On 21 August 2018, the General Department of Taxation (“GDT”) issued Instruction 11946 to clarify its position with respect to the applicability of Prakas 9986 (the transfer pricing (“TP”) regulations) to interest-free loans between related parties. Since 2014, Instruction 151 had permitted loans from related parties to be interest-free, if the loan agreement was registered with the GDT. Clearly, this was inconsistent with the new TP regulations, which require that all transactions be at “arm’s length” values.
Instruction 11946 states that all loan transactions between related parties must bear interest, the rate of which must be determined in accordance with the arm’s length principle, as stated in the TP regulations. Instruction 11946 also states that loan agreements between related parties bearing interest at market rates do not now need to be registered with the GDT.
While this Instruction may be consistent with TP principles, many within the business community have pointed out that the reason Instruction 151 was issued in the first place was to facilitate the ability of investors to provide low-cost funding to their Cambodian subsidiaries to enable them to survive the difficult early years of business, or to promote expansion, and that such funding is in the nature of capital rather than a commercial loan. In addition, there is confusion about how an appropriate arm’s length interest rate should be set, given that funding is coming from outside Cambodia.
VDB Loi very recently had the opportunity to meet with senior members of the GDT’s Transfer Pricing team to discuss the complexities of this subject, and we are pleased to highlight below some important clarifications we obtained, as well as some areas that are still under discussion.
How to determine an appropriate rate of interest?
The GDT reconfirmed that the terms and conditions of loans between related parties must now conform with arm’s length principles, and carry an appropriate rate of interest. In other words, when taxpayers lend to or borrow money from related parties, pricing must now be determined based on the rate of interest that would have been charged between independent parties under similar circumstances. The arm’s length principle should be applied on a transaction-by-transaction basis, which suggests that each transaction should be analyzed on a stand-alone basis. Loan agreements between related parties do not now need to be registered with the GDT, although the terms and conditions of such loans, including the interest rate charged, must be described and justified in the TP documentation.
The TP regulations (which are in line with OECD TP guidelines) require the following process to determine an arm’s length interest rate:
Step 1. Conduct a comparability analysis
The taxpayer must consider the relevant facts and circumstances relating to the loan, such as the credit rating of the borrower, the nature and purpose of the loan, the security offered by the borrower, market conditions at the time the loan is granted, etc. This is to assess the extent of similarities and differences between controlled (i.e. related party) and uncontrolled (i.e. unrelated party) transactions. If the loan is made to a subsidiary company in Cambodia from a parent company in Singapore, clearly the lending rate offered by commercial banks in Cambodia should not be relevant.
Step 2: Identify the most appropriate TP method
The guidelines require that the taxpayer selects one of the five prescribed valuation methods to price intercompany loans. The Comparable Uncontrolled Price (“CUP”) method is generally the most suitable for loan transactions, although in some circumstances the Cost Plus method may be more appropriate.
Step 3: Determine the arm’s length results
If the CUP method is selected, data consisting of the details of transactions between independent parties is collected and reviewed to arrive at the arm’s length result. The base reference rate is normally a publicly available rate such as the Singapore Inter Bank Offered Rate (SIBOR), the London Inter Bank Offered Rate (LIBOR) or prime rates offered by banks.
What action should be taken with respect to existing related party loans?
Following the issuance of Instruction 11496, many taxpayers with existing related party loans have revisited the terms and conditions of such loans, to review whether they are in accordance with the arm’s length principle, and many previously interest-free loans have been converted to interest-bearing loans. Existing interest-bearing loans must also be reviewed. An excessively high interest rate may result in partial non-deductibility of the interest expense, and an excessively low interest may result in additional withholding taxes being assessed.
In an earlier Client Alert we noted that an advance approval mechanism or advance pricing arrangement, under which taxpayers could obtain advance approval of the value of their related party transactions from the GDT, thereby reducing the risks of challenge and adjustment in subsequent tax audits, had not been established. In our most recent discussions, the GDT indicated that it might be open to some form of advance approval process.
Is there a threshold for related party transactions that do not require TP documentation to be prepared?
The GDT has acknowledged that the current TP regulations do not set a threshold for related party transactions under which a full TP report is not required. The GDT officers recognize that it would be very costly for taxpayers with only a small number of related party transactions to engage a consultant to prepare a TP report meeting the requirements of the regulations. Accordingly, the GDT has advised that it is now in the process of developing a simplified TP report template for taxpayers with a small (as yet undefined) number of related party transactions.
First-year implementation of TP regulations?
The GDT has reconfirmed that TP documentation does not need to be filed with the annual tax return, but must be readily available at the time the return is filed. The GDT has also reconfirmed that taxpayers with a tax year running from 1 January 2018 to 31 December 2018, must have their TP documentation readily available upon filing their 2018 annual income tax return by the deadline of 31 March 2019. Instruction 11496 is not explicit as to when arm’s length interest charges should commence, whether from the beginning of the 2018 financial year (the first year for which TP documentation is required), or from the date of the Instruction. A conservative approach would be to charge interest from the beginning of 2018, however we will continue to seek clarity from the GDT on this issue.
Could interest-free loans still be allowed?
Interest-free loans from investors has helped to create a favorable investment climate by allowing funds to be injected into a Cambodian subsidiary company without locking such funds in as share capital. It is far easier to repay loans when cash becomes available than to reduce paid-in share capital when such capital is no longer required, which involves going through a lengthy Ministry of Commerce approval process.
If the position taken by Instruction 11946 is maintained, this would appear to weaken the Cambodian investment climate. In addition if investors are required to charge interest on loans to their Cambodian subsidiaries there will actually be a net loss to the State, as such interest will be deductible for income tax purposes at 20%, but only 14% (or less if Double Taxation Agreement relief is available) will be collected as withholding tax.
The GDT has indicated that it may still accept interest-free related party loans, if there are valid commercial reasons. Such reasons may include financial distress, or a lack of ability to borrow commercially, but the GDT’s position on this does not appear to be fully developed as yet.
We will continue to pursue a dialogue with the GDT on these and other issues relating to the implementation of the new TP regulations. In the meantime, readers are invited to contact the undersigned, or their usual VDB Loi adviser to discuss these matters and what needs to be done now to react to these developments.
VDB Loi is a network of leading law and tax advisory firms with offices in Cambodia, Indonesia, Laos, Myanmar and Vietnam. We provide the highest quality solutions for transactions and taxation. Our general areas of practice are corporate, finance, licensing and disputes. Our principal specialized areas of practice are energy, infrastructure, real estate and construction, telecom, and taxation.
You can find more information on our Cambodia office here.
Robert Porter | DirectorM:
+855 10 333 509
+855 23 964 430~434
+855 23 964 154
No. 33, Street 294 (corner of Street 29)
Sangkat Tonle Bassac, Khan Chamkarmorn
Phnom Penh 12301
This e-mail is confidential and may also be privileged. If you are not the intended recipient, please notify the sender immediately,
delete it from your system and do not copy, disseminate, distribute or disclose any information contained therein. Thank you.