Court Of Appeal Allows Taxpayer’s Appeal And Rejects Apportionment Of Interest Deduction Under Section 33(1) Of The ITA

Recently, the Court of Appeal in S REIT Holdings Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri held that apportionment of interest expenses is not permissible under Section 33(1) of the Income Tax Act 1967 (ITA) and allowed a full deduction of the interest expenses incurred by the taxpayer.

The taxpayer in this case was represented by our Tax, SST & Customs partner, S. Saravana Kumar together with associate, Lim Chinn Wei.

Background Facts

Following a group restructuring exercise, the taxpayer acquired units in S Real Estate Investment Trust (S REIT) from S Berhad pursuant to a sale and purchase agreement. The acquisition was financed through a combination of external and related-party borrowings.

As an investment holding company, the taxpayer’s sole source of income was the distribution received from S REIT. For the relevant year of assessment, the taxpayer received a distribution comprising both taxable income and what was described as a return of capital. The details of the distributions are as follows:

Distributions	Amount (RM)
Distributions of Income	24,468,528.00
Distributions of return of capital	8,781,044.00
Total (RM)	33,249,572.00

Relying on the tax vouchers issued by S REIT, the taxpayer subjected only the distributions of income amounting to RM24,468,528.00 to income tax. The distributions for the return of capital amounting to RM8,781,044.00 were not subjected to income tax as they were return of capital.

Subsequently, the taxpayer claimed a deduction of RM18,316,912.00 in interest expense incurred in acquiring the REIT units.

However, the Revenue took the position that the interest expense ought to be apportioned between the taxable and non-taxable portions of the distribution, in line with the formula for apportionment stated in paragraph 6 of the Public Ruling No. 2/2011. The Revenue’s computation was as follows:

(a) Apportionment to the taxable distribution:

RM24,468,528 x RM18,316,912 = RM13,479,509.00 (deductible)

RM33,249,572

(b) Apportionment to the non-taxable distributions and tax-exempt distributions:

RM8,781,044 x RM18,316,912 = RM4,837,403.00 (not deductible)

RM33,249,572

On the other hand, the taxpayer contended that the Revenue’s computation was incorrect and instead, should be computed in the following manner:

(a) Apportionment to the taxable distribution:

RM24,468,528 x RM18,316,912 = RM18,188,537.00 (deductible)

RM24,641,226

(b) Apportionment to the non-taxable distributions and tax-exempt distributions:

RM172,698 x RM18,316,912 = RM128,375.00 (restricted)

RM24,641,226

Despite disagreeing with the Revenue’s position, the taxpayer took a prudent approach by filing its tax return on a without prejudice basis, in accordance with the Revenue’s position, by apportioning the interest expenditure incurred between the taxable distributions, non-taxable distributions and the tax-exempt distributions received from S REIT.

Subsequently, the Taxpayer filed an appeal to the Special Commissioners of Income Tax (SCIT). The SCIT ruled in favour of the Revenue, finding that the distribution labelled as a return of capital constituted taxable income in the hands of the taxpayer.

Dissatisfied with this outcome, the taxpayer appealed to the High Court by way of case stated but the appeal was subsequently dismissed for the following reasons:

(a) The taxpayer failed to prove any capital contribution or injection into S REIT to justify a genuine return of capital;

(b) The term “return of capital” used by the taxpayer was merely a label and did not reflect the true nature of the payment;

(c) The distribution received and labelled as a “return of capital” was in substance income in the hands of the taxpayer and therefore taxable;

(d) Under Section 61A of the ITA, once a REIT distributes more than 90% of its income, it is exempt from tax—but such exemption applies to the REIT, not the unit holder;

(e) The taxpayer remained the holder of the REIT units, with no indication that any capital was returned or realised; and

(f) Therefore, the entire distribution received was treated as gross income, and interest expense had to be apportioned between taxable and allegedly non-taxable components.

Dissatisfied with the High Court’s decision, the taxpayer appealed to the Court of Appeal.

The Taxpayer’s Argument At The Court of Appeal

The taxpayer submitted that:

(a) Public rulings are merely guides that set out the Revenue’s view or interpretation of a particular taxing provision and are not binding on the Courts. (see Multi-Purpose Holdings Berhad v Ketua Pengarah Hasil Dalam Negeri [2006] 1 CLJ 1121 and Ketua Pengarah Hasil Dalam Negeri v NV Alliance Sdn Bhd [2011] 10 CLJ 345)

(b) Section 33(1)(a) of the ITA does not provide any room for apportionment. As the interest expense was wholly and exclusively incurred in the production of taxable income, it should be fully deductible under Section 33(1)(a) of the ITA.

