Scope of Charge: Categories of Income

1. In our last post, we looked into the difference between Revenue and Capital Income, where an income is classified as Revenue, it would be subject to taxation under the Income Tax Act, 1967 and where it is classified as Capital, it would be exempt from tax.
   
   
2. As mentioned previously, the Act does not define what is 'Income' however, once an 'Income' is determined to be 'Revenue' in nature, the next step is to identify which category it falls within.
   
   
3. Section 4 of the Act categorises income as follows:
   
   "Subject to this Act, the income upon which tax is chargeable under this Act is income in respect of:
   (a) gains or profits from a business, for whatever period of time carried on;
   (b) gains or profits from an employment;
   (c) dividends, interests or discounts;
   (d) rents, royalties or premiums;
   (e) pensions, annuities or other periodical payments not falling under any of the forgoing paragraphs;
   (f) gains or profits not falling under any of the foregoing paragraphs.
   
   
4. Apart from the above, Section 4A sets out special classes of income on which tax is chargeable. This section applies specifically to income earned by non residents. We will consider this section in detail in our subsequent articles.
   
   
5. The question which may pop into one's mind is that why the need to categorise the income separately? Why can't we just lump it all up and apply the applicable tax rate and compute the tax liability?
   
   
6. The answer to the question above is that, by categorising the income (and expenses) separately, the tax collection is maximised. Consider the following example:
   
   Mr A has the following income in the year 2013:
   - Salary RM36,000
   - Rental RM12,000
   
   This makes a total income of RM48,000.
   
   Mr A took a loan to acquire the property he is renting. The interest expense for the year was RM15,000.
   
   What would be Mr A's tax liability assuming an average tax rate of 10%?
   
   If the 'lum sum' approach is used, then Mr A's tax liability would be:
   
   (RM48,000 - RM15,000) x 10% = RM3,300
   
   However, where the income is assessed separately, Mr A's tax liabilty would be as follows:
   
   RM36,000 + (RM12,000 - RM15,000*) x 10% = RM3,600
   
   *The 'loss' from the rental income would be deemed to be a permanent loss, therefore not allowed to be offset against the Employment Income.
   
   As it can be seen, by categorising and computing the income and their respective expenses separately, the Inland Revenue Board would be able to maximise its tax collection!
   
   
7. So, why don't we compute the tax using the 'lum sum' method? The answer to that question lies with the provisions of Section 5 of the Act, which specifies the step by step procedure in which chargeable income is ascertained.
   
   
8. The following are the steps in computing Chargeable Income as per Section 5 of the Act:
   
   (a) The Basis Period for each source of income is determined as set out in Sections 20 to 21 of the Act.
   (b) The Gross Income for each source of income is determined as set out in Sections 22 to 32 of the Act.
   (c) The Adjusted Income for each source of income (or for business source, the adjusted income or adjusted loss) is determined as set out in Sections 33 to 41 of the Act.
   (d) The Statutory Income for each source of income is determined asset out in Section 42.
   (e) The Aggregate Income is computed as set out in Sections 43 to 44. The Aggregate Income is the total of the Statutory Income computed separately above less other deductions allowed under Sections 43 and 44.
   (f) The Chargeable Income is then computed as set out in Sections 45 to 51.
   
   
9. Once the Chargeable Income is computed, the applicable tax rate (determined based on tax resident status) would be applied to determine the tax liability.
   
   
10. The following is the summary of the tax computation process:
    
    Basis Period -> Gross Income -> Adjusted Income -> Statutory Income -> Aggregate Income -> Chargeable Income
    
    
11. The most common misconception on income among tax payers is that they need not pay taxes if they have yet to receive it. However, based on the provisions of the act, the tax payer has to account for income when is it 'accrued' or 'derived' in Malaysia. The derivation of income (as categorised above) is set out in Sections 12 to 17. We will be discussing the topic of derivation of each income in our subsequent articles.
    
    
12. This concludes our article on the Categories of Income. Our next article would be on the topic of tax residence status.