On the 5th October 2017, the Ministry of Finance enacted, through Legal Notice 262 of 2017, the long awaited Notional Interest Deduction Rules. For decades we have argued that from a tax perspective debt is more efficient than equity when financing a corporate vehicle, since our tax legislation allows a deduction for interest incurred on finance used to generate income. On the other hand dividend payments are considered to be a distribution of profits rather than an expense incurred in the production income, thereby resulting in no tax deduction being afforded by the Income Tax Act.
The Notional Interest Deduction Rules attempt to address this inconsistency by allowing a deduction for “interest on risk capital”. For the purpose of the Rules, risk capital includes share or partnership capital of a company or partnership, any share premium, positive retained earnings, loans or other debt borrowed by the undertaking which do not bear interest (typically including shareholders loans), and any other reserves resulting from a contribution to the company or partnership. An equivalent deduction is permitted to a Maltese permanent establishment of a foreign undertaking (based on the capital attributable to the Maltese PE).
The substantive provisions of the Rules provide that in computing the chargeable income of a company or partnership, such undertaking may opt to take a deduction for interest on risk capital, at a rate established by reference to the current yield to maturity on Malta Government Stocks with a remaining term of approximately 20 years plus a premium of 5%. Such deduction is capped at a maximum of 90% of the chargeable income (before grossing up for FRFTC) with the excess being carried forward to be deducted in subsequent years. The deduction is claimed through the tax return and requires that on an annual basis, all shareholders or owners of the undertaking approve the claiming of such deduction.
Whenever a company or partnership claims the notional interest deduction, each shareholder or partner as applicable, is deemed to have received his proportional share (of the risk capital, that is equity, reserves, share premium, shareholders’ loan, etc) appertaining to him. For all intents and purposes, the receipt is classified as interest income for income tax purposes. However the Rules specifically preclude the application of the Investment Income Provisions (15% final tax option) on such interest income. On the other hand the classification of such income as interest income imply that receipt of income is exempt from tax in terms of Article 12 (1) (c) (i) when paid to a non-resident (except in the case of a permanent establishment). Since the deduction is classified as interest for all intents and purposes, the interest deduction limitation in Article 26 (1) (h) ITA will still disallow such deduction:
- when the risk capital is used to finance the acquisition of immovable property in Malta; and
- the shareholder or partner is a non-resident who has a relationship of more than 10% with the undertaking.
Finally, whenever a company takes the optional notional interest deduction, the company is required to allocate to the FTA 110% of the deduction availed of, up to a maximum of the profits allocated to the other taxed accounts, with any excess being ignored. The application of this rule is explained in the example below assuming the shareholders of the company are registered for tax refunds.
The Notional Interest Deduction Rules provide new opportunities. Our specialized tax team can assist you with reviewing your corporate capital composition so as to establish what benefits your company can reap from the Notional Interest Deduction.