This article first appeared in Forum, The Edge Malaysia Weekly on November 6, 2017 - November 12, 2017

The projected increases in tax revenue from 2016 to 2018 paint a hopeful picture of our economy. After two consecutive years of decline in direct tax collections, we expect to see a strong increase/growth in direct taxes for 2017.

The Economic Report 2017/18 states that the government expects to collect RM119.7 billion in direct tax, representing a 9.2% increase against 2016’s collections, with a further increase in 2018 to RM127.7 billion (or by 6.7%).

Income taxes represent half of our total government revenue and it is right to focus on maintaining the integrity of the tax system and be vigilant against the erosion of our tax base. Over the last decade, we have seen the introduction of a number of protective measures such as transfer pricing rules to keep up with rapidly evolving business models driven by globalisation, technology and innovation.

Malaysia has also committed to the automatic exchange of information (AEOI), which includes the exchange of financial account information between Malaysian financial institutions and foreign tax authorities starting September next year. In return, the Inland Revenue Board of Malaysia will receive financial accounting information of Malaysian residents from foreign tax authorities.

In Budget 2018, it was announced that earnings stripping rules (ESRs) would be introduced on Jan 1, 2019, to replace existing thin capitalisation legislation and address perceived tax leakages from excessive interest claims on related party loans. You would recall that thin capitalisation laws were introduced in 2009 but not implemented. The rules were not released, having been deferred on multiple occasions, most recently until Dec 31 this year. These laws will be abolished with the passing of the Finance (No 2) Bill 2017.

Its replacement, the ESRs, will limit related party net interest deductions claimed by an entity to a fixed percentage (between 10% and 30%) of earnings before interest, taxes, depreciation and amortisation (Ebitda) or earnings before interest and tax (Ebit). The ESRs are very much in line with the fixed ratio” recommendation suggested by the Organisation for Economic Co-operation and Development (OECD), though we note that the recommendation applies to both third party and related party net interest.

Malaysia’s decision to implement ESRs puts the country in the early wave of adopters such as the US, the UK, Japan and EU member states and it is evidence that Malaysia is actively looking to international developments when shaping tax policy. The ESRs will join other rules already in place that limit deductions, such as:

• Interest deductions are generally allowed only against income from the source to which borrowings are applied.

• Interest deductions are only allowed when the interest is “due to be paid”.

• Interest paid to related parties must be at arm’s length under Malaysian transfer pricing rules.

• No interest deductions are available on interest payments made to non-residents if withholding tax rules have not been complied with.

In my view, there are a number of design considerations that need to be addressed if the ESRs are to be implemented successfully and with minimal disruption to businesses. These include:

• Interaction with existing interest deduction rules: Which rules will take priority? Are they cumulative?

• In-country group transactions: Should the rules apply to transactions that do not result in base erosion? For example, are both related parties in Malaysia and subject to the same rate of tax? Where interest deductions are restricted for the payer, will there be automatic corresponding adjustments for the interest recipient to achieve neutrality?

• Business-friendly fixed ratio: Will the fixed ratio accommodate potential increases in interest rates? What about average gearing ratios that differ for companies at different stages of their life-cycle and in different industries/sectors?

• Ebitda: Should an average Ebitda be used to smooth volatility in earnings? Will the rules examine the ratio on a group basis or an entity basis?

• Other OECD recommendations: Should there be special rules for public interest projects? And other selected industries? Can we carry forward disallowed interest expenses?

I am particularly encouraged that the implementation of ESRs is scheduled to take place on Jan 1, 2019. This should allow sufficient time for the formulation of a manageable policy that finds support from all concerned. With the 14-month horizon, it is now a good time for policymakers to consider a structured programme to obtain feedback on the framework and language of the rules.

To achieve a strong general buy-in to proposed policies, it will be important for policymakers to engage with the business community. Sector representatives, business leaders, tax advisory firms, professional bodies, trade associations and chambers of commerce are but a few examples of parties who would welcome the opportunity to participate in shaping this policy. I am keen to see, for example, a public exposure of the draft rules, with scheduled workshops and/or consultation sessions.

Too often have proposals been implemented without sufficient time for meaningful stakeholder consultation, resulting in uncertainty and rules that either increase the cost of business or do not achieve the desired policy objective. We have ample time for discussion, so let us use this time wisely.

Yeo Eng Ping is EY’s Asean tax leader. The views in this article are hers and do not necessarily reflect the views of the global EY organisation or its member firms.

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