Transfer Pricing: High Court Rules Interest Paid To A Related Party Is At Arm’s Length
Recently, the High Court in Ketua Pengarah Hasil Dalam Negeri v Watsons Personal Care Stores (M) Holdings Limited dismissed the Revenue’s appeal in a transfer pricing appeal. Amongst others, the High Court held that the interest paid by the taxpayer for money borrowed from its related party was at arm’s length as required in Section 140A of the Income Tax Act 1967 (ITA).
Key Facts
In 2003, the taxpayer borrowed money amounting to USD 36,842,335 from Watson Labuan to acquire a substantial number of shares in Watson Malaysia. Later, the taxpayer borrowed another USD 1.2 million from Watson Labuan to finance the acquisition of shares. The amount of money borrowed from Watson Labuan was to be paid with interest at the rate of 3% plus the London Interbank Offered Rate (LIBOR) annually. The principal amount borrowed was to be paid on demand by Watson Labuan.
The Revenue took the position that the interest paid by the taxpayer for the money borrowed was not at arm’s length under Section 140A and rules 8(1)(b) and 8(2) of the Income Tax (Transfer Pricing) Rules 2012 (TP Rules 2012). Accordingly, the Revenue substituted the interest payable with the rate of 0% on the basis that no independent party would carry out such a transaction. Subsequently, additional income tax assessments were raised against the taxpayer.
Being aggrieved by the assessments, the taxpayer filed an appeal to the Special Commissioners of Income Tax (SCIT). The SCIT ruled in favour of the taxpayer and the Revenue appealed to the Court of Appeal.
The Revenue’s Position
Briefly, the Revenue invoked Section 140A on the following basis:
(i)The taxpayer’s transaction was not at arm’s length as the loan did not provide for capital repayment. This non-repayment was not in line with Article 9 of the Model Tax Convention on Income and on Capital and thus, the interest payment should be disregarded.
(ii)In the decision letter, the Revenue contended that the taxpayer’s financial relation with the associated enterprise, i.e. Watson Labuan differs from similar transactions that happen between independent parties. According to the Revenue, the lender of the loan transaction usually gives a single large amount of money to the borrower who in return will pay back money previously borrowed from a lender. The repayment of a loan usually takes the form of periodic payments that normally include that part principal amount plus interest in each payment by relying on the following excerpt extracted from INVESTOPEDIA:
“Failure to keep up with repayments of debt can force you to declare bankruptcy and severely affect your credit rating. Before declaring bankruptcy, most people should explore every alternative such as earning additional income, refinancing and negotiating with creditors.”
In other words, the loans were not given at arm’s length as the money borrowed was repaid on demand based on INVESTOPEDIA.
The Taxpayer’s Position
The taxpayer disagreed with the Revenue’s position for the following reasons, amongst others:
(i)The Revenue cannot read rule 8(1) of the TP Rules 2012 in isolation. Reading together with rule 8(2), the Revenue was required to make adjustments to the structure of that transaction to reflect that would have been adopted by an independent person dealing at arm’s length. As such, the Revenue failed to replace the interest rate with a rate that would have been applicable between independent persons. Thus, the Revenue had not acted within the requirements of Section 140A and rule 8.
(ii)In alleging that the taxpayer’s interest rate was not at arm’s length, the Revenue failed to proffer any documentary evidence that a transfer pricing analysis was conducted. The taxpayer had furnished the Revenue with the transfer pricing documentation which contains the proper analysis of the price of the interest rate.
(iii)The Revenue’s reliance on INVESTOPEDIA in reaching the decision was unreliable.
SCIT’s Decision
In allowing the taxpayer’s appeal, the SCIT held that the Revenue failed to provide a satisfactory explanation in concluding that the taxpayer’s loan and the interest paid were not at arm’s length. It was further held that the Revenue failed to provide a satisfactory explanation in concluding that the taxpayer’s loan and the interest paid were not at arm’s length.
The Revenue subsequently appealed to the High Court.
High Court’s Decision
In dismissing the Revenue’s appeal, the High Court held that the taxpayer’s transfer pricing documentation was adequately prepared to establish an arm’s length interest rate. The High Court observed that the taxpayer has provided a functional analysis, considerations on economic circumstances, benchmarking analysis and comparability analysis to support that the applicable interest rate was at arm’s length.
