in place in order to determine if the manufacturing capacity risk was acknowledged and duly allocated to the local entity. Another determining factor would be the varying preferences of businesses, where for example, some businesses are able to continue with minimal profit or possibly having proportionate losses allocated to the local outfit, whilst other ventures are duly aware that unlike Malaysia, certain other jurisdictions allow the carry back of losses which then makes it good sense to maintain the ‘status quo’.
TP Issues – Inter-Company Financing
The IRBM views financial assistance between associated persons (whether with or without consideration), as controlled transactions which necessitate the application of the arm’s length principle [2012 TP Guidelines (updated in 2017)].
During the COVID -19 crisis, the Malaysian government, in its efforts to ease the cash flow of borrowers, introduced a 6-month loan moratorium on mortgage payments (interest compounded) and hire-purchase payments (interest not compounded). The question that now arises is whether borrowers of inter-company loans can apply the similar moratorium on interest payments.
With the arm’s length principle in mind, the Malaysian TP laws will rely on the same behavioural pattern that is the acceptable norm between independent parties, and most likely grant borrowers of inter-company loans the same ‘elbow room’. Furthermore, inter-company loan arrangements that are agreed upon based on fixed interest rates may be revisited in line with Bank Negara Malaysia’s reduction in Base Rate (BR). In light of the current crisis, it would be advisable to review such inter-company loan arrangements and possibly alter the interest rates from that of a fixed rate to a variable one, or alternatively reduce the interest rates charged to better commensurate market practices. Factors such as the character of the loan, the currency of the loan (if it is a cross-border arrangement) and the credit worthiness of the borrowers, amongst others, must be duly considered before such pertinent decisions are made.
Inter-company financing arrangements in Malaysia are not regarded as actions directly related to business activities and therefore, any waivers granted on such loans will neither be allowed deductions nor subject to tax. However, the IRBM contemplates that it has the power to scrutinise expenses incurred out of the borrowed money and start disallowing them [Section 30(4) of the Income Tax Act 1967 (ITA), refers]. In this regard, it is advisable not to waive the principal amount but restrict planning strategies to interest payments with proper contemporaneous documents duly maintained.
In relation to cross-border financing arrangements, Withholding Tax (WHT) payment obligations (15% on all outbound interest payments from Malaysia) are important considerations during strategic planning. Labuan, being Malaysia’s offshore jurisdiction, does not impose any applicable WHT on payments made to non-residents. Although popular in the past, cross-border business structures involving Labuan have somewhat waned. Significant regulative amendments were also made to the Labuan tax regime (which came into effect on I January 2019), in order to refine the taxation system and incapacitate harmful tax practices.
Another form of group financing arrangement would be intra-group guarantees, created when a company (with good credit ratings) provides a guarantee for a bank loan advanced to its related company (with a lower credit rating) so that the borrower enjoys beneficial conditions via the funding arrangement, i.e. a lower interest rate. The question then arises as to whether the granting of such a guarantee is tantamount to an intra-group service chargeable to the borrower.
Pursuant to the Australian case, Chevron Australia Holdings Pty Ltd vs Commissioner of Taxation, the Courts considered the possibility of charging guarantee fee to a subsidiary where a third-party bank provides funding to the subsidiary which is backed by parental guarantee. Should the IRBM take a similar view on this matter, it would create tax inefficiencies since such a fee will be taxable in the hands of the recipient, but the payer may not be allowed any tax deductions. Therefore, it is advisable to navigate cautiously when structuring such arrangements, especially considering the tax risks involved and the uncertainties surrounding the current crisis.
Expatriate Tax and Permanent Establishment (PE) Issues
Under the Malaysian taxation system, residents enjoy lower tax rates due to its progressive scale rate from 0 – 30%, as compared to non-residents who are taxed at a flat rate of 30%. To qualify as a tax resident, the IRBM does not look at a taxpayer’s citizenship status but the number of days spent in Malaysia (Section 7 of the ITA refers). Taxpayers who are frequent travellers due to their nature of work, will generally have their travel dates closely monitored to ensure the days spent in Malaysia are within the residency requirements. However, with the COVID-19 crisis resulting in global travel restrictions, careful tax consideration is necessary to enable expatriates working in Malaysia to qualify as tax residents, where say for example, once travel restrictions are uplifted, expatriates should quickly travel back to Malaysia to clock-in the required number of days to qualify as tax residents. Subsequent to the webinar, the IRBM has issued guidelines allowing days of absence from Malaysia arising from COVID-19 travel restrictions to be deemed as being present in Malaysia but there is no guideline on the manner of application for frequent business travellers.
Such unpredictable travel restrictions would cause unprecedented PE issues as well. Say for example, a China Co and a Malaysia Co entered a contract for the supervision of an installation project in Malaysia for a period of five months. Pursuant to the Double Tax Agreement (DTA) with China, PE is created in Malaysia only after a period of six months. Therefore, it was budgeted that the payments made to the China Co would only attract a 10% WHT for services performed in Malaysia. Due to the COVID-19 restrictions, workers from China had to leave Malaysia at the end of the second month and were only scheduled to return six months later to complete the remaining work.
Based on the Organisation for Economic Co-operation and Development’s (OECD’s) interpretation, this six-month absence is deemed part of the project which unfortunately increases the project timeline to 11 months (2+6+3) and thereby creating a PE in Malaysia. The WHT charged will then increase to 13% (10%+3%) throughout the 11-month duration, instead of the earlier budgeted rate of 10%. The IRBM has remarkably expressed willingness to overlook the existence of PE arising from COVID-19 travel restrictions, subject to meeting certain critera. In this regard, it is imperative that strategic PE assessments are carried out extensively on outbound service payments to foreign vendors to minimise future tax disputes attributable to the COVID-19 crisis.