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Time to revisit cross-border structures using treaty benefits
TTCS Virtual Sharing Session on Indirect Tax

29 April 2024

ALL businesses doing international trade will have to take into consideration the double tax agreements (DTA), if any, that Malaysia has entered into with other countries. The original intention of DTA until recently was to help carry on international business without suffering double taxation in two or more countries and to prevent fiscal tax evasion and avoidance.

Large companies over the years have not only sought relief from double taxation but have gone further to avoid paying taxes or paying minimal taxes worldwide. One of the avenues used here is treaty shopping, where they set up structures internationally with the sole aim of taking advantage of the tax benefits granted under the respective DTA.

An example of treaty shopping will be to create an intermediate holding company in a middle country which has more favourable DTA provisions, such as lower withholding tax on dividends, interests, royalties, etc, flowing through the middle country back to Malaysia without any further withholding taxes. The intermediate holding company may be a nameplate company or may not have any business presence in the middle country.

In response to this abuse of DTA, the Group of 20 countries came together and developed rules to avoid such non-double taxation. The outcome of this initiative was the issuance of the Base Erosion Profit Shifting recommendations. One of the important recommendations was introducing anti-avoidance provisions into DTA. This will be done through widening the intention of the parties to the DTA to state clearly that the DTA entered into will not create opportunities for non-taxation or reduced taxation through tax evasion or avoidance including treaty shopping arrangement aimed at obtaining reliefs for the indirect benefit of residents of third countries.

What is happening in Malaysia

Malaysia has about 75 DTA and it is extremely time consuming to negotiate with each country to amend the respective agreements. Consequently, to avoid delay in introducing changes, more than 100 countries have agreed to one single document called the Multilateral Instrument to automatically introduce this intention and related provisions into the respective treaties “in one go”.

Malaysia is one of the signatories and agreed to implement this from June 2021. In addition to incorporating the intention into the DTA, Malaysia has also accepted a specific anti-avoidance provision into the agreements. This is called a “principal purpose test” (PPT). Effectively, if obtaining the benefit under the DTA was one of the principal purposes of the arrangement of transactions that resulted directly or indirectly in obtaining the benefit, the Inland Revenue Board can deny the benefit under the DTA.

Even if the transaction has supporting commercial reasons, the tax benefit under the DTA can still be denied if one of the principal purposes in entering into the transaction was to obtain a tax benefit under the DTA.

What needs to be done?

The application of this rule will be prospective for structures introduced after 2021. However, for structures entered into prior to 2021 which is now generating income post-2021 can be challenged by the tax authorities on the basis that these structures will fail to meet the PPT because one of the main reasons for entering into the transaction prior to 2021 was to obtain a tax benefit under the DTA.

If you have such structures, you need to revisit the arrangements so that you can pass the PPT, otherwise, you will be sitting with an exposure from 2021 to date. The consequence of failure to meet the PPT would result in reallocating the income back to Malaysia and disregarding the intermediate entity.

To overcome this problem, it is important for the intermediate company in the middle country to show that there is economic substance in the middle country (i.e. economic activity, presence and perhaps assets) connected to the profit generating activities in the middle country.

This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).

This article was originally published on the Sun daily.

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