Effective January 1, 2022, the current income tax exemption on Foreign Source Income (FSI) received in Malaysia by Malaysian residents will be removed.
This article highlights the impact and practical considerations businesses and individuals should take into account in preparing for the impending ISP tax. The content of this article reflects publicly available legislation and FAQs as of December 20, 2021.
Overview of the existing ISP exemption
Currently, the FSI of any person received in Malaysia is exempt from income tax, with the exception of Malaysian resident companies engaged in banking, insurance or air or sea transport. This has not always been the case – the FSI tax exemption was first introduced in 1998 for resident companies to encourage taxpayers earning income overseas to repatriate their income to Malaysia ( except for the few industries mentioned above). In 2004, this exemption on the FSI was extended to all taxpayers, including individuals.
Imminent taxation of ISP in Malaysia
During the Budget 2022 announcement, the government proposed to remove the ISP tax exemption enjoyed by residents of Malaysia from 1 January 2022. This proposal is reflected in the Finance Bill 2021, which has been passed by the House of Representatives, but is still being read in the Senate and has yet to be published in the Official Gazette as law at the time of writing (Money Bill).
Under the Finance Bill, FSIs received in Malaysia between January 1, 2022 and June 30, 2022 by all tax residents, including individuals and companies, will be taxed at 3% on a gross basis. The tax rate on the FSI received after this period will be the tax rate in force for resident individuals and companies. The proposal as it stands covers all forms of income (e.g. business or employment income, dividends, interest, royalties) and will affect all Malaysian resident taxpayers, regardless of size or their sectors.
On November 16, 2021, the Inland Revenue Board of Malaysia announced in a press release that it would offer a special income remission program (Khas Peremitan Pendapatan program, also known as PKPP) for the period from January 1, 2022 to June 30 2022, during which ISPs received in Malaysia by taxpayers who declared their participation in the PKPP before July 30, 2022 will not be subject to audits, investigations or sanctions.
The Inland Revenue Board issued FAQs regarding the PKPP on December 17, 2021 (PKPP FAQs), which provide that taxpayers can declare their participation in the PKPP in an online form via MyTax.
Basis for Change in ISP Tax Treatment
According to the Budget Speech 2022, the reasons for the proposal to tax FSI received in Malaysia by Malaysian residents are to ensure sustainable revenue for Malaysia and to comply with international best tax practices.
For context, on October 5, 2021, the Council of the European Union included Malaysia in its “grey list” as a jurisdiction that has committed to amending its “harmful” ISP exemption regime by December 31, 2022. Other jurisdictions like Hong Kong, Costa Rica, Qatar and Uruguay have also been included in the gray list on the same basis.
Although the Malaysian government is expected to modify the existing tax regime to address EU concerns, many had not anticipated the general removal of the FSI exemption for Malaysian residents. This is all the more so as the EU has clarified in its guidance that ISP exemption schemes are not in themselves problematic and that the concern is with the ‘double non-taxation’ circumstances that may arise with respect to passive income from a company that has no substance in the country.
Hong Kong, which adopts a source-based tax regime similar to that of Malaysia, announced on the same day as the gray list was released that it would continue to adopt the territorial source principle of taxation despite its inclusion. in the gray list. However, to address EU concerns, it will change its legislation by the end of 2022 and the proposed legislative amendments will simply target companies (not individuals) that earn passive income, especially those that have no no substantial economic activity in Hong Kong.
Malaysia’s immediate neighbour, Singapore, which was not on the gray list, imposes ISF while maintaining certain exemptions for certain categories of income (e.g. foreign sourced dividends, branch profits or income from professional, consulting and other services) subject to satisfaction of specified conditions. Non-resident individuals in Singapore are generally exempt from tax on their ISP.
Indonesia recently introduced the Omnibus Law, one of the main amendments of which is the introduction of a tax exemption for dividends received by Indonesian tax residents from offshore companies, provided that the income is reinvested in Indonesia for a certain period and other qualifying investment requirements.
The jurisdictions mentioned above appear to be consciously adopting tax policies in a targeted manner to ensure that they remain attractive for investment, while balancing other considerations such as the need to maintain a healthy tax base on income and the defensibility of the tax system under international agreements. meticulous examination.
Similarly, in an era of globalization and increased international scrutiny of each jurisdiction’s tax regimes, the challenge for Malaysia would be to address international tax concerns with a focused and measured approach, in order to remain competitive on the global stage. as an attractive jurisdiction. for investments and business transactions.
