Scope of Charge: Revenue vs Capital Income

1. In our previous post, we had identified 3 areas of tax which needs to be considered prior to determining the tax liability, which are "Scope of Charge", "Residence Status" and "Deductions". In this article, we will explore the concept of "Scope of Charge: Revenue and Capital Income" in detail and discuss its tax implications.
   
   
2. In order for an income to be taxed in Malaysia, it needs to fall within the ambit of Section 3 of the Act, which reads:
   
   "Subject to and in accordance to this Act, a tax to be known as income tax shall be charged for each year of assessment upon the income of any person accruing in or derived from Malaysia or received in Malaysia from outside Malaysia."
   
   
3. Section 2 of the Act lists down the interpretation of specific terms used throughout the Act, for example, in relation to Section 3 above:
   "tax" means the tax imposed by this Act
   "year of assessment", subject to subsection (5), means calendar year.
   "person" includes a company, a body of persons and a corporation sole.
   "Malaysia" means the territories of the Federation of Malaysia, the territorial waters of Malaysia and the sea-bed and subsoil of the territorial waters, and includes any area extending beyond the limits of the territorial waters of Malaysia, and the sea-bed and subsoil of any such area, which has been or may hereafter be designated under the laws of Malaysia as an area over which Malaysia has sovereign rights for the purposes of exploring and exploiting the natural resources, whether living or non-living.
   
   
4. Therefore, as long as the conditions of Section 3 are met, the income would be subject to tax. As mentioned previously, foreign source income (except for banks, insurance, sea or air transport) repatriated back to Malaysia has been exempted from income tax with effect from year 2004 by virtue of Para 28 of Schedule 6 of the Act.
   
   
5. Since 'person' has been defined in the Act to include a company  or body of persons, which covers clubs and associations, one cannot argue that a company or association is not a 'person' since they are not natural persons.
   
   
6. As for "Malaysia" some tax payers may get creative in performing the transactions on the sea or under water and claim that the income was not performed 'in' Malaysia. Since the definition of "Malaysia" includes territorial waters, therefore, this argument is not valid.
   
   
7. This brings into question income generated in international waters. Would they be subject to Malaysian tax? On principle, if the source has been derived in international waters, therefore it is tax exempt. For example, a casino on board a ship, which picks up passengers from Malaysia and only commences casino activities in international waters. The income for the 'transportation' of passenger may be taxable. However, the casino income would not be taxable in Malaysia because the activity is carried out in international waters. Of course there are other considerations pertaining to maritime revenue, which would not be discussed in this article.
   
   
8. Some may even argue that income derived in the airspace, on board an airplane or helicopter, may not be subject to tax because Section 3 only mentions territories and territorial waters and no mention of air space! Although, logically airspace should be covered as part of 'territories of the Federation of Malaysia', Section 3 only mentions subsoil, sea bed and territorial waters. No mention of airspace! By applying the literal rule of interpretation, since there is no mention of airspace, should the income, where it could be clearly proven is derived from airspace, be liable for tax? To date, we are not aware of any case law which have been tested for this. But with commercial space tourism coming closer to reality in the near future, it is possible for 'consultancy' and 'advisory' services to be rendered in 'space' which is 100 km above Earth as defined by the Karman Line. In this case, where the income is derived in 'space' 100 km above Malaysian soil, would it still be taxed under the Act? It would be interesting to find out!
   
   
9. Please take note that the chargeable income for sea and air transport is determined by Section 54 of the Act. The above examples are to illustrate the derivation of other income at sea and air, not in relation to the rendering of transportation service as defined in Section 54.
   
   
10. From the looks of it, it seems like the Act is quite detailed in its definition and interpretation, however, despite its detailed interpretations and definitions of  the specific words used throughout, the Act does not define the most important word used within it, which is INCOME.
    
    
11. In order for a person to be taxed, there must be an element of income which falls within Section 3. If the 'income' is does not qualify to be taxed, then, the person will not be subject to income tax.
    
    
12. So, what is income? Since there is no definition of income given in the Act, one would need to look into the ordinary meaning of income and case laws to determine what is income and more importantly, what is taxable income?
    
    
13. In general, income can be classified into 2, i.e. REVENUE and CAPITAL. In Malaysia, only revenue income is subject to the Income Tax Act, 1967, whereas Capital Income is not subjected to the Act, i.e. it is tax free! (except for capital gains which are subject to the Real Properties Gains Tax Act, 1976).
    
    
14. So how does one classify income into Revenue or Capital? The general rule is that if the income arose from the day to day activity of a vocation, example, trading business, consultancy business, rental income, employment income, interest income and other frequent sources of income, this is deemed to be Revenue Income. Where the income has the characteristics of a "windfall" for example an unexpected gain, or a realisation of a long term investment, lottery winnings, gambling winnings and lucky draw prizes.
    
    
15. The preliminary tests to determine whether an income is Revenue or Capital are as follows:
    
    Frequency of the transaction
    Where there is frequency in receiving the said income, it is more likely to be Revenue than Capital.
    
