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Focus Malaysia: Taxation in Malaysia: Expense Deduction Dilemma
Repost of publication on Focus Malaysia on 24 August 2019.
The Malaysian tax regime only taxes income. Capital gains (other than gains from real property) is not taxable. All our neighbours except Singapore and Hong Kong brings both income and capital gains to tax.
Are all expenses and outgoings deductible? That is the million-dollar question! The answer is not all expenses are deductible. In order to get the maximum tax deduction, businesses need to think “out of the box” but within the framework of the law to maximise your deductions and minimise your taxes without falling into the anti-avoidance trap.
Tax vs. accounting
It is not uncommon to mistakenly claim an expenditure deduction on the belief that the business has incurred expenses in order to generate income, and therefore it should be deductible. This is not the case because the tax principles supporting the deductibility of expenses is distinct from the expense deductions taken for accounting purposes or outgoings from a cash flow perspective.
Revenue vs capital expenditure
Capital expenditure is not deductible. The exceptions are capital expenditure qualifying for tax depreciation or capital allowances, and any special deductions such as the purchase of treasury shares provided for specifically in the ITA.
To make life difficult for businesses, there is no definition of “revenue” or “capital” in the tax legislation and therefore guidance has to be sought from case laws which are constantly evolving. Broadly, the general principles distilled from the case laws to determine whether the expenditure is capital or revenue are:
- Is it one-off/lump sum or recurring every year?
- Does the expenditure give rise to a permanent or enduring benefit?
- Does the expenditure give rise to an identifiable asset?
- Is the expenditure incurred for working capital or fixed capital purposes?
Overall, the underlying thread that connects all the above principles is for a business to claim a tax deduction, the expenditure has to be incurred on a regular basis and it has to be directly connected to generating the income of the company on a day-to-day basis.
The expenditure becomes a capital expenditure which is not deductible for tax purposes when such expenses give rise to a permanent benefit such as a capital asset. Examples will include incurring research and development expenditure which results in an intangible asset such as a software, or a capital asset such as plant and machinery or making a compensation payment to change the terms and condition of a long-term contract which is beneficial to the payer.
Principles of tax deduction
Tax is governed strictly by tax laws which in Malaysia is principally the Income Tax Act 1967 (ITA). The legislation dealing with the general deduction is stated in Section 33(1) of the ITA.
The key issue that one should pay attention when claiming a tax deduction is whether the expenditure is wholly and exclusively incurred in the production of income during that period.
Wholly and exclusively
The word “wholly” refers to the quantum of the expenditure incurred to generate the income. If the expenditure is excessive and remotely connected to the outcome, then one may not meet the “wholly” test.
The word “exclusively” refers to the motive or objective behind incurring the expenditure. The motive has to be solely in the production of that income. If the expenditure has a dual purpose (e.g. for business and private purposes), strictly, the deduction should not be given.
However, in practice there is some leeway given by the tax authorities based on the “reasonableness approach”. Usually such an approach is not uncommon during negotiations that leads towards a settlement of tax audits or investigations.
Broadly to satisfy the word “incurred”, there must be an obligation to settle the liability or in ascertaining the profits, an accurate estimate of an impending liability can be determined.
In the production of income in that period
The expenditure incurred should result in income in the same year or at a later date. Therefore, businesses can incur expenditure in an earlier period, whilst the income arises in a later period or vice versa.
Can capital expenditure be converted to revenue expenditure?
Yes, it can be legitimately done, provided the taxpayer has the choice and it is a choice that is available to all businesses. An example would be expenditures incurred to build software which will be treated as capital and non-deductible can be converted into a deductible expenditure if the same software was produced by a third party and licensed to the business. Another example would be capital expenditure incurred by a lessee in renovating a leased office building can be converted into revenue expenditure provided the lessor incurs the expenditure and charges a higher rental which is deductible to the lessee.
If one carefully examines the expenses that are not deductible and thinks innovatively to reorganise the expenditure in a way that is commonly carried out by others in the commercial environment, the expenditure can be converted from a capital expenditure to a revenue expenditure.
The key question one should answer positively to avoid being accused of tax avoidance is whether the revamped transaction can be explained in normal commercial terms (i.e. whether other third parties carry out similar transactions in their day-to-day operations).
One can also defend any challenge on the grounds of tax avoidance if it can be shown that the business has incurred an expenditure or a loss in order to obtain a tax benefit.
This is an area that the tax authorities are always challenging taxpayers and attempting to disallow expenses. The best defence against such a challenge is to garner your facts and documentary evidence to show that the transaction undertaken is legitimate, revenue in nature, and was not intended to avoid taxes and obtain a tax benefit without incurring any cost.