Last 22 January 2014, the General Department of Taxation (“GDT”) issued Circular 151: “On the Determination of Interest Expense of Enterprises.” This circular supersedes Circular 1707, issued last October 2013, which laid down the rules on the recognition of debt and interest.
Circular 151 retains many of the general rules laid down by Circular 1707, but adopts two very significant changes:
- The rules for setting the interest rate benchmark, which limits the deductibility of loans, were revised.
- The GDT now needs to be notified of the existence of loans in order for these loans to be recognized as such and not be deemed as subsidies.
A Refresher: Circular 1707
It may be recalled that Circular 1707’s most important elements were:
- The explicit recognition that parties to loan agreements may set lower than market or even zero interest rates on their loans without the risk of being subjected to deemed interest expense (which would lead to withholding tax obligations for the borrower) or of the loan being deemed to be a subsidy if these parties follow certain documentary and administrative rules:
- The loan agreement must be certified by lawyers of both the lender and the borrower;
- The borrower must reflect the loan in its books; and
- The borrower must keep a record of its receipt of the loan amounts;
- The imposition of a limitation on interest deduction in addition to the annual interest deduction limits set in Law on Taxation: a Cambodian taxpayer may only deduct interest that accrue on a loan up to a deemed market interest rate: the benchmark rates of (i) 6% + LIBOR for loans with foreign lenders, and (ii) the average interest rate of the National Bank of Cambodia for loans with local lenders were adopted; and
- The specific adoption of the rule that loans which fail to follow Circular 1707’s documentary and administrative rules will be considered as subsidies and subjected to the 20% Tax on Profits.
New Rules on Interest Rates
Circular 151 still allows borrowers and lenders to set lower than market or zero interest rates on their loans without the risk of being subjected to deemed interest expense or of the loan being deemed a subsidy.
Like Circular 1707, Circular 151 limits the interest deduction of Cambodian taxpayers to a specific deemed market rate. However, it does away with the old benchmark rates and replaces them with a new procedure for setting the deemed market interest rates.
The GDT will publish each year the new deemed market rate, which will be based on the average rate adopted by at least five (5) Cambodian banks (the “New Benchmark Rate”). The interest rate deduction limit of borrowers will be based on this new benchmark:
- Taxpayers who borrowed money from non-related persons may deduct interest expenses up to 120% of the New Benchmark Rate applicable at the time of the borrowing.
- Taxpayers who borrowed money from related persons may deduct interest expenses up to 100% of the New Benchmark Rate applicable at the time of the borrowing.
These interest deduction limits are applied for each loan, and is in addition to the annual deduction limit under Article 12 of the Law on Taxation and Section 5.9 of Prakas on Tax on Profit, which caps the annual interest deduction to the sum of 50% of the taxpayer’s non-interest income and 100% of its interest income for the applicable tax year.
New Administrative Requirement: GDT Loan Notification
Circular 151 now requires borrowers to notify the GDT about the existence of loans not later than 30 days after the occurrence of the loan by submitting a notice to the GDT and attaching any contract, agreement or document specifically evidencing the borrowing. A taxpayer which fails to notify the GDT and which does not possess proper loan documentation risks having the loan principal deemed as income and subjected to the 20% Tax on Profit.
What should you do next?
Having a loan treated as income that gives rise to additional tax on profit is a very harsh punishment for what are essentially administrative lapses. It is therefore important for Cambodian taxpayers to set their house in order and make sure that their internal documentation, financial reporting and GDT notification processes are efficient. We strongly advise all our clients to create internal standard operating procedures on loans and inform each responsible employee or corporate officer about the administrative requirements connected with loan transactions. Such procedures should stress the importance of:
- Formally documenting each and every loan;
- Checking that the loans are properly booked in the balance sheet and the interest payments correctly reflected in the income statement and the appropriate ledgers;
- Keeping records of the drawdowns and disbursements; and
- Reporting the loans to the GDT.
Circular 151 does create some uncertainties for more complicated borrowing transactions. It is not clear, for example how it would apply to loan facilities where drawdowns are not scheduled but on an as-needed basis: Should the company report the loan to the GDT at the time the loan facility or at the time of the drawdown? It is also not clear what would constitute proper documentation of loans: Since Circular 151 explicitly supersedes Circular 1707, should loan agreements still be certified by lawyers?
We advise our clients to err on the side of caution. It is likely that the GDT will clarify the implementation of Circular 151 and the rules on the recognition of loans and interest (both the procedural and substantive rules) will continue to evolve. In the meantime, it is best if you cover all your bases because the risks certainly outweigh the additional administrative costs of compliance. Hence:
- If a loan agreement is entered into in advance of the drawdowns, we strongly advise that you notify the GDT within 30 days of the execution of the loan. Unless a future circular explicitly states that reporting should only be made upon execution of the document, we also advise you to update the GDT within 30 days of a drawdown under this agreement.
- We also recommend that loans be documented formally. While the circular seems to relax the documentary requirements by seeming to accept “any contract, agreement or document” as evidence of the existence of a loan, it is unwise to use informal and unsigned documents such as an email exchange between the lender and the borrower when notifying the GDT. A properly executed and signed loan agreement should always be used. With regard to the lawyer certification, we would recommend that loans still be certified until the GDT releases an explicit statement that it is dispensing with this requirement.