This article first appeared in The Edge Malaysia Weekly on November 22, 2021 - November 28, 2021

BUDGET 2022’s proposal for Malaysia to withdraw the tax exemption on foreign-sourced income has caused a stir among companies and individuals with significant investments abroad.

From Jan 1, 2022, the tax exemption on foreign-sourced income received in Malaysia under Paragraph 28, Schedule 6 of the Income Tax Act (ITA) 1967, will be withdrawn, meaning that foreign-sourced income — whether from business or employment or in the form of dividend, royalties, interest or rental — remitted into the country will be subject to Malaysian tax.

The exemption, says EY Asean tax leader and tax managing partner Amarjeet Singh, has been in place since 1998 for companies and since 2004 for individuals, in a bid to encourage remittance of such income.

“It was one of the measures to deal with the 1997/98 Asian financial crisis. Prior to these years, remittance of foreign-sourced income was taxed in Malaysia,” recalls Amarjeet.

It is no wonder, then, that companies that have invested significantly abroad ever since the exemption was in place are now scrambling to assess the implications of this measure on their tax position and businesses.

What seems to be of utmost concern for such companies is the dividends they receive, as dividends are one of the means by which profits from overseas investments are remitted back to headquarters.

Dividends are paid out of net profit, and net profit would have already been taxed under the corporate income tax rate imposed by the foreign country.

“Many of these businesses have structured their global investments based on the assumption that profits will not be subject to potential double taxation. Given the broad change that is proposed, these structures could lead to dividends being subject to additional taxes, hence reducing their returns,” says PwC Malaysia tax leader Jagdev Singh.

“It is sometimes not easy to change these structures overnight. Businesses thrive on certainty in tax regulations, and the introduction of such a major change without prior engagement has caused alarm in many sectors.”

Individuals are not spared too. According to KPMG Malaysia corporate tax exe­cutive director Nicholas Crist, those who have investments abroad and have been receiving foreign-sourced dividends, interest income and rental or who have made gains on the disposal of properties overseas over the years may now find it challenging to segregate the nature of their remittance to Malaysia.

One question that many have raised is: What compelled the government to withdraw the foreign-sourced income exemption (FSIE)?

The obvious answer, according to the 2022 Budget speech, would be to ensure that Malaysia complies with international standards in the aspect of “foreign harmful tax practices”.

To recap, on Oct 5, the European Union (EU) put Malaysia on its “grey list” of non-cooperative jurisdictions for tax purposes. What that means is that Malaysia was identified by the EU as a tax jurisdiction that has a “harmful” foreign-sourced income exemption, but it has committed to amending or abolishing this regime by making necessary legislative changes to remove or amend the harmful features by Dec 31, 2022.

Malaysia is not alone, as other jurisdictions such as Hong Kong, Costa Rica, Qatar and Uruguay are also on the list.

It is important to note, however, that the EU does not consider FSIE regimes, or regimes that charge corporate tax on a territorial basis, as problematic in themselves, tax consultants point out.

“Based on the EU’s guidance, FSIE regimes that apply on a territorial basis are not inherently problematic. The EU is concerned, however, about where such regimes create situations of double non-taxation. In particular, they are concerned with the non-taxation of passive income in the form of interest or royalties, where the income recipient has no substantial economic activity,” says Deloitte Malaysia tax leader Sim Kwang Gek.

If the intention was for the country to comply with international best practices, there could have been other ways to address the situation instead of a blanket withdrawal of the FSIE regime.

“Why was there a need to rush this?” asks Dr Veerinderjeet Singh, the non-executive chairman of Tricor Malaysia. “We have until December 2022 to come up with a solution.”

Amarjeet believes that if the sole objective of the proposal for the FSIE withdrawal was to have Malaysia removed from the EU’s “grey list”, the country could have achieved it by putting in place certain conditions or safeguards to the FSIE.

He says: “Hong Kong, which is in a similar predicament as Malaysia, has indicated that it will continue to adopt the FSIE and is likely to introduce certain minimum substance criteria in order for companies to enjoy tax exemptions on foreign-sourced income. Meanwhile, the FSIE for individuals is likely to remain completely unchanged.”

PwC’s Jagdev adds that Malaysia has several options to consider, as most countries worldwide offer some form of foreign income tax exemption.

“One is to exclude active business income from the scope of the FSIE removal. In fact, as Malaysia has committed to implementing Pillar 2 of the Base Erosion and Profit Shifting (BEPS) Plan, Malaysian-headquartered corporates with revenues of €750 million or more would be subject to a global minimum tax rate of 15%, with Malaysia being entitled to collect any shortfalls,” he says.

Jagdev adds that Malaysia could also consider taxing passive income, but introduce certain criteria for exemptions to encourage remittance back for domestic investment.

“Most countries apply a shareholding participation exemption, whereby remittance by subsidiaries in which the Malaysian shareholder has a certain minimum shareholding (certain countries have participation requirements as low as 5%) are exempted from tax,” he elaborates.

Another country mentioned by tax consultants that is not on the EU’s grey list but has an acceptable FSIE regime is Singapore, where there are minimum criteria to be met for exemption.

The proposed change leaves no doubt that Malaysia has addressed the EU’s concerns about any potential “foreign harmful tax practices”.

