Tax Matters – Waiving debts could give rise to tax bills

IN THE course of running a business, it is common for companies to incur debts to be settled at a later date. This could arise either through credit transactions where goods and services are supplied and settled later, or through receiving financial assistance such as loans or advances for working or permanent capital purposes.

Third parties usually do not waive or forgive such debts except under special circumstances, for example, when there is a restructuring of debt, or the debtor is in financial difficulties. However, this situation is more common between related parties where one party has control or influence over the other party. The reason being the owners of the group of related companies take the position that it is all “within the family”.

Debtor’s tax treatment

The Income Tax Act has a specific provision dealing with the waiver of debts. The principle behind this treatment is that if the debtor has benefitted from a tax deduction from the debt, any debt waiver by the creditor will result in the claw back of any benefits enjoyed earlier by the debtor which will bring the debtor into a tax neutral position so that the Inland Revenue Board (IRB) does not lose out.

For example, if the debt arises from a trading transaction where the debtor has claimed a tax deduction previously (i.e. purchase of stock in trade), the subsequent waiver of the debt by the creditor is taxable income for the debtor.

Similarly, if the debt arises from the purchase of an asset which qualifies for capital allowance or tax depreciation which has been claimed by the debtor, the subsequent waiver of such debts will be taxable at the hands of the debtor.

How are creditors impacted?

For a creditor who is waiving the debt, there is a separate provision under the Income Tax Act to determine whether such a waiver is deductible. To claim a tax deduction, the creditor needs to prove that the debt is wholly or partially irrecoverable and that it has taken reasonable steps to recover the debt.

In many instances, the related party credits are usually unable to prove that the debt is truly irrecoverable since the normal steps of attempting to collect and pursuing the legal action is non-existent. Hence, there could be a mismatch where the debtor is taxed, and the creditor is unable to get a tax deduction.

Waivers no longer straightforward

The general consensus is that as long as the debtor has not claimed any tax deduction on the debt, the waiver by the creditor will not be taxable income for the debtor (i.e. this is not a revenue or trading transaction). However, a recent case law development has thrown “the spanner into the works” to the above principle.

In the case of Multi-Purpose Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri on Jan 23 Jan 2024, the High Court did not rely on the abovementioned provision under the Income Tax Act and instead held that the debts of the taxpayer arising from loans and advances (where no tax deduction was claimed) which were subsequently waived by its related parties constituted a gain and subject to income tax as business income. There is another case where a waiver of debt was treated as income in the hands of the debtor (FT Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri in 2014).

These rulings mean that you cannot take for granted that a debt waiver that does not meet the above conditions will not give rise to a taxable outcome. Now there is a possibility that it could be taxed. Taxpayers need to navigate this minefield carefully by distinguishing your circumstances versus the facts and the legal support surrounding the above cases.

IRB can revisit past years

Taxpayers must be prepared for IRB to open tax audits for the past five years and challenge debtors who have enjoyed such tax-free waivers. It is timely for such taxpayers to thoroughly review their past positions on this matter.

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