(c) The law in respect of interpreting taxing statutes strictly has been settled, whereby even if there is doubt, a provision in a taxing statute must be read strictly and to be applied against the Revenue and not in its favour.

(d) Even if the Revenue had a basis to impose a restriction on the interest deduction, it ought to have invoked Section 33(2) of the ITA to do so, as this provision restricts the deductibility of interest expense where part of the borrowing has been used to fund an investment that generates income from a different source.

(e) In the present appeal, the entire borrowing was used to fund the acquisition of an investment in S REIT and hence, the taxpayer’s taxable and non-taxable income were derived from the same source.

(f) The Revenue had ignored the clear provision of Section 61(1A) of the ITA, which sets out the method for ascertaining a unit holder’s total income. Section 61(1A) of the ITA is clear- the total income of the unit holder shall mirror the total income of the unit trust.

(g) Since the capital allowances and industrial building allowances claimed by S REIT do not form part of the total income of S REIT, the non-taxable distribution resulting from the capital allowances and industrial building allowances claimed by S REIT should also not form part of the taxpayer’s income.

(h) Having stated the above, the non-taxable distribution amounting to RM8,608,346.00 should not form part of the total income nor the chargeable income of the taxpayer.

The Revenue’s Argument At The Court of Appeal:

The Revenue argued that:

(a) By virtue of Section 61A of the ITA, when a REIT or Property Trust Fund distributes more than 90% of its total income to its unit holders, the REIT or Property Trust Fund company is exempt from tax in respect of its total income.

(b) When S REIT claimed industrial building allowance and capital allowance, the amounts became part of its income, which was subsequently distributed to its unit holder, i.e., the taxpayer. Accordingly, the distribution constituted income and not a return of capital.

(c) There was no evidence to show that there is a realisation of capital between S REIT and the taxpayer i.e. withdrawal/ selling off of the assets by REIT to the taxpayer.

(d) There was no evidence to show any relationship between the Appellant’s investments and any capital injection or contribution by the Appellant to S REIT in respect of the qualifying assets—namely, plant and machinery and industrial buildings—owned and used for the purposes of S REIT’s real property letting business.

(e) The taxpayer has also failed to establish the existence of any contractual obligation between the taxpayer and S REIT for the taxpayer to receive a distribution constituting a return of capital.

The Court of Appeal’s Ruling

The Court of Appeal unanimously reversed the decisions of the High Court and the SCIT and held the following:

(a) At the outset, the Court of Appeal agreed with the lower courts that the entire distribution—including the portion labelled as a return of capital—constituted taxable income, as there was no nexus between the taxpayer and the industrial building allowance claimed and enjoyed by S REIT.

(b) However, the Court disagreed with the Revenue’s apportionment of the interest expense and held that Section 33(1) of the ITA does not provide for such apportionment. The Court affirmed that interest expense incurred in the production of gross income from a single source is fully deductible, unless specifically disallowed under Section 39 of the ITA.

(c) Furthermore, the Court held that Public Ruling No. 2/2011 was inapplicable and ultra vires, as it sought to impose a limitation not provided for in the statute:

“[33] We have carefully read s. 33(1) and s. 39 ITA and do not find that apportionment of expenditure is statutorily provided therein. Public Ruling No. 2/2011 is thus ultra vires and inapplicable here. In the premises, the computation of the deductible interest expenditure done by the Respondent based on the apportionment of the Appellant’s income and return of capital (but which has been found to be also taxable income) that has been affirmed by the SCIT as well as the learned Judge is flawed.

…

[35] In our view, the learned judge in having endorsed the Respondent’swrongful apportionment on the deductibility of interest expenditure here is hence a misdirection that warrants appellate intervention.”

(d) As the taxpayer had only one source of income (S REIT distributions), the entire interest expense was deemed wholly and exclusively incurred in the production of income and thus fully deductible

Conclusion

The Court of Appeal’s decision provides clear guidance that Section 33(1) of the ITA does not permit any apportionment of interest expenses, and as such, the Revenue’s attempt to impose such a requirement through a public ruling is ultra vires.

The Court also reaffirmed that where the law does not expressly provide for a limitation or condition, the Revenue cannot rely on administrative guidelines i.e. Public Ruling to introduce new obligations or restrict taxpayers’ statutory rights.

11 April 2025