In unprecedented ways, the Covid-19 pandemic has significantly impacted businesses across many sectors in Malaysia. With the Malaysian Restriction on Movement Order (RMO) extended twice and subsequent relaxed Conditional Movement Control Order beginning May 4, 2020, companies have to contend with market downturns that may affect financial performance, as well as concerns about a looming global recession.
Many companies, in certain industries more than others, are suffering from the knock-on effects of Covid-19 and the ongoing RMO, as reflected in their inability to continue operations, stifled cash flow, and difficulties in servicing their debts.
This article highlights a key area that may be of interest to taxpayers in these challenging times, namely whether: (i) a lender is allowed to claim a tax deduction for a waiver of debt to its borrower; and (ii) the loan waiver is taxable in the hands of the borrower.
Is a Waiver of Debts Deductible?
Increasingly, companies are allocating a provision for doubtful debts or writing off bad debts for a variety of reasons—for example, in the interest of goodwill, if a debtor is bankrupt/wound-up, or if a disproportionate effort is necessary to recover monies.
Under Section 34 of the Income Tax Act 1967 (Act), a taxpayer has to satisfy two conditions in order to qualify for a waiver related tax deduction:
- first, the debt is reasonably estimated to be irrecoverable; and
- secondly, it was previously treated as a gross income of the taxpayer.
In order to determine what amounts are “reasonably estimated” to be irrevocable, courts will take cognizance of whether reasonable efforts were made to recover the debt. This includes issuing reminder notices, having a debt restructuring scheme, or entering into a debt settlement based on sound commercial considerations. It is inadequate for the taxpayer to simply assert that it is pessimistic about the prospects of debt recovery due to an ongoing economic crisis.
Taxpayers are reminded that timely legal action is necessary as proof of their bona fide intention and genuine efforts to recover the debt. For example, in Sastep Sdn Bhd v. Ketua Pengarah Hasil Dalam Negeri (KPHDN), the High Court found that although the taxpayer had sent notices of demand to recover the debt, proper legal action was only taken some 13 years later, after it was time-barred. Given that the taxpayer and the debtor were related parties, there were conflicts of interest in the financial management of both companies, and the decision to delay taking the debt recovery action and writing off the debt was regarded as neither bona fide, nor based on prudent commercial business considerations.
Where appropriate debt recovery steps have been taken, the likelihood of a taxpayer successfully 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 settlement sum as the taxpayer had taken actions to negotiate and submit the matter for arbitration. This is notwithstanding that the arbitration proceeding was subsequently abandoned.
In short, courts will tend to favor taxpayers who can demonstrate genuine effort to recover the debt.
Is a Waiver of Debts Taxable?
Generally, yes. A beneficiary may be taxed on the waiver of debts as income.
Under Section 30(4) of the Act, there are two situations where a waiver of debts is taxable: namely, if the debts relate to the taxpayer’s business and the taxpayer had either:
- taken a tax deduction under Section 33 of the Act; or
- claimed a capital allowance under Section 42 and Schedule 3 of the Act.
In instances where a taxpayer’s debts do not relate to the above two categories, the general principle ought to be that a waiver of the debts should arguably not result in taxable income, though the legal test currently lacks clarity in Malaysian case law.
The Special Commissioners of Income Tax (SCIT) in FT Sdn Bhd v. KPHDN (FT case) considered this issue. Although the waiver of intercompany loans 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 agreed with the IRB, and found that such monies were “gains or profits from a business” as they were used by the taxpayer to pay its trade creditors and fulfill its business obligations. On that basis, it was held to be for trading purposes.
Furthermore, the SCIT rejected the taxpayer’s argument that the loan was a “gift.” The SCIT opined that amounts received from the loan were clearly used to settle its trade debts and connected with the taxpayer’s business. When waived, it became income in the hands of the taxpayer.
Section 4(a) is the general taxing provision for income derived from a source of business, such as receipts from sale of goods/provision of services. It was unusual for the SCIT to equate the waiver of loans given to a subsidiary with income received from the course of its business, without applying Section 30(4) of the Act to the facts of the case.
The decision, whether rightly or not, was not overturned and the ratio of the FT case remains binding on all taxpayers—unless and until a case on similar facts is brought before a higher court.
Conversely however, the Court of Appeal in KPHDN v. Bandar Nusajaya Development Sdn Bhd (Bandar Nusajaya) adopted a clearer position and stated clearly that Section 30(4) is the only provision that the tax authorities may rely on to claw back a release of debt.
Here, the taxpayer was given a loan by the holding company. The taxpayer had claimed a tax deduction for the interests payable on the loan against two different sources of income: business income and non-business interest income. Subsequently, the holding company waived the interests payable. The taxpayer brought to tax only the business income portion pursuant to Section 30(4), but did not bring to tax the waiver relating to the non-business interest income on the ground that it did not fall under Section 30(4).
The IRB raised an additional assessment against the taxpayer to bring to tax the waiver of interests payable from loans advanced by the holding company to the subsidiary under Section 22(2)(a) of the Act, as income from a non-business source. More precisely, the IRB sought to rely on the word “otherwise” in Section 22(2)(a) on the ground that it should be construed widely, and not be given a meaning that is ejusdem generis with “insurance, indemnity, recoupment, recovery, reimbursement.”
In Bandar Nusajaya, the Court of Appeal agreed with the High Court judge, inter alia, that:
- By applying the ejusdem generis rule, the word “otherwise” ought to bear the same genus as the words before. Therefore, the waiver of interests payable should not be treated as sums receivable or deemed to have been received in the hands of the taxpayer for the purpose of Section 22(2)(a).
- The maxim generalibus specialia derogant necessitates that where there is a specific provision on a point of law, that provision takes precedence over a general provision. In this case, Section 30(4) is a specific or special provision for the tax authorities to claw back a release of debt from a business source to tax. Hence, Section 30(4) should be applied.
- Section 30(4) envisages the release of debt that is to be brought to tax in limited circumstances, i.e. when it is income from a business source. 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 in Bandar Nusajaya had referred to the equivalent statutory provision in England of our Section 30(4), and observed that it was created to tax the waiver of debts incurred in deriving income from selling goods or rendering services.
Unfortunately, the Court of Appeal ruling was overturned by a subsequent appeal to the Federal Court, albeit on other technical grounds. Nevertheless, the Court of Appeal’s written ground remain useful in providing guidance as to how Section 30(4) ought to be applied in instances pertaining to taxability of debt waivers.
Whilst the current Covid-19 pandemic presents significant challenges to businesses, businesses ought to act out of an abundance of caution when dealing with the waiver of debts. 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 take note of the preconditions for claiming deductions on waiver of debts, especially for intercompany loans. Taxpayers should assess the strength of each receivable and ensure there are good, cogent reasons for claiming a deduction. Any deduction taken should be supported with sufficient, proper documentation. A bare assertion of poor economic conditions without substantive evidence is unlikely to support the taxpayer’s case for a deduction.
Likewise, debtors whose debts have been waived must account for the ambiguity in the law pertaining to Section 4(a) vs Section 30(4), assess, consult their tax advisers and consider whether it is taxable under the Act to avoid additional assessments and penalties.
Adeline Wong is a Partner, Jason Liang is a Partner, Kellie Allison Yap is a Senior Associate and Sophia Choy is a Pupil at Wong & Partners, Malaysia.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.