    Subject matter and circumstances of the transaction
    Whether the income is received due to a vocation, i.e. employment or trading activity? If so, this would be revenue income. However, if the income is for example a lottery winning or in the form of a compensation for loss of employment, then such income may be deemed Capital.
    
    Period of ownership
    The period in which an item of trade was held prior to generating the income is also a consideration on determining whether an income is Revenue or Capital in nature. Usually, items held for a long period of time prior to disposal would indicate a realisation of investment, therefore Capital in nature. Whereas, where an item is purchased and traded within a short period of time, would indicate a trading nature, thus may be deemed as Revenue in nature.
    
    
16. Please take note that the above is not a definitive test to determine whether an Income is Capital or Revenue. In reality, the courts have applied many tests in determining whether an income is Capital or Revenue. It has been held in the case of LFY Sdn Bhd vs DGIR that whether an income is Capital or Revenue depends on the facts and circumstances of the transaction.
    
    
17. Naturally, most (if not all) tax payers would prefer to classify their income as Capital rather than Revenue in order to pay minimal (if not at all) taxes. Once, they know of the 'rules' of determining 'Capital' income, they would have the tendency to see every transaction in the light of  being Capital income!
    
    
18. For example, a "windfall income" is a characteristic of a Capital Income. A small time home renovator whose regular renovation contracts amount to less than RM200,000 would argue the big contract worth RM3 million he or she just landed is a "windfall" as it is out of the norm. Or an employee may argue that the 12 month bonus he or she received for the first time after working with the same employer for 10 years without any bonus is a "windfall". However, even though in the eyes of the tax payer, this is a "windfall" it is still an income received within their ordinary vocation, therefore it is a Revenue income.
    
    
19. The line between Capital and Revenue often gets blurred. Especially when tax payers take the route of tax planning prior to commencing a venture and in some cases, the tax payers choose to take the route of 'creative accounting' so that their income falls within the definition of Capital income.
    
    
20. Therefore, when disputes with the Inland Revenue Board cannot be resolved, the courts would look at the substance of the transaction as a whole, instead of just the 'form' of the transaction. When this happens, the tax payers who engage in 'creative accounting' to avoid taxation would be exposed, since the 'substance of the transaction' would prove that the accounting transactions were created just to avoid paying taxes.
    
    
21. Tax planning on the other hand involves structuring the business operations within the provisions of the Act, to minimise their tax exposure. It is perfectly legal and within the tax payer's rights to structure their business operations to that which would give them the most optimum tax exposure.
    
    
22. However, even though tax planning is legal, the Inland Revenue Board tends to disagree with certain tax planning exercises due to the interpretation of law. As such, when disputes arise, it is up to the courts to decide the correct interpretation and application of the law in relation to the disputed transaction.
    
    
23. So in summary, for most people, ALL income are taxable except FOREIGN SOURCE income and CAPITAL income. The Act is quite clear on what income from 'outside Malaysia' is since it has defined the meaning of "Malaysia". However, whether an income is CAPITAL or REVENUE is not defined. Therefore, one has to consider the substance of the transaction and applicable decided case laws before arriving at the conclusion that a certain income is indeed CAPITAL in nature, therefore not taxable.
    
    
24. This concludes our article on CAPITAL and REVENUE income. Kindly feel free to post your queries on Capital and Revenue income in the comments section or email us at dason@dason.com.my.

Tax Law and Interpretation

1. In this article, we will briefly discuss about the Income Tax Act, 1967 and the misconceptions about the role of the Inland Revenue Board and how the law works in Malaysia. 
   
   
2. The common misconception people have about the Income Tax Act, 1967 is that the law is actually set by the Inland Revenue Board (IRB) and therefore the IRB would have the final say in any tax disputes.
   
   
3. In reality, the laws pertaining to Income Tax are determined by Parliament and the IRB are entrusted to enforce the law. This means that the IRB officers are also bound by the provisions of the Income Tax laws and if the tax payer is unhappy with the assessment raised, there are appeal procedures available under the law.
   
   
4. Another important matter pertaining to the tax law in Malaysia is the rule of interpretation. In law, there are generally 3 rules of interpretation, namely, golden rule, mischief rule and literal rule. In short, the golden rule and mischief rule allow a certain degree of discretion in the interpretation of the wording of the law to determine the 'purpose' or 'fairness' of the application of law. However, the literal rule demands strict application of the law to the letter of the law. This means, there is no room to consider the 'purpose' or 'fairness' of the application of the law.
   
   
5. In Malaysia, tax laws are are interpreted using the literal rule. This has been determined in the case of Mamor Sdn Bhd vs Director General of Inland Revenue. So, what does this mean to the tax payer? It means that if a certain provision is not literally stated in the Act, then we cannot make presumptions about it.
   
   
6. Let's take a look at the provisions of Section 3 of the Act which reads as follows:
   
   "Subject to and in accordance with this Act, a tax to be known as income tax shall be charged for each year of assessment upon the income of any person accruing in or derived from Malaysia or received from outside Malaysia."
   
