NEW INCOME-TAX EXECUTIVE REGULATIONS
Restriction on Deduction of Interest Expense on Loans from Related Parties
The Executive Regulations issued by The Ministry of Finance is a welcome step, especially where interest expense deduction on loans from related parties is concerned. This has now diminished the ambiguity and doubt in its determination, whereas in the past much was left to the judgment and discretionary powers of the Tax Department. The following rules apply in determining the interest expense which can be deducted in determining the taxable income for any tax year in cases where the taxpayer is related to the lender.
Following conditions must be fulfilled:
- The proprietor or any other person controlled by the proprietor should have given loans to the proprietorship.
- The lender should have obtained loans from banks registered in Oman.
- The proprietorship should have utilized the loans for the sole purpose of carrying on its activities and not to finance or raise its capital.
- The proprietorship should have expensed such interest costs.
Omani company (other than banks and insurance companies):
The rules and methodology for deduction are as under:
|Interest on loans due to related parties including members|
|A||Average owners’ equity (i.e. average of paid-up capital + share premium + legal reserve + retained profit + general reserve) at the beginning and end of the accounting period;|
|B||Average of all unpaid balances of loans and borrowings (excluding interest free loans) at the beginning and end of the accounting period;|
|C||Total interest charged in the accounts, on an arms’ length basis;|
|D=||2 times average equity (A) x Total interest charged (C)_____
Average of all unpaid balances of loans and borrowings (B) (excluding interest free loans)
|E||Interest paid to unrelated parties|
|F||Interest expense allowable as a deduction on loans from related parties = X – E|
|G||IF X > C, then whole of C will be allowed.|
|For example, if|
|Average owners’ equity is OMR 750,000;|
|Average of bank loans and bank borrowings is OMR 1 Million;|
|Average loans from related parties (including 0.5 million interest free loans) is OMR 1.5 Million;|
|Total interest charged by related parties is OMR 32,500;|
|Bank interest during the year is OMR 77,500;|
|Total interest charged in financial statements is OMR 110,000 (i.e. OMR 32,500 + OMR 77,500); then|
|2 times average owners’ equity x Total interest charged|
|(Average bank borrowings + Average loan from related parties – Average interest free loan from related parties)|
_2 x OMR 750,000 x (OMR 32,500 + OMR 77,500)_
(OMR 1 Million + OMR 1.5 Million – OMR 0.5 Million)
|X=||OMR 1,500,000 x OMR 110,000
|X – E = F|
|OMR 82,500 – OMR 77,500||=||OMR 5,000 (allowable interest on loans from related parties)|
|Thus, out of total interest charged by related parties of OMR 32,500 only OMR 5,000 will be allowed as a deductible expense in the annual return of income.|
Any other permanent establishment (other than banks):
The following condition must be fulfilled:
The head office should have taken the loan from a third party (which is not related to the head office), for the benefit of the permanent establishment in the Sultanate of Oman and the same should have been utilized to finance the expenses necessary for the permanent establishment to carry on its activities.
Whilst the Regulation has brought a lot of clarity towards the deduction of interest expense, since the calculation of the allowable amount is based on opening and year-end balances of owner’s equity, related parties’ loans and borrowings, the provision may be misused, as funds could be withdrawn by the related parties just before the year end and again introduced after the year end to increase the allowability of interest paid to related parties. In such cases, the Tax Department is likely to use its discretionary powers and set aside such year-end funds transfers so as to arrive at the proper amount of deductible interest. On the other hand, if funds have been brought in by the related parties just before the year-end and again withdrawn after the year-end, this would decrease the allowability of interest paid to related parties causing hardship to the tax payer.
(This article is compiled by Mr. Ian Pereira, a Director in PKF L.L.C., Muscat, the PKF member firm in the Sultanate of Oman.)