KUALA LUMPUR (Nov 16): Effective Jan 1, 2022, a proposal to remove tax exemption on income derived from foreign sources and received in Malaysia by Malaysian residents under Paragraph 28, Schedule 6 of the Income Tax Act (ITA) 1967 was announced in the recent Budget 2022. 

The Proposal to abolish the exemption under Paragraph 28 is stated to be in line with Malaysia’s commitment towards compliance with international best practices.

In accordance with international best practices, granting exemption to foreign sourced income can be a harmful tax practice if it results in double non-taxation.

It should be noted, however, that income derived by Malaysian enterprises and funds overseas are already taxed at the jurisdictions where the income was derived, before repatriation to Malaysia. Hence, exemption of such foreign sourced income from Malaysian tax when received in Malaysia does not give rise to double non-taxation at all, and the exemption should not be viewed as a harmful tax practice. Moreover, it is clear that the exemption does not unfairly impact the tax base of other jurisdictions.

The proposal need not be enacted in the way it has been done. In fact, the proposal represents a knee-jerk reaction to the European Union’s (EU) action to add Malaysia to its "grey list" of non-cooperative jurisdictions for tax purposes, whereby the country was identified as having a “harmful” foreign source income exemption, which had committed to amend or abolish this regime by Dec 31, 2022.

Hong Kong, which has the same territorial tax system as Malaysia, has been reported to have defended its tax system and has also stated that it plans to modify the system to incorporate some substance criteria in the tax legislation in respect of certain categories of income, so as to counter the possibility of double non-taxation that arise, which was the concern expressed by the EU.

Malaysia should also seriously consider such an approach, so that there would not be undue challenges for taxpayers and tax administrators alike, as had been the case when Malaysia last had the “Derived and Remittance” tax system. That system did create more administrative work in terms of assessing and verifying foreign income which was also a consideration when Malaysia decided to switch to the territorial system like that of Hong Kong. In fact, the current territorial tax system is a very efficient one, which is also attractive to investors.

In addition, the Inland Revenue Board had earlier this year issued a Consultation Paper entitled “Withdrawal of Income Tax Exemption under Paragraph 28 of Schedule 6 of the ITA 1967” but this referred to interest income and royalty income to be deemed as foreign sourced income. Professional bodies which responded to the consultation paper did not agree with the suggestion to remove the foreign sourced income exemption (in Paragraph 28, Schedule 6) but provided some constructive suggestions.

Notwithstanding that, there is nothing to prevent the tax authorities from introducing alternative derivation rules that could achieve the objective of imposing income tax on income derived from intellectual property developed in Malaysia and on interest income derived by corporations via Malaysian derived funds lent to overseas corporations. Why has this not been considered?

The proposal may have the serious unintended consequences of discouraging Malaysian companies and individuals from bringing back their foreign income that would be much needed for the economic development of the nation. 

One of the key rationales for the introduction of Paragraph 28, Schedule 6 of the ITA 1967 about 25 years ago to grant exemption for any remittance of foreign income to Malaysia was to encourage taxpayers who derived income overseas to repatriate their profits back to Malaysia, thereby contributing to the country’s foreign exchange earnings and the funds needed for nation building. In response to the growing trend of globalisation of trade and businesses, many Malaysian enterprises have ventured overseas to exploit business opportunities available outside the country. The pace of globalisation/regionalisation will certainly gather even greater momentum when the Regional Comprehensive Economic Partnership takes effect from the beginning of 2022.

If the exemption in Paragraph 28 is abolished pursuant to the Proposal stated above, Malaysian enterprises deriving foreign income will be encouraged to keep such income outside Malaysia. Even if some of them decide to repatriate some of their foreign income, the implementation of this proposal will not necessarily turn out to be a revenue generating proposal. This is because the foreign tax paid on the foreign income which is remitted to Malaysia would be allowed as a credit claim against the income tax Malaysia would impose. The result is that not only will there be little generation of additional Malaysian taxes but the country’s foreign exchange earnings will be severely and adversely impacted by the non-remittance of the foreign income into Malaysia.

As stated above, the exemption was formulated to encourage Malaysian enterprises to grow into competitive global enterprises, while continuing to repatriate their foreign profits to Malaysia. An abolishment of the exemption at this moment is most untimely, when the country requires inflow of funds from both Malaysian and foreign investors to support and spur the recovery of the national economy, which is a key focus of the Budget.

Malaysian funds that invest abroad will also be disadvantaged, as the foreign income remitted by the funds is now taxable. Investors may then invest through foreign funds or foreign vehicles, instead of Malaysian funds, as the additional tax cost will reduce the investment returns. Ultimately, this would result in movement of funds abroad to invest in foreign funds. The proposal introduced in Budget 2022 exempts non-residents from income tax on foreign income remitted into Malaysia.

The proposal to withdraw the exemption in Paragraph 28 would have a huge impact on the investment landscape and tax system in Malaysia, despite what the Minister of Finance has stated. 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. What makes things worse is that there is no mid-term plan announced on future changes envisaged for the tax system so that investors, both domestic and foreign, can visualise the planned changes to the tax system and not be made to bear the consequences of changes introduced annually with no clear rationale/ basis other than supposedly revenue-generation.

While abolishing the exemption under Paragraph 28 is unlikely to generate much tax revenue as explained above, it will certainly create the need to deal with challenges arising from the change, e.g., situations involving “deemed remittance” for tax purposes, tracing of income if the amount is reinvested/co-mingled with other income outside Malaysia before being remitted into the country, determination of foreign tax paid to be deducted against Malaysian tax applicable, etc. All these will, undoubtedly, result in a higher cost of compliance for both taxpayers and the tax authorities, without meaningful contributions to tax collection. From simplicity, the Government policy makers have moved to make things more complex for taxpayers. That certainly will not sit well when all are coming out of a pandemic with so many challenges and impact to profitability faced by so many entities.

A number of issues arising from this proposal need to be considered. These include:

The proposal is not a well-thought out measure. By a stroke of the pen, the Minister of Finance is relegating Malaysia to the back of the pack in the competitiveness stakes. The proposal cannot be a revenue generating measure, as the parties that one expects will bring back foreign income will not do so and funds will now move outside. It is hoped that sense will prevail in the end.

Dr Veerinderjeet Singh is Non- Executive chairman of Tricor Malaysia and President of the Malaysian Institute of Certified Public Accountants (MICPA).