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.