With effect from Jan. 1, 2022, the current income tax exemption on foreign-sourced income (FSI) received in Malaysia by Malaysian residents will be removed.
This article highlights the impact and practical considerations that businesses and individuals alike should contemplate in preparing for the impending tax on FSI. The contents of this article reflect the legislation and FAQs publicly available as at Dec. 20, 2021.
Overview of Existing FSI Exemption
Currently, FSI of any person that is received in Malaysia is exempted from income tax, with the exception of Malaysian resident companies carrying on the business of banking, insurance, or air or sea transport. This has not always been the case—the tax exemption on FSI was first introduced in 1998 for resident companies to encourage taxpayers deriving income overseas to repatriate their income back to Malaysia (with the exception of the few industries mentioned above). In 2004, this exemption on FSI was extended to all taxpayers, including individuals.
Impending Taxation of FSI in Malaysia
During the Budget 2022 announcement, the government proposed to remove the tax exemption on FSI received by residents in Malaysia with effect from Jan. 1, 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 gazetted as law at the time of writing (Finance Bill).
Under the Finance Bill, FSI received in Malaysia between Jan. 1, 2022 until June 30, 2022 by all tax residents, including individuals and companies, will be taxed at 3% on a gross basis. The tax rate on FSI received after this period will be the prevailing tax rates for resident individuals and companies. The proposal as it stands covers all forms of income (for example, business or employment income, dividends, interests, royalties) and will affect all Malaysian resident taxpayers regardless of their size or sectors.
On Nov. 16, 2021, the Inland Revenue Board of Malaysia announced in a media statement that they will be offering a Special Income Remittance Program (Program Khas Peremitan Pendapatan, also referred to as PKPP) for the period of Jan. 1, 2022 to June 30, 2022, during which FSI received in Malaysia by taxpayers that have declared their participation in the PKPP by July 30, 2022 will not be subject to audits, investigations or penalties.
The Inland Revenue Board issued FAQs in relation to the PKPP on Dec. 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 Tax Treatment of FSI
According to the Budget 2022 speech, the reasons behind the proposal to tax FSI received in Malaysia by Malaysian residents are to ensure that there is sustainable revenue for Malaysia, and to comply with international tax best practices.
For context, on Oct. 5, 2021, the Council of the European Union included Malaysia in its “Grey List” as a jurisdiction that has committed to amend its “harmful” FSI exemption regime by Dec. 31, 2022. Other jurisdictions like Hong Kong, Costa Rica, Qatar and Uruguay were also included in the Grey List on the same basis.
Although it was expected that the Malaysian government will amend the existing tax regime to address the EU’s concerns, many did not anticipate the blanket removal of the FSI exemption for Malaysian residents. This is especially so as the EU has clarified in its guidance that regimes exempting FSI are not in themselves problematic and the concern is on the circumstances of “double non-taxation” that may arise in respect of passive income of a company that does not have substance in-country.
Hong Kong, which adopts a similar source-based tax regime as Malaysia, announced on the same day the Grey List was published that it would continue to adopt the territorial source principle of taxation despite its inclusion in the Grey List. However, to address the EU’s concerns, it will amend its legislation by the end of 2022 and the proposed legislative amendments will merely target corporations (not individuals) that earn passive income, especially those with no substantial economic activity in Hong Kong.
Malaysia’s immediate neighboring country, Singapore, which was not on the Grey List, imposes tax on FSI while maintaining certain exemptions for categories of income (for example, foreign-sourced dividends, branch profits or income from professional, consultancy and other services) subject to the satisfaction of specified conditions. Nonresident individuals in Singapore are generally exempt from tax on their FSI.
Indonesia recently introduced the Omnibus Law, with one of the main amendments being the introduction of a tax exemption for dividends received by Indonesian tax residents from offshore companies, subject to the income being reinvested into Indonesia for a certain period of time and the fulfillment of other qualifying investment requirements.
The jurisdictions mentioned above appear to be consciously adopting tax policies in a targeted manner in order to ensure that they remain attractive to investment, while balancing other considerations such as the need to maintain a healthy income tax base and the defensibility of the tax regime under international scrutiny.
