This article is relevant to candidates preparing for P6 (MYS) and the laws referred to are those in force at 31 March 2017. This article discusses the provisions in the Income Tax Act 1967 (the Act) and the Real Property Gains Tax Act 1976 (RPGT Act). While reading this article, candidates are expected to make concurrent references to the relevant provisions of the Act and the RPGT Act, as amended.
This article is relevant to the section of the syllabus and study guide falling under items B1, 2, 3 and 4. Section B of the syllabus and study guide covers 'the impact of relevant taxes on various situations and courses of action, including the interaction of taxes'.
Section B1 requires candidates to identify and advise on the 'taxes applicable to a given course of action and their impact'. Section B2 expects candidates to identify and understand that the 'alternative ways of achieving personal or business outcomes may lead to different tax consequences'. Section B3 pertains to how taxation can affect financial decisions, while section B4 deals with the 'advantages and disadvantages of alternative courses of action'.
This article will examine the comparative tax treatment of:
- A. Investing in a company through debt or equity capital
- B. Acquiring a business through a share deal or asset deal
- C. Acquiring business assets through outright purchase, hire purchase, or leasing, and
- D. Leasing and sub-leasing real properties.
A. Investing in a company through debt or equity capital
A.1 Comparative tax treatment
Investment by way of debt or equity capital produces markedly different tax results, as seen in the table below (or access larger version of table):
Thin capitalisation (thin cap) rules
Simply stated, thin cap rules limit the proportion of debt permitted to finance a resident company’s operations. The provisions can apply to the overall gearing ratio of the company or alternatively only to related party debt or even only to offshore related party debt. It is important to determine what is defined as debt and equity because, for instance, preference share funding may be treated as debt. Tax authorities prescribe acceptable debt to equity ratios, which vary from jurisdiction to jurisdiction. Ratios in the order of 3:1 are fairly common.
Any debt in excess of the permitted ratio may be reclassified as equity, with the associated interest treated as dividends and not deductible in arriving at taxable income.
The existence of thin cap rules reflects tax authorities' concerns that tax deductions claimed for interest paid to an offshore party may erode the tax revenue of the country in which the investment is made. Thin cap rules are also in existence to address the fact that withholding tax rates on interest paid to an offshore party are generally lower than the domestic company tax rate, hence inbound investors may heavily gear their investments by using debt finance rather than equity capital.
In Malaysia, laws [section 140A) have been introduced to, inter alia, empower the prescription of thin cap rules with effect from 1 January 2009. However, the implementation of these provisions has been suspended until 31 December 2017. A Government announcement (in 2016) informed that the thin cap provisions will be enforced with effect from 1 January 2018. The detailed Malaysian thin cap rules are therefore expected anytime in the year 2017.
Where there is intra-group borrowing, indebtedness or a loan from one group company to another, interest will arise. To bring it on par with arms' length transactions, transfer pricing rules will normally require for such related-parties indebtedness or loans to bear interest at prevailing commercial rates.
A.3 Comparative analysis
Advantages of loan capital
- Interest is tax deductible in arriving at the adjusted income of the investee company.
- Interest tends to be a more tax-efficient mechanism to repatriate profits to the investor company.
- After-tax profits can be repatriated at no cost by repayment of the loan.
- Subject to exchange control restrictions, the currency of the loan can be selected, whereas share capital is often restricted to the currency of the investee jurisdiction; this enables better management of exchange exposure on the investment.
- Capital duties are often payable on the issue of share capital, but not on loan capital.
- Where the investor is a non-resident, the withholding tax rate is 15% of gross (or even lower under some tax treaties), which is lower than the current head-line tax of 24%.
- Loans are more flexible than shares; they can be repaid easily or can be converted to share capital.
Advantages of share capital
- The timing, frequency and quantum of a distribution of dividend may be determined by the parties involved, unlike a loan, where the rate of interest must approximate marker rates and interest accrues automatically with the passage of time.
- Where desired, a dividend distribution may be deferred to maximise the investee’s retained profits and minimise/defer income to the investor.
- In a cross-border situation, where the investor country has a higher tax rate than the investee country, investment by way of share capital may facilitate a deferral of taxation in the higher tax jurisdiction.
- Some tax incentives apply only to return on share capital. For example, the tax sparing benefit under double tax treaties is applicable to dividends only.
Commercial requirements, rather than tax considerations, may be an overriding factor in the level of share capital or loan capital. It is often necessary for a foreign investor to have a significant equity base in a Malaysian entity to project confidence and positive public perception. Additionally, a sufficient (according to regulations) equity base may be required to enable and facilitate the raising of third party borrowings.
B. Acquiring a business through a share deal or asset deal
When a company (the acquirer) contemplates the takeover of an existing business activity (the target), it will likely consider the relative merits of a share deal or asset deal.
B.1 Share deal
By this, the acquirer acquires the entire or majority of the ordinary paid up share capital of the target, thus assuming control of the target company. The entity continues unchanged; the controlling shareholders changed. Along with the target company will come:
- all its assets (tangible and intangible) and liabilities, and
- all its tax attributes, such as unabsorbed capital allowances, tax losses, and tax residual expenditure, debtors, holding periods of assets (including real properties), etc.