Yet, it effectively changes Malaysia’s tax system from a territorial tax system into a worldwide tax system by taxing all foreign income earned by Malaysian tax residents upon remittance.

Most likely, it would yield much-needed additional revenue for the country, given the strained financial position it is in.

Notably, the Ministry of Finance estimates that RM1.2 billion in revenue can be collected by taxing foreign-sourced income in 2022.

It is also worth highlighting that the Inland Revenue Board (IRB) recently said it was offering a Special Income Remittance Programme (PKPP) to residents in Malaysia who have income kept abroad, which will run from Jan 1 to June 30, 2022.

During these six months, the Finance Bill 2021 proposed that the concessionary rate of 3% tax would be imposed on foreign-sourced income remitted. IRB added that it would not carry out an audit review or investigation nor impose a penalty on income brought in during this period, but would accept it in good faith.

Aside from this, there has been no further guidance from IRB on whether there will be any exemption given on foreign-sourced income.

What are the implications from such a major change in the tax system?

One likely impact is that companies will retain more of their earnings abroad for reinvestment, says Lee Heng Guie, executive director of the Associated Chinese Chambers of Commerce and Industry of Malaysia’s Socio-economic Research Centre.

This would mean that less investment income will be remitted back home, he adds.

Balance of Payments data shows that corporates have repatriated an annual average of RM27.8 billion in investment income — from both direct and portfolio investment — back to Malaysia between 2010 and 2020, compared with RM7.5 billion the decade before.

“We need to recognise that Malaysia is at a stage where it has to enhance its reliance on private sector investments and reduce reliance on public sector investments. Removing the FSIE effectively reduces the ability of, and attractiveness to, the private sector to reinvest in Malaysia or use the country as a base from which to run their global operations,” says Amarjeet.

Compared with other countries in Asean, Jagdev says, Malaysia faces the existing challenge where the headline tax rate has stayed at 24% whereas many neighbouring countries have been lowering their corporate tax rates to 20%.

“With this change, it certainly would weigh negatively as investors look for an alternative location for their investments. Countries in the region, such as Singapore, Thailand and Indonesia, also provide exemption of foreign-sourced dividend income, subject to conditions such as minimum shareholding participation — where it is 10% in Singapore and 25% in Thailand — and the dividend being subject to a minimum tax, for example, 15%, in the source country, or reinvestment requirements,” he explains.

Deloitte’s Sim shares similar sentiments, adding that Malaysia may be less attractive as a location for businesses to set up their holding company to house their overseas companies.

Malaysia should take guidance from what Singapore is doing, she says, considering that the city-state is not on the EU’s grey list, yet exempts certain foreign-sourced income, albeit with conditions.

The Indonesian government recently amended the country’s tax laws to allow tax exemptions for foreign-sourced income remitted to the country. A taxpayer that reinvests part of its dividend income in qualifying Indonesian assets would be given an exemption.

Meanwhile, for institutional investors such as the Employees Provident Fund, Permodalan Nasional Bhd and other fund management companies that have invested in foreign asset classes and are expected to remit most of their foreign-sourced income as part of the distribution of dividends to their investors, investment returns may be affected.

Among the challenges that could crop up next year, says KPMG’s Crist, is how foreign-sourced income “received in” Malaysia would be defined.

“Would this include constructive receipt or deemed receipt? There is no clarification on the definition at this juncture,” he says.

Crist adds that the computation of unilateral or bilateral credit could be complicated while transfer pricing documentation to prove that transactions are made at arm’s length will be increasingly important.

Less explicit but equally detrimental is how existing and potential investors view the country. Stability and visibility are crucial for businesses.

Tricor’s Veerinderjeet says: “The withdrawal may be viewed by investors as suggesting a trend of uncertainty and frequent changes in the Malaysian tax system. Perceived lack of stability alone can sway investment decisions.

“The withdrawal may also lead to perceptions that Malaysia is moving away from a tax system which has proven itself to be stable and reliable — a tax system that has been able to develop and sustain the country through difficult times.”

Veerinderjeet believes the change in FSIE has been rushed. Without a mid-term plan announced on future changes envisaged for the tax system, investors will have a hard time visualising the planned changes to the tax system.

“If there is a mid-term plan available, investors can visualise the planned changes to the tax system and would not be made to bear the consequences of changes introduced annually with no clear rationale or basis other than supposed revenue-generation,” he says.

While it is perfectly acceptable to look at measures to increase government revenue, says Jagdev, any potential situation that could lead to double taxation is perceived to be unfair.

“A holistic approach would be key in ensuring equitable treatment for businesses. The FSIE is a fundamental change in our tax system that has far-reaching effects for both corporates and the rakyat, unlike the Cukai Makmur, which is a one-off measure,” he adds.

Amarjeet believes a mid- to long-term approach with the ultimate aim of generating sustainable increase in tax revenue would have been preferred.

“We can better achieve this through digitalising the tax administration system such that tax leakages from the shadow economy are reduced and, possibly, when the economy is more stable, implementing a broad-based consumption tax,” he says.

It would be a great loss for Malaysia if the withdrawal of the FSIE fails to  generate the expected amount of revenue, with less foreign income being remitted, but instead causes the country to lose out on domestic reinvestments and economic activity.

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