Similarly, in the era of globalization and increased international scrutiny of the tax regimes of each jurisdiction, the challenge for Malaysia would be to address international tax concerns with a targeted and measured approach, in order to remain competitive on the global stage as an attractive jurisdiction for investments and business operations.
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 granted outside Malaysia or foreign bonds, rental income from real property located outside of Malaysia, and even employment income earned by Malaysian tax residents from outside Malaysia, will be subject to Malaysian income tax when received in Malaysia on or after Jan.1, 2022.
We summarize below the key issues that Malaysian residents should take note of when considering the implications of this new tax development.
- Definition of “received”
FSI which is not received in Malaysia will not be taxed. The Finance Bill and the Malaysian Income Tax Act (ITA) do not currently specify the definition of “received.” Accordingly, based solely on legislation, there are uncertainties as to whether certain transactions, such as contra transactions between related entities or the satisfaction of debt incurred in respect of a business in Malaysia, could potentially be deemed to be received in Malaysia.
However, the Inland Revenue Board has recently clarified in the PKPP FAQs that only income remitted, brought in or transferred into Malaysia in (i) a physical manner, or (ii) through the banking system, will be considered as income “received” in Malaysia. In light of this, it appears that contra transactions may not be caught but the transfer of funds into Malaysia to a creditor in satisfaction of a debt may potentially be caught.
As the meaning of “received” is crucial to the determination of whether a tax liability arises in respect of the FSI, this clarification is welcomed.
- Distinction between income and capital
The tax on FSI will only affect a receipt that is “income” in nature. Capital gains remain outside the scope of charge 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 FAQs.
Resident taxpayers will need to consider whether their receipt falls within the category of income or capital based on all the circumstances and factors surrounding the receipt. Specific types of receipts such as dividends, royalties and interest will usually fall within the category of income.
From a practical perspective, it will be challenging for taxpayers to prove the nature of a receipt to the Inland Revenue Board’s satisfaction, especially if the receipt in Malaysia is from funds that have been maintained outside Malaysia for a longer period.
Moving forward, taxpayers will have to be more diligent in maintaining records of their gains (both income and capital) and transfers of money into and out of Malaysia.
- Double tax relief
FSI that is received in Malaysia may already have been taxed elsewhere. To address double taxation of the same income, the ITA provides for relief in the form of (i) bilateral tax credits, where the relevant foreign country in which tax has been paid has a double tax agreement (DTA) with Malaysia; or (ii) unilateral tax credits, where the relevant foreign country in which tax has been paid does not have a DTA with Malaysia.
Based on the PKPP FAQs, such credits have to be claimed in respect of the FSI received in Malaysia within two years from the end of the relevant Year of Assessment in which the FSI is declared. Taxpayers are required to maintain evidence of foreign taxes that have been paid in respect of the FSI.
In practice, it will be challenging for resident taxpayers to prove that tax has been paid in the foreign jurisdiction in respect of the amount that is remitted into Malaysia, especially if the amount remitted is from funds that have been maintained outside of Malaysia for a number of years.
Taxpayers should start compiling and preparing supporting documents evidencing that foreign taxes have been paid in respect of income that they are planning to remit as FSI into Malaysia after Jan. 1, 2022, in order to ensure that any tax credit claims can be substantiated.
Moving forward, taxpayers will need to continue maintaining similar supporting documents in respect of their FSI.
The claiming of tax credits may be administratively burdensome for resident taxpayers, especially individuals. It remains to be seen if the Inland Revenue Board will be able to reduce the administrative challengers for taxpayers by simplifying the manner of claiming tax credits.
- Reporting obligations
The PKPP FAQs suggest that the existing income tax return forms will be updated to include a new line item for taxpayers to declare the amount of FSI received in Malaysia for Year of Assessment 2022 onward. Taxpayers should keep a lookout for developments relating to reporting obligations, to ensure that they are compliant with any new rules.
Although the effective date for the removal of the FSI exemption is fast approaching, there remains some uncertainty from both technical and administrative perspectives.
In these final days leading up to the new year, it will be important for Malaysian resident individuals and businesses to take a closer look at their financial affairs, assess potential tax exposures and plan in advance to ensure that they are in the best position to weather the tax 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 an associate with Wong & Partners, a member firm of Baker McKenzie in Malaysia.