LOCAL VERSUS FOREIGN SOURCED INCOME
Malaysia’s tax system is territorial. Under Section 3 of the Income Tax Act 1967, it provides that only income that is accruing in or derived from Malaysia, and income remitted to Malaysia from outside Malaysia is subject to tax. In ongoing efforts to encourage Malaysian businesses to venture overseas and thereafter repatriate their profits to Malaysia, the government has, since 1995, introduced various legislations for tax exemptions. Foreign-sourced income is not subject to tax in Malaysia, although tax is levied on worldwide income for certain activities, such as banking, insurance, and air and sea transport operations. Unless profits or gains are attributed directly to activities conducted outside Malaysia, they are assumed to be derived from Malaysia. Thus, the burden is on the company or branch to prove which part of its income is foreign sourced.
The current law is provided in Paragraph 28, Schedule 6 of the Act which exempts from tax,
“… income of any person, other than a resident company carrying on the business of banking, insurance or sea or air transport, for the basis year for a year of assessment derived from sources outside Malaysia and received in Malaysia.”
The word “source” is not defined in the Act and guidance is often sought from case laws. However, the derivation of business income is further dealt with under Section 12(1)(a) of the Act. This section deems an item of income to be derived from Malaysia, hence taxable in Malaysia, unless it can be proven that the income is attributable to the operations of the business carried on in a foreign country (outside Malaysia).
From the year 2000, there were a few cases under appeal to the courts against the Inland Revenue Board’s challenge of the treatment of income received by taxpayers as foreign sourced income: Cardinal Health Malaysia 211 Sdn Bhd and Kyros International Sdn Bhd. are two of the most remarkable cases that shall be studied.
Ketua Pengarah Hasil Dalam Negeri v Cardinal Health Malaysia 211 Sdn Bhd
Loans provided by a Malaysian company to its related company with charging interest, whether interest income was local or foreign sourced income?
The taxpayer CHM was in the business of manufacturing latex and synthetic gloves. CHM was a part of the same group of companies (“the Group”), and AHBV is a related company in the Netherlands. AHBV was an investment holding company and functioned as a financing entity for the Group. It monitored the cash flow conditions and funding requirements of entities within the Group. Surplus funds within the Group were channeled to other related companies requiring funding. This reduced the need for external debt. The central treasury function within the Group enabled entities with surplus funds to invest by way of loans to AHBV, which were repayable at commercially competitive rates. The loans were then utilised by AHBV to invest abroad within the Group.
The CHM and AHBV entered into various revolving credit agreements, whereby they made advances to each other. The agreements were standard loan agreements used in the Group to facilitate the central treasury function. The transactions were approved by Bank Negara Malaysia. When CHM made advances to AHBV, interest was paid to CHM. The taxpayer treated the interest received from AHBV as tax exempt on the basis that it was foreign sourced income.
The Revenue disagreed with the taxpayer’s treatment of its interest income and issued notices of additional assessment for the years of assessment 1999 to 2005 with penalties.
The taxpayer CHM appealed to the Special Commissioners of Income Tax, who allowed the taxpayer’s appeal.
The Revenue appealed to the High Court and contended that:
- The originating cause of the interest income is the loans given by the taxpayer in Malaysia;
- The interest income accrued in and was derived from Malaysia.
- Being a Malaysian sourced income, the interest income is not exempted from tax under the Income Tax (Exemption)(No. 48) Order 1997 (“the Exemption Order”) and paragraph 28 of Schedule 6 of the Income Tax Act 1967 (“ITA”).
Meanwhile, the taxpayer CHM submitted that:
- The interest income was received by the taxpayer from AHBV and was therefore sourced, arose and derived in the Netherlands and received in Malaysia; and
- The interest income was sourced in the Netherlands and was not chargeable for tax by virtue of the Exemption Order and paragraph 28 of Schedule 6 of ITA.
Whether the interest income received by the taxpayer from AHBV was foreign sourced income?
The High Court dismissed the Revenue’s appeal. The High Court applied the broad guiding principle introduced by the Privy Council in Commissioner of Inland Revenue v Hang Seng Bank Ltd  1 AC 306
The broad guiding principle is:
(a) First, what has the taxpayer done to earn the profit in question; and
(b) Second, where did the transaction that produced the profit to the taxpayer take place?
The High Court rejected the Revenue’s argument that the originating cause of the interest income was the source of the funds. According to the High Court, the originating cause that produced the interest income was the taxpayer’s transaction and activity of providing loans to AHBV.
