Effective from 1 January 2022, Foreign-sourced income (FSI) received in Malaysia will be taxed. Prior to Budget 2022, FSI is not subject to tax in Malaysia, except for certain activities, such as banking, insurance, and air and sea transport operations.
References - Income Tax Act, 1967
Section 3 of the Income Tax Act, 1967 (ITA) states that “income shall be charged for the income of any person accruing in or derived from Malaysia or received in Malaysia from outside Malaysia”. The phrase accruing in or derive from Malaysia means the source of income must be in Malaysia
With effect from YA 2004, foreign source income derived from sources outside Malaysia and received in Malaysia by any person is not subject to Malaysian income tax
Section 12 of the Income Tax Act, 1967 is about the determining the source of income or derivation of income
The tax exemption is stated in the Schedule 6, Paragraph 28 of the Income Tax Act, 1967 - click the link below for the PDF copy of the Schedule 6;
Budget 2022 proposal, Finance Bill 2021 and Finance Act 2021
It is proposed in Budget 2022 on 29 October 2021, that the foreign-sourced income of Malaysian tax residents which is received in Malaysia be taxed - effective from 1 January 2022. The Finance Bill 2021 has been passed with some amendments and the MOF has issued a media release dated 30 December 2021 on the amendments and subsequently, the Finance Act 2021 has been gazetted and published on 31 December 2021 with the following amendments:
Company and LLP who received Dividend Income as FSI in Malaysia, will be exempted from tax - for the period from 1 January 2022 to 31 December 2026.
Individual who received all types of FSI in Malaysia will be exempted from tax - for the period from 1 January 2022 to 31 December 2026, except for those individuals who carrying out partnership business in Malaysia will be subject to tax for the FSI received in Malaysia effective from 1 January 2022.
The above is subject to eligibility conditions that will be detailed in the LHDN Guidelines to be issued.
How to determine income derived from Malaysia or Outside Malaysia (Foreign-Sourced)
Derivation of income is defined in Section 12 of the ITA.
Determining the source of income is indeed difficult and often open to discussion and also can be complex and contentious. There is no exact guide that can be applied to every scenario to determine whether an income is Malaysian-sourced or foreign-sourced. It depends on the nature of the income and of the business transactions which give rise to such income.
Generally, the income shall be deemed derived from outside Malaysia if the income is attributed directly to activities conducted outside Malaysia. The burden is on the tax payer to prove that his income is foreign-sourced.
As per the Section 12(1)(a), gross income that is not attributable to operations of business carried on outside Malaysia would be deemed Malaysian derived income.
Therefore, if the gross income is related to the work performed outside Malaysia and the taxpayer wishes to treat it as foreign source income, the taxpayer would need to substantiate that it is attributable to operations of business carried on outside Malaysia.
General points to consider in determining source of income
Where does the contracts concluded - in Malaysia or Outside Malaysia?
Whether the ownership risk of the business is in Malaysia or Outside Malaysia
Whether services are rendered in Malaysia or Outside Malaysia
Application of Section 12 (1) & 12 (2):
Section 12 (1) says that if the taxpayer cannot prove that his/her business operation is conducted outside of Malaysia, it will then be considered to be conducted in/from Malaysia. - A case study; DGIR v Aneka Jasaramai Ekspress Sdn Bhd (2005), which concerned income from ticket sales in Singapore of a Malaysian transport company. The Courts held that the said income was sourced in Singapore, therefore, not subject to Malaysian income tax.
Section 12 (2) says that any dividend or interest income which relates to a business in Malaysia will be considered as Malaysian income, and therefore subject to Malaysian income tax. - A case study; DGIR v Cardinal Health Malaysia Sdn Bhd In Malaysia (2011), the Special Commissioners of Income Tax, the High Court and the Court of Appeal has affirmed that interest income derived by a taxpayer from loans made to an offshore entity is foreign-sourced and therefore not subject to Malaysian income tax. The DGIR argued that the interest income was in fact sourced in Malaysia as the funds lent were generated from business activities of the taxpayer in Malaysia and transmitted from the taxpayer's bank account in Malaysia. The Court of Appeal affirmed the judgment of the High Court that the source of the interest income is located "where money was lent", and it followed that what had been done to earn the income was the placement of the funds in the Netherlands. Therefore, the interest received by the taxpayer from its related company in the Netherlands is foreign-sourced income and not subject to Malaysian income tax.
Section 12 (3) and 12 (4) was introduced in Finance Act 2018 and gazetted on 27 December 2018.
Briefly on Section 12 (3) & 12 (4):
Section 12 (3) says that other than the derivation of business income stated in Section 12 (1) and (2) of the ITA, the income of a person who has a place of business in Malaysia will be subject to tax in Malaysia.
Section 12 (4) provides the list of what will be included under "a place of business in Malaysia", that is;
a) a place of management
b) a branch
c) an office
d) a factory
e) a workshop
f) a warehouse
g) a building site, or a construction, an installation or an assembly project
h) a farm or plantation
i) a mine, an oil or gas well, a quarry or any other place of extraction of natural
resources.
Section 12 (3) & (4) applicable for a non-DTA (double tax avoidance agreement) person who were to carry out a business in Malaysia via arrangements or via places which fall under Section 12 (3) & 12 (4) above, of which, he will be considered to be carrying on a business in Malaysia and subject to income tax in Malaysia.
The above factors are not conclusive on their own and must be considered collectively.
We wish to advise you to consult your accountants, auditors and tax agents extensively before determining foreign-sourced income, due to the complexity of the law and the diverse range of income and circumstances.