Connected persons - Defining the relationships in GST

November 2016

by Geeta Balakrishnan

Are we making the right connections?
The intrinsic ambiguity in the connected persons tests

Commonly, the terms “related parties”, “associated persons” or “connected persons” refer to anti-avoidance-type provisions which stipulate that taxpayers must transact at market value on normal commercial terms in a timely manner[1]. The provisions are designed to ensure that the tax authorities are not denied GST revenue in what maybe a potentially less than arm’s length transaction. The presumption is that the motivation in a related party/connected person transaction goes beyond a simple desire for profit.

As such transactions are subject to scrutiny, due consideration needs to be given to the way a buyer and seller organise their commercial relations. The key is to assess the existence of a relationship and in case related, to demonstrate that the terms of transaction are in fact commercial. The latter can generally be done by observing the valuation rules under Paragraph 1, Third Schedule to the GST Act 2014. The former, however, requires detailed analysis based on the 7 connected persons test set out in Paragraph 2 of the Third Schedule to the GST Act 2014.

Incorrectly establishing a “connection” creates at the minimum a cash flow inconvenience and at the worst, it adds to a business’ cost of operations. In failing to appropriately diagnose a “connection”, a business may end up underpaying taxes and opening itself to potential penalties (e.g. late payment, incorrect returns, etc.). On the flip side, a business may find itself overpaying taxes as a result of inaccurately determining that a connection exists.

So how well have you dotted your “i”s or crossed your “t”s?

The concept of “connected persons” is not new in the GST rules. It is there in the current income tax laws, transfer pricing rules and it was provided for in the Sales and Service Tax Acts. So, if a connection had been determined under one of these regimes, that connection should generally follow through to GST right? In theory, perhaps, but when was the last time you studied the connected persons tests in the GST law?

The GST “connected persons” tests is taken largely from the definition of “related parties” under the World Trade Organisation Customs Valuations Agreement.

In its current shape and form, there appears to be a lack of uniformity between the rules employed for GST compared to the other tax regimes, such as the Income Tax Act or even the Service Tax Act. The peculiarity of the wholesale adoption of the RMCD related party tests into the local GST law stands out even more when we look at corresponding tests in the neighbouring GST regimes such as in Singapore.

To illustrate, let’s look at this particular test from the Singapore law:

(5)  A company is connected with another company —

(a) if the same person has control of both, or a person has control of one and persons connected with him, or he and persons connected with him, have control of the other; or

There is no argument here that the 2 persons this test seeks to connect are “companies”. Now let’s look at a provision from the Malaysian law which we understand is intended to establish the same connection – i.e. a company with another company:

“A person shall be deemed to be connected if they are officers or directors of one another’s business.”

 <Para 2(1), 3rd Schedule, GST Act 2014>

To decipher the test we looked at the ordinary meanings of the following:

(a)  “officers of a business” - officers are generally employed by the board of a company to set the direction of the company and run it to basically generate profits for the shareholders e.g. CEOs or president (implying that officers or directors are normally individuals); and

(b)  “one another” -  or “each other” generally refers to 2 parties who are doing something together or in relationship to the other.

Contextualise the above and the result is:

“A person [A] shall be deemed to be connected [to a person, B] if they [A and B] are officers or directors [implying A and B are individuals] of one another’s business [in each other’s (note: possessive) companies].”

We illustrate the concept as below:

Does this mean that A and B own companies in their own right and have appointed each other to hold office in each other’s companies. And by virtue of this appointment A and B are connected to each other?

What would be the purpose of establishing a connection between A and B? Other than in limited circumstances what supplies would A the individual possibly make to B the individual or vice versa?

If you recall in 7th issue of Pulse the tax authorities took the view that the “persons” connected through above test were in fact the companies and not individuals. Thus, the test should establish that 2 companies are connected if they had common officers/directors.

In practice, this would be the more compelling interpretation of the above test: When 2 companies are governed by the same party, there is a greater impetus for “less than arm’s length” dealings. Consider something as simple as one company providing the other with temporary man power for no additional costs – an unlikely scenario in a commercial setting, given that there is no such thing as a free lunch.

RMCD’s interpretation, does not, however, appear to be a result of a literal reading of the law. A key shortcoming of the current law is the absence of the qualification of “persons”. If we look at the Service Tax Act, it makes specific reference to companies with respect to related party transactions. Similar parameters exist in the Income Tax Act as well.

To achieve the “reasonable” interpretation (if it was so intended) a remodelling of the law is necessary. However, until such time businesses need to be particularly careful with their application of these rules.

A misstep in this regard may result in RMCD:

  • Withholding GST refund claims;
  • Varying or disregarding arrangements and raising assessments for taxes (as they deem fit) to counteract any tax advantage[1] garnered from the arrangement;
  • Instituting penalties on one or both parties on charges which may range from the furnishing of incorrect returns to the evasion of tax; and/or
  • Holding the officers in the related parties accountable for the taxes/penalties/monies deemed as due and payable to RMCD.

If you would like to discuss the issues set out in this article in more details, please do not hesitate to contact us.

 

Geeta Balakrishnan is a Senior Consultant of the Indirect Tax Advisory Group at PwC Malaysia.

 

Notes:

[1] An exception to this (in the local GST law) is where the recipient of a related party supply is registered for GST and is entitled to recover 100% of the input tax incurred on that transaction. In this scenario, any amount of GST which is charged, collected and remitted to the tax authorities as output tax will be claimed as an input tax credit. As there is no leakage of revenue to the tax authorities, there is less scrutiny over the terms of the transaction.

[2] Section 44(4) of GST Act 2014 – Tax advantage includes any reduction in the total consideration payable by any person in respect of any supply of goods or services and any postponement of the time when tax is due and payable.

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