The High Court upheld the Special Commissioners’ decision as:
(a) The interest income was generated from the effective placing of deposits abroad; and
(b) The agreements and provision of credit were not made in Malaysia.
Ketua Pengarah Hasil Dalam Negeri v Kyros International Sdn Bhd
The case of Kyros International Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (2013) MSTC 30-056 is the most recent case decided in Malaysia on foreign sourced income.
Franchise fee collected by a Malaysian company from the franchisees abroad, whether franchise fee income was local or foreign sourced income?
Kyros International Sdn Bhd (“Kyros”)
- the registered owner of trademark “KYROS”
- granted sole and exclusive rights to establish and operate in a designated area
- supported its franchisee in the operations by providing certain services such as auditing the operating system to ensure compliance with the standard operating procedures
- giving advise to franchisee on ways to improve operations and business development.
The IRB challenged Kyros’ treatment of the franchise fees as foreign sourced income as it was of the view that the franchise fees were derived from Malaysia under Section 12(1)(a) of the Act.
Decisions of the SCIT and High Court
The SCIT held that franchise fees received by Kyros from Pakistan, China, Indonesia, Singapore and Brunei are exempt under paragraph 28(1) of Schedule 6 to the Income Tax Act 1967 (“ITA”).
In this regard, the SCIT found as a fact that the foreign franchise took place outside Malaysia and held:
“We find as a fact the execution or operations of business by the foreign franchisees took place outside Malaysia, through the evidence of the Respondent’s witness (RW1). The foreign franchisees are independent i.e. not related to the Appellant. We therefore hold that all activities in respect of the agreements entered into with the foreign entities took place outside Malaysia.”
The SCIT also applied the principle enunciated in the case of CIR v Hang Seng Ltd and held that the income is derived where the franchise was exercised.
Further, on the issue of whether the penalty imposed under section 113(2) of the ITA was correct in law, the SCIT held that the incorrect return was made in good faith and waived the penalty.
However, on appeal to the High Court, Ketua Pengarah Hasil Dalam Negeri (“KPHDN”) succeeded on the first issue that franchise fees received by Kyros were not exempt under paragraph 28(1) of Schedule 6 to the ITA. KPHDN’s appeal on the issue of penalty was dismissed by the High Court.
The basis of judgement by High Court on the income is not foreign sourced
The High Court in its opinion decided that the income was derived from the operation from outside Malaysia by referring to the franchisees operated the business outside Malaysia was an error as it was not the franchisor who operating the business of selling kebab outside Malaysia. The franchisor was in receipt of franchise fee from the franchisees which is irrelevant with the franchisees’ business operation outside Malaysia.
Hence, the High Court allowed the appeal by IRBM and the taxpayer appealed to Court of Appeal.
Decision of the Court of Appeal
The Court of Appeal allowed the appeal by Kyros on the franchise fee and dismissing KPHDN’s cross-appeal on penalty under section 113(2) of the ITA.
The Court of Appeal upheld the opinions of the SCIT that concluded that the franchise fees were foreign sourced income as the business operations of the foreign franchisees took place outside Malaysia. The SCIT applied the principles established in the Hang Seng Bank case in concluding that the fees received from its foreign franchisees were akin to “profit earned ….by letting of property” where “ …. the profit will have arisen in or derived from where the property was let ….”.
The High Court overturned the SCIT’s decision as it did not think it was correct to look at the operations of the franchisees (as the SCIT did), instead of the operations of the Malaysian franchisor, Kyros. However, the Court of Appeal reversed the High Court’s decision as it found that the High Court did not have sufficient reason to interfere with the SCIT’s finding of facts.
Based on the above two tax cases, there are some factors that need to be considered and studied in assessing the income whether is foreign sourced or derived from within Malaysia, some of the factors are:-
- Where is the agreement of the activities generating income is executed?
- What activities did the person do to make him earn the income and where are the activities generating income carried out?
- Section 12(1)(a) of the Act shall be considered as well e.g. can the income be proven that it is attributable to operations of the business carried on outside Malaysia? (if fail to prove so, it can be deemed to be derived from Malaysia).
It is observed that the Malaysian courts have generally applied the broad guiding principle. However, in applying case precedents, our specific legislation should be considered e.g. the deeming provision under Section 12 of the Act.
Finally, due to the complexity of the law and the diverse range of income and circumstances, the facts of each case must be considered separately in determining the tax treatment to be adopted. The continuous development of cases taken to the courts both overseas and in Malaysia, indicates that the concept of source of income is indeed difficult and often open to discussion.
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