Recently, I was trying to explain to a potential client about the tax implications of giving interest-free loan to directors of companies. He in turn replied, “What’s the big deal about giving interest-free loans to directors? I’ve been doing it for many years and my accountant says there are no issues attached to it.”
Well, the answer is, if he cares to listen, there ARE.
Owners of privately-owned small/medium-sized businesses would normally form a company to run their business. Examples of such businesses are family-owned businesses or persons carrying out a profession such as accountants and medical practitioners. These companies receive all the income from the business and in return, the directors/shareholders receive salaries, directors fees and dividends from the company. Inevitably, there will be a huge chunk of cash left in the companies.
Now, placing the excess cash in fixed deposits with the financial institutions is a good idea, but the interest earned by the companies on these fixed deposits will be subject to income tax of either 20% or 25% tax rate. So in practice, what the directors do instead would be draw the excess cash from the company as interest-free loan to the directors and in turn, place them in fixed deposits in the financial institutions. The interest earned by on these fixed deposits are now tax-exempt in the hands of the directors by virtue of the Income Tax (Exemption) (No. 7) Order 2008.
Sounds like a great ‘tax-planning’ idea, right?
Pursuant to Section 140 (1) of the Income Tax Act 1967, the Director General, where he has reason to believe that any transaction has the direct or indirect effect of-
(a) altering the incidence of tax which is payable or suffered by or which would otherwise have been payable or suffered by any person;
(b) relieving any person from any liability which has arisen or which would otherwise have arisen to pay tax or to make a return;
(c) evading or avoiding any duty or liability which is imposed or would otherwise have been imposed on any person by this Act; or
(d) hindering or preventing the operation of this Act in any respect,
may, without prejudice to such validity as it may have in any other respect or for any other purpose, disregard or vary the transaction and make such adjustments as he thinks fit with a view to counter-acting the whole or any part of any such direct or indirect effect of the transaction.
This is EXACTLY what the Inland Revenue Board did in the case of YEHHSB v DGIR (2010), where the company gave interest-free loan with no fixed repayment terms to its directors and its directors in turn placed the amount of the loans in various fixed deposits accounts in various financial institutions. The IRB invoked Section 140 of the Income Tax Act to tax the taxpayer on the interest earned from the fixed deposits placed by the directors and WON.
In any case, with the introduction of the Income Tax (Transfer Pricing) Rules 2012, Rule 12 (1) of the said Rules require that “Any person in a controlled transaction who provides or receives financial assistance, directly or indirectly, to or from another person with or without consideration shall determine the arm’s length interest rate for such assistance.” Therefore, the company that gives financial assistance (ie. interest-free loan) to the directors would have to account for a deemed interest income (even though none has been actually charged or received by the company) which would be taxed on the company.
With proper planning, the company will still have avenues to reduce the tax implication connected with these interest-free loans. The tax planning ideas will be shared in the members’ section in due course.