B.2 Asset deal
Under this, the acquirer acquires the selected means of production or the target business activity, including:
- all or part of the business assets (plant, machinery, equipment, building, premises, trade debtors, intangibles, etc) with or without the liabilities
- the existing network of suppliers, clientele, retailers, etc, and
- the distribution network.
B.3 Comparative tax treatment
Access larger version of table.
C. Acquiring business assets through outright purchase, hire purchase (HP) or leasing
C.1 Comparative tax treatment
There are different ways of financing the acquisition of fixed assets used in business: outright purchase, HP, and leasing. They each lead to different tax treatments, have different impacts on cash flow, and pose different eligibility conditions vis-a-vis qualifying expenditure for tax incentives such as investment tax allowance (ITA) and reinvestment allowance (RA).
Under this option, the asset is acquired outright – ie beneficial and legal ownership passes to the buyer, usually (but not necessarily) upon full payment. The full payment may be funded by the company's own working capital or with a loan from a third party. It may also be acquired with credit from the seller, or with staggered payments. It is important to note at this stage that a staggered payment scheme does not necessarily mean HP (more about this later).
Whether the acquisition price has been settled or otherwise, the qualifying plant expenditure (QPE) of an asset acquired under outright purchase is the entire cost (1). This means that the full amount (whether paid or otherwise) of the cost of the asset constitutes the QPE eligible for capital allowance for that year of assessment (YA).
The basis for this full QPE despite non-full-payment is that the acquirer has incurred the entire sum because, for the purposes of Schedule 3, the expenditure on the asset is deemed incurred when the asset is capable of being used in the business.
Hire purchase (HP)
The Hire Purchase Act 1967 is tasked to regulate the form and contents of HP agreements and the rights and duties of parties to such agreements. The full list of goods covered by the said Act is as follows:
- All consumer goods
- Motor vehicles, namely:
(a) Invalid carriages
(b) Motor cycles
(c) Motor cars including taxi cabs and hire cars
(d) Goods vehicles
(e) Buses, including stage buses.
When an asset is acquired under a HP agreement, the two contracting parties are 'owner' and 'hirer'. Hence, paragraph 46 of Schedule 3 provides that the hirer under a HP agreement is deemed to be the owner for purposes of Schedule 3 and the aggregate capital payments paid by him on that plant or machinery in the basis period for the relevant YA shall be the QPE incurred by him.
Therefore, it is important to differentiate HP from the purchase on credit under which instalments are payable.
Assets such as manufacturing machinery, factory equipment and construction machinery cannot qualify as HP assets. Therefore, they should be treated as outright purchases for the purposes of CA.
Leased assets may come under the categories of an operating lease or a finance lease. For the purposes of income tax, both are treated in the same manner (2).
However, if a finance lease transaction is deemed a sale under regulation 4 of the Leasing Regulations 1986, it will be treated as an outright sale (3). The lessee, not the lessor, will be the party eligible to claim CA based on the cost price of the asset. There are six situations cited in regulation 4 which constitute deemed sales.
Access larger version of table.
D. Leasing and sub-leasing real properties
When a lease over real property – ie land situated in Malaysia, is created, amounts payable are to be considered under income tax to determine the capital or revenue nature. For instance, a premium, per se, is capital in nature because it secures a right to the lease, and the lease then becomes an asset.
When the said lease over land is in turn sub-leased, the asset, that is the lease, is disposed of. This will require considerations under the Real Property Gains Tax Act, 1976 (RPGT Act), pursuant to Paragraph 25 of Schedule 2 of the RPGT Act which reads: 'The grant of a lease is the disposal of an asset, namely the lease.'
Pertama Sdn Bhd (Pertama) acquired a piece of land in Perak, Malaysia for RM500,000 in the year 2000. On 1 May 2014 Pertama granted a 30-year lease to Kedua Sdn Bhd (Kedua) at a premium of RM1 million and an annual lease rent of RM12,000.
On May 2017, Kedua sub-leased 70% of the Perak land to Ketiga Sdn Bhd (Ketiga) at a premium of RM600,000, and annual lease rent of RM10,000.
The RM1 million premium is capital in nature, not subject to income tax
|Kedua||Kedua acquired an asset – ie the 30-year lease for RM1 million on 1 May 2014. In sub-leasing on 2 May 2017, Kedua has disposed of 70% of its asset, the lease, for RM600,000. It also begins to derive lease income of RM10,000.
Computation of RPGT is as follows:
(on 2 May 2017)
|Less Acquisition price|
(1 May 2014)
(30 years – 3 years)/
30 x 600,000
Disposal in 4th year
|Ketiga||Ketiga has acquired an asset, the lease, at RM600,000 on 2 May 2017.|
Written by a member of the P6 (MYS) examining team
(1) See Public Ruling 6/2015, paragraph 7
(2) See Public Ruling 5/2014, paragraph 11.2
(3) See Public Ruling 5/2014, paragraph 11.5
(4) See Public Ruling 6/2015, paragraph 5.7