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Source of Interest Income Impacts Holding & Treasury Companies
Foreign sourced income is exempt from tax in Malaysia. This makes Malaysia an attractive location for holding companies, as foreign sourced income received in Malaysia is tax exempt. Further this income can be flowed out as dividends without attracting any other taxes, as Malaysia does not impose a dividend withholding tax.
The question as to what constitutes foreign sourced income, particularly in the context of interest income has long been debated with the tax authorities, who have taken a narrow view of interest income being deemed to have a domestic source where the funds are giving rise to the interest income (i.e. the loan) originate from Malaysia. Taxpayers now have the comfort of case law which contradicts the tax authorities' view. The High Court in the "Cardinal Health Malaysia" case recently ruled in favour of the taxpayer. Details of the judgement are being awaited. Taxand Malaysia sets out the facts of the case and the impacts this will have on holding and treasury companies.
This case involved the question of whether interest income derived by a Malaysian company from a loan to a Netherlands entity was Malaysian sourced or foreign sourced. The facts are briefly as follows:
- The Malaysian company ("Lender") and the Netherlands company ("Borrower") were related entities
- The Lender was in the business of manufacturing gloves domestically
- The Borrower was the financing entity for the group - hence surplus funds held by entities within the group were channelled to the Borrower to reduce the need for external debt within the group. All such loans within the group were made on commercial terms
- The Lender and Borrower entered into an agreement whereby the Lender made advances to the Borrower from time to time and interest was payable on such amounts. The Lender treated these advances as deposits from which it derived interest income.
- The Lender treated the interest income as passive foreign sourced income
- The Malaysian tax authorities sought to tax the interest income as Malaysian sourced income
At the first level of litigation, the Special Commissioners of Income Tax (SC) held that the interest was foreign sourced income. The SC referred to the well-established tax case of Commissioner of Inland Revenue v. Hang Seng Bank  1 AC 306 and the case of Commissioner of Inland Revenue v. Orion Caribbean Ltd  2 HKC 449. On appeal by the tax authorities to the High Court, the latter upheld the decision of the SC, in favour of the taxpayer.
Therefore, the interest income on the loan to the Netherlands company was held to be foreign sourced income and was accordingly exempt from tax.
It has since been learnt, however, that the tax authorities will be appealing to the Court of Appeal soon.
This case sets a clear precedent (subject to the outcome of the appeal by the tax authorities to the Court of Appeal), that interest income derived from loans made to foreign parties would be treated as foreign sourced income. It would be important to show that the funds have been used outside of Malaysia, and preferably, the loan documentation should also be completed outside of Malaysia. The fact that the funds from which the loan was extended originated from Malaysia will be irrelevant (contrary to the view enforced by the tax authorities in the past).
Clearly, in using Malaysia as a location for structuring loans to foreign parties, the impact of withholding tax on the out flowing interest payments (from the borrowing locations) needs to be considered alongside possible treaty relief in the form of lower withholding tax rates. As the income will be exempt from tax in Malaysia, double tax relief for withholding taxes suffered on the interest income will not be available.
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