   
7. Applying the literal rule on the above, in order for income tax to be charged, there must be an element of 'income', it must be earned by a 'person' in Malaysia or received in Malaysia from outside Malaysia.
   
   
8. If for example, in a highly unlikely scenario, a show animal is able to legally receive an income of say RM1 million a year in its own name in Malaysia, it would not be subject to tax because it is not a 'person' as defined under Section 2 of the Act. The definition of a 'person' under the Act is limited to natural individuals, companies and body corporates.
   
   
9. Even though, it would seem unfair that a natural person who earns RM80,000 would be subject to tax and the show animal in the above example which earns RM1 million is not taxed. One cannot argue that the animal must be taxed due to fairness under the literal rule of interpretation of the Income Tax Act, 1967. If the Golden rule or mischief rule of interpretation is used, then probably one can argue that the show animal needs to pay tax. However, since it has been decided in the Mamor case that the literal rule is to be applied, it is a binding precedent which will not be changed with regards to the interpretation of the Income Tax Act, 1967.
   
   
10. The above scenario is of course absurd, however it is to illustrate the point that since the literal rule is applicable, one has to read the Act to the letter when dealing with tax matters, instead of making assumptions or drawing logical conclusions.
    
    
11. Frequently we encounter clients who argue that they refuse to pay taxes because they feel it is unfair due to various reasons. Sometimes, their reasons and circumstances may even be justified given the circumstances. However, even with the best justification, one cannot be exempted from paying tax unless it is specifically allowed under the law, i.e. one cannot refuse to pay tax on the grounds of just and equity because of the literal rule of interpretation used on the Income Tax Act, 1967, which clearly states that income tax liabilities must be paid, even if the person is no longer alive!
    
    
12. This concludes our article on Tax Law and Interpretation. We hope that this article would set the foundation on the significance of the wordings of the law and its application. The next article would deal with the concept of "Scope of Charge" and how to determine whether an income is taxable in Malaysia or not. 

Introduction to Malaysian Taxation

1. In Malaysia, there are 2 types of tax systems in operation, which are, direct and indirect taxation. Direct taxation involves paying taxes on income or gains generated from a venture and indirect taxes is imposed by way of tariffs, custom duties, sales tax, services tax and the soon to be implemented Goods and Services Tax better known as GST.
   
   
2. Direct taxes come under the purview of the Inland Revenue Board whereas indirect taxes come under the purview of the Royal Malaysian Customs Department. Ultimately, both these agencies come under the Ministry of Finance.
   
   
3. The focus of these articles would be on the direct taxation system, which is legislated by the Income Tax Act, 1967 (henceforth referred to as the Act). However, we would post articles on indirect taxation and other tax related matters from time to time.
   
   
4. For many, taxation is a very complicated subject, with many rules and regulations to be adhered to. But in reality, the 'complication' actually boils down to only 3 matters. Once these 3 matters are identified, computation of the income tax can be done by applying the appropriate tax rate. The 3 matters of consideration are "Scope of Charge", "Residence Status" and "Deductions".
   
   
5. The "Scope of Charge" determines the chargeability of the income. Section 3 of the Act sets out 2 conditions for income to be taxed in Malaysia. First, the income must be accrued or derived, i.e. earned in Malaysia. The second condition is that the income must be received in Malaysia from outside Malaysia, i.e. foreign sourced income.
   
   
6. However, with effect from year 2004, foreign sourced income which are repatriated back to Malaysia is no longer subject to tax by way of the exemption granted under Para 28, Schedule 6 of the Act. As such, the second condition mentioned above is no longer applicable for everyone except, companies in the business of banking, insurance, sea or air transport.
   
   
7. The "Residence Status" would determine the applicable tax rates, whether tax reliefs are available (for individual tax) and/or whether the income derived would be subject to withholding tax and in some cases, whether income would be exempted from tax. In the context of the Act, citizenship does not determine the Tax Residence status. A person would be deemed to be a Tax Resident so long as the individual (whether citizen or not) satisfies the conditions (i.e. the number of days stay in Malaysia) as set out in Section 7 of the Act, and Section 8 for Companies.
   
   
8. The "Deductions" comprise of expenses and reliefs which may be claimed against the income to reduce the taxable income. These 'deductions' come in the form of expenses, capital allowances, double deductions, and personal reliefs which are allowed under various provisions of the Act, the specifics of which, will be discussed in future articles.
   
   
9. If there are only 3 matters of consideration to taxation, how can it get complicated? The complication arises due to the interpretation of the law. Naturally, the tax payer would like to interpret the law to his or her benefit and pay as little tax as possible whereas the Inland Revenue Board would take the view of maximising tax collection for the government coffers. This differing view ultimately leads to tax disputes, and where no resolution can be found between the tax payer and the authorities, the matter would need to be referred to the courts to interpret and resolve.
   
   
10. This concludes our Introduction to Malaysian Taxation article. Our future articles would be a further discussion on the topics of "Scope of Charge", "Residence Status" and "Deductions". If you have any queries on this article or any other tax related questions, kindly feel free to post it on the comments or email us at dason@dason.com.my. Thank you.