Background
The taxpayers, NYK and NYH, directors and shareholders of a family holding company, NHA & Sons Private Limited ('the Company'), received interest-free loans from the Company over a period of time. NYK and NYH used the loans for various personal purposes. There were neither loan agreements nor directors' resolutions approving these loans. Though the loans did not have any terms of repayment, NYK did make some repayments as and when his cash flow allowed.

The Comptroller of Income Tax ('CIT') assessed the taxpayers from years of assessment 1993 to 1997 on the deemed interest on these loans on the grounds that the loans granted by the Company were 'perquisites' in respect of the gains from employment as directors of the Company.

Issues
Whether the taxpayers, being directors, were employees of the Company.

Whether the interest-free loans were 'perquisites' in respect of the gains from employment as directors of the Company.

Whether the rates used by the CIT, (i.e. the lowest prime lending rate a bank would grant to its most creditworthy customers) in computing the deemed interest, was unreasonable.

Arguments by the taxpayers
The taxpayers argued that: They, being directors of the Company, were not employees of the Company because there were no employment contracts and they did not receive any remuneration for their services. The interest-free loans were not derived from employment. The interest-free loans were not gains from employment, but were advances on capital to shareholders.

Arguments by the CIT
The CIT argued that: The taxpayers, being directors were deemed employees under the Income Tax Act ('ITA'). The interest-free loans were not advances on capital. The interest-free loans were 'perquisites' granted in respect of employment. The benefit of interest-free loans was taxable to the directors. The interest rate used in computing the taxable benefits was not unreasonable.

Decision
The Board held for the CIT and dismissed the appeal of the taxpayers.

Our comments
Under the ITA, interest-free loans to employees are 'perquisites' granted in respect of employment, that is taxable to the employees including company directors. However, as an administrative concession, the CIT decided not to impose tax on interest-free loans granted to employees who do not have substantial shareholdings or who do not have control or influence over the employer company.

Companies that grant interest-free loans to directors are required to compute the deemed interest benefits and report the amount of taxable benefits in the director's Form IR8A. If the benefits were discovered not reported, the CIT would raise assessments on them and impose penalties if applicable.

Various alternative ways to mitigate the tax impact are:

If cash flow allows, the interest-free loans to directors are to be repaid.

If there are retained earnings and section 44 balance, dividend can be declared to the director-shareholder to pay off the interest-free loans. The directors, however, need to consider their personal tax on the dividend income.

If the loans remain outstanding, the company may need to convert the terms of the loans to interest bearing and to charge interest based on the reasonable interest rate as held in the above case.

If the loans remain outstanding and interest-free, the directors' Form IR 8A should reflect the deemed interest benefits and the directors would pay tax on the item accordingly.

Year published : 2002