Considerations for Malaysian Residents
The removal of the FSI exemption for Malaysian residents will mean that FSI such as dividends distributed by foreign companies, interest from foreign loans made outside Malaysia or from foreign bonds, rental income from immovable property located outside Malaysia, and even employment income earned by Malaysian tax residents outside Malaysia will be subject to Malaysian income tax when received in Malaysia on January 1, 2022 or after.
Below we summarize the key issues for Malaysian residents to consider when considering the implications of this new tax development.
- Definition of “received”
ISP which is not received in Malaysia will not be taxed. The Finance Bill and the Malaysian Income Tax (ITA) Act do not currently specify the definition of “receipt”. Accordingly, on the basis of the legislation alone, there is uncertainty as to whether certain transactions, such as counterparty transactions between related entities or the settlement of debts owed to a business in Malaysia, could potentially be considered received in Malaysia.
However, the Inland Revenue Board recently clarified in the PKPP FAQs that only income paid into, brought into or transferred to Malaysia (i) physically, or (ii) through the banking system, will be considered income” received” in Malaysia. Malaysia. In light of this, it appears that quid pro quo transactions are not covered, but the transfer of funds to Malaysia to a creditor in settlement of a debt could potentially be.
Since the meaning of “receipt” is crucial in determining whether tax is due under the FSI, this clarification is welcome.
- Distinction between income and capital
ISP tax will only affect a receipt that is “income” in nature. Capital gains remain outside the scope of income tax under the ITA, even if they are foreign-sourced and subsequently received in Malaysia. This has also been confirmed by the Inland Revenue Board in the PKPP FAQ.
Resident taxpayers will need to determine whether their receipt falls into the category of income or capital based on all of the circumstances and factors surrounding the receipt. Specific types of revenue such as dividends, royalties, and interest generally fall into the income category.
From a practical point of view, it will be difficult for taxpayers to prove the nature of a receipt to the satisfaction of the Inland Revenue Board, especially if the receipt in Malaysia is from funds that have been kept outside Malaysia. for a longer period.
Going forward, taxpayers will need to be more diligent in keeping records of their earnings (income and capital) and money transfers to and from Malaysia.
ISPs received in Malaysia may have already been taxed elsewhere. To remedy double taxation of the same income, the ITA provides relief in the form of (i) bilateral tax credits, where the relevant foreign country in which the tax was paid has entered into a double taxation (CDI) with Malaysia; or (ii) unilateral tax credits, where the relevant foreign country in which the tax was paid does not have a DTC with Malaysia.
Based on the PKPP FAQ, these credits must be claimed in respect of FSI received in Malaysia within two years of the end of the relevant assessment year in which the FSI is declared. Taxpayers are required to retain proof of foreign taxes that have been paid under the FSI.
In practice, it will be difficult for resident taxpayers to prove that tax has been paid in the foreign jurisdiction in respect of the amount transferred to Malaysia, particularly if the amount transferred is from funds which have been kept outside Malaysia. Malaysia for a number. of years.
Taxpayers should start compiling and preparing supporting documents proving that foreign taxes have been paid on income they plan to remit as an ISP in Malaysia after January 1, 2022, to ensure that any claim for tax credit may be justified.
Going forward, taxpayers will need to continue to maintain similar supporting documentation with respect to their ISP.
Claiming tax credits can be administratively cumbersome for resident taxpayers, especially individuals. It remains to be seen whether the Inland Revenue Board will be able to reduce the administrative challenges for taxpayers by simplifying the way to claim tax credits.
The PKPP FAQ suggests that existing tax return forms will be updated to include a new line for taxpayers to report the amount of FSI received in Malaysia from tax year 2022. Taxpayers should stay alert changes relating to reporting obligations, in order to ensure that they comply with any new rules.
Although the effective date for the removal of the FSI exemption is fast approaching, uncertainties remain from both a technical and administrative point of view.
In the final days leading up to the New Year, it will be important for individuals and businesses residing in Malaysia to take a closer look at their financial affairs, assess potential tax risks and plan ahead to ensure that are in the best position to face the fiscal challenges ahead.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Yvonne Beh is a partner and Irene Khor is a partner at Wong & Partners, a member firm of Baker McKenzie in Malaysia.