It was further held that the Revenue must provide its basis supported by facts and law for rejecting the said transfer pricing documentation once the said documentation which was prepared in accordance with the law was presented. As such, the Revenue had failed to perform any transfer pricing analysis report to prove the contrary.
The High Court held that the Revenue failed to provide any documentation to rebut the transfer pricing documentation which was properly prepared by the taxpayer:
“ I am of the view that if DGIR disagreed with the TP Documentation, the DGIR would have commissioned a counter-veiling TP study. This was not done by the DGIR.”
Moreover, the High Court ruled that Section 140A does not give the Revenue the power to disregard any transactions. Instead, Section 140A stipulates that the Revenue may exercise its discretion to substitute the price in a transaction to reflect an arm’s length price when there are reasons to believe. Thus, the High Court upheld the SCIT’s decision in holding that the Revenue’s failure to make adjustments to the loans or substitute the interest rate was contrary to Section 140A.
The High Court held that the substitution of interest rate with zero is in effect disregarding the transaction without substituting an arm’s length as it is inconsistent with the language used under rule 8(2) of the TP Rules 2012 which provides that:
“Where the Director General disregards any structure adopted by a person in entering into a controlled transaction under subrule (1), the Director General shall make adjustment to the structure of that transaction as he thinks fit to reflect the structure that would have been adopted by an independent person dealing at arm’s length having regards to the economic and commercial reality.”
Having examined the loans, the High Court found that the loans are similar to facilities typically offered by commercial banks. The High Court was of the view that INVESTOPEDIA relied on by the Revenue was not an authority to support its allegation, especially when no transfer pricing report or any analysis was carried out.
“The court is of the view that Investopedia is not an authority on the issue alleged by the DGIR. It is merely a website like that of Malaysiakini or even Wikipedia. The writings contained in the website are not authoritative and should not be used as a tool to determine TP Analysis under Section 140A of the ITA. This shows that the justification and the reasoning on the part of the DGIR to impose section 140A of the ITA on the Company is flawed.”
Commentary
In holding that the Revenue must provide its own TP report, the High Court relied on MM Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2013] MSTC 10-46 and Ketua Pengarah Hasil Dalam Negeri v Procter & Gamble (Malaysia) Sdn Bhd [2022] MLJU 743. MM Sdn Bhd was the first transfer pricing case litigated and reported in Malaysia. This is a precedent-setting case for the subsequent transfer pricing cases in Malaysia as this is the first decision that addressed the need for the Revenue to provide good reasons to disregard a taxpayer’s transfer pricing documentation.
The High Court’s decision Watson underscores the importance of the Revenue’s role in producing transfer pricing documentation. It may suggest that an evidential burden may be imposed on the Revenue to produce countervailing transfer pricing documentation in supporting their contentions. The High Court’s decision also serves as a reminder that the Revenue as a public decision-making maker must always exercise its power by adhering to the principles laid down by the judiciary.
Therefore, the completeness and precision of transfer pricing documentation are crucial factors in transfer pricing disputes. Recently, the Income Tax (Transfer Pricing) Rules 2023 (2023 Rules) was gazetted and there are greater requirements in preparing the transfer pricing documentation. In previous years, taxpayers were only required to prepare contemporaneous transfer pricing documentation annually without any statutory deadline. Effective from the year of assessment 2023, the transfer pricing documentation must be prepared contemporaneously by stating the completion date and a list of mandatory information and documents. Although the transfer pricing documentation is not required to be filed, contemporaneous transfer pricing documentation must be furnished to the Revenue within 14 days upon request under rule 5(3) of the 2023 Rules. With effect from 1.1.2021, taxpayers who fail to furnish contemporaneous documentation upon request by the IRB within 14 days, may be subject to prosecution and on conviction, which may entail a fine of between RM 20,000 and RM 100,000 and/ or imprisonment of up to 6 months. In light of the 2023 Rules, taxpayers are advised to take proactive measures to ensure the transfer pricing documentation is prepared with robust foundation, comprehensive analysis and supporting evidence.
26 September 2023