NEWS & DEVELOPMENTS MALAYSIA NEWS & DEVELOPMENTS. TAXAND EVENTS page 8 MALAYSIA INTERNATIONAL

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1 TAX nsights An Occasional Series 2/2007 NEWS & DEVELOPMENTS MALAYSIA Real Property Gains Tax (RPGT) page 1 Iskandar Development Region page 2 Customs Rulings page 2 Islamic Financial Services Sector page 3 Labuan page 4 Decision Impact Statements page 5 Double Tax Agreements page 5 INTERNATIONAL China page 6 India page 6 Canada page 6 U.S.A page 6 Indonesia page 7 Taiwan page 8 TAXAND EVENTS page 8 W e are pleased to issue the next edition of Tax Insights, the TAXAND MALAYSIA Newsletter which is issued from time to time on local and international developments which may be relevant to clients. From a TAXAND perspective, our Global network continues to grow and we now have member firms in 38 countries. Firms in three new countries, namely, Australia, Finland and Denmark have recently joined the TAXAND network. Our global network continues to work cohesively to provide professional services to our clients to the highest standards. The following developments, both in Malaysia and overseas, are of interest and are important to businesses locally as well as those overseas. NEWS & DEVELOPMENTS MALAYSIA Real Property Gains Tax (RPGT) On 22nd March 2007, the Prime Minister announced at the Invest Malaysia Conference that an exemption from RPGT would be available with effect from 1 April This announcement was followed up by the Real Property Gains Tax (Exemption) (No.2) Order 2007 which provides an exemption from RPGT in respect of all disposals of chargeable assets after 31 March The promptness with which the gazette order was released was welcomed together with the clarification from the Ministry of Finance that the exemption applied to all persons and that acquirers of real property were also exempt from the obligation to file returns on acquisitions of real property. The exemption has been well-received and is expected to spur the growth of the property sector. The question arises however as to why this was implemented in the form of an exemption order rather than a repeal of the RPGT Act Do we anticipate that the Government will reintroduce RPGT once the growth of the property development sector has been achieved? This is a possible likelihood. Therefore, taxpayers with property assets seeking to unlock the value of these or seeking to streamline group properties should take the opportunity to address how best to achieve their needs sooner rather than later. It is also possible that in the wake of the RPGT exemption, the stamp duty rate may be increased in the future. Therefore, it is best to implement any property reorganisation strategies promptly. There are benefits to be gained from reviewing property assets to determine how best to unlock the value of these effectively. A further important point to note is that not all property transactions will be altogether tax-free. While these will no longer be subject to RPGT, the possibility of transactions being subjected to income tax remains. Where companies and individuals acquire and sell real properties such that a trading pattern emerges, such transactions will be subject to income tax. Therefore, to determine whether 1

2 a property transaction will be subject to income tax, the ageold questions of whether the gain is capital in nature or revenue in nature and whether the badges of trade exist need to be addressed. For instance, where property developers dispose of investment properties rather than trading stock, they would need to ensure that adequate support is available to argue that investment properties were not acquired with a trading intention in mind. There are several planning opportunities available to allow for freeing up the value of assets while streamlining and strengthening the efficiency of the use of property assets. Iskandar Development Region Another exciting development for Malaysia is the announcement of the incentive package for the Iskandar Development Region (IDR) in South Johor. This area has been earmarked by the Government to attract foreign investment into Malaysia and will offer attractive fiscal and non-fiscal incentives to foreign investors. On 22 March 2007, the Prime Minister announced the following incentives: Corporate income tax exemption for specific qualifying activities carried out within specific approved zones in the IDR for clients/customers located in the IDR and for those located outside Malaysia for 10 years upon commencement of operations Withholding tax exemption on royalties and technical fees for 10 years upon commencement of operations Exemption from Foreign Investment Committee rules Freedom to source capital globally Unrestricted employment of foreign employees within the specific approved zones Further details of the incentive and support package will be announced in due course by the Iskandar Regional Development Authority (IRDA). The latter will operate as a one-stop centre to deal with investors and to receive and process applications, etc. Aside from the tax incentives, the freedom to structure entities as 100% foreign owned companies and to source human capital without immigration restrictions are exciting developments for Malaysia. While the proposed tax incentives are attractive, the fact that the incentives will only apply in respect of services provided to customers in the IDR and outside Malaysia restricts the application of the incentives. This limitation is arguably deliberate to prevent Malaysian companies operating elsewhere in the country from relocating to the IDR purely for tax incentives. The incentives are aimed at attracting foreign investment which would not otherwise have considered locating their operations in Malaysia. Customs Rulings Further to the announcements in the 2007 Budget, the legal framework for obtaining rulings in relation to indirect tax matters, broadly known as Customs Rulings has been introduced through changes to the Customs Act 1967, Sales Tax Act 1972, Service Tax Act 1975 and Excise Act Effective from 1 April 2007, Customs Rulings may be sought in relation to the following matters: product classification; valuation of goods and services; determination of taxable persons and services; and other matters as prescribed by the Director General of Customs. Rulings are issued via a formal application process, and applicants seeking a Ruling will be required to pay a fee of RM200. Rulings will be based on information supplied by applicants which necessitates ensuring that information provided is accurate and complete. It is expected that Rulings will be issued within a 90-day period (from the date of submission) as stipulated in the Regulations, unless the information furnished by the applicant is insufficient or additional analysis is required to be conducted. It is encouraging to note that the turn-around time for the issuance of Rulings has been clearly stipulated. Customs Rulings will be valid for a period of three (3) years from the date of issuance unless the Rulings are cancelled in writing or otherwise cease to have effect under the respective Acts. Under each of the Acts, there are provisions to allow the Director General to amend, modify or revoke a Customs Ruling by giving written notice under certain circumstances. On the basis that a Ruling remains valid for the three years, the ruling can be further renewed for a period of two (2) years from the date of its original expiry. If an applicant is dissatisfied with a Customs Ruling, the applicant may appeal to the Customs Appeal Tribunal within 30 working days from the date of issuance of the Ruling. 2

3 Notwithstanding the above, where the Director General is of the opinion that a Ruling has been obtained by way of fraud, misrepresentation or falsification of facts, the Ruling may be declared to be null and void. Islamic Financial Services Sector The Islamic Financial Services sector was given a boost in the 2007 Budget with the announcement of several generous tax incentives for Islamic banking, stock broking, fund management, etc. Several of these incentives have recently been gazetted, including those outlined further below. As Islamic finance is fast becoming an alternative to conventional methods of financing, it is useful to understand some of the more common methods of financing and terms referred to in the exemption orders mentioned below: An International Takaful Operator means a takaful operator registered under the Takaful Act 1984 which carries on a takaful business in any currencies other than Ringgit Malaysia. An International Currency Business Unit (ICBU) means a unit within any of the following: (a) an International Islamic Bank as defined above (b) a licensed institution under the Banking and Financial Institutions Act 1989 and approved to carry on Islamic banking businesses in any currencies other than Ringgit Malaysia under section 124 of the same Act; or (c) an international takaful operator as defined above. Qualifying Ringgit Account is an account of investment made in Ringgit Malaysia which is related and incidental Mudharabah Musyarakah Ijarah Istisna This is a profit-sharing arrangement made between two parties i.e. the bank and the borrower. The concept allows the use of the funds for the borrower s business purposes, with profits being shared between the parties on pre-arranged terms. Losses will be borne by the bank, unless these arise through the willful default or negligence of the borrower, etc. This is a joint venture arrangement between the bank and the borrower to undertake a specific business venture. The profits will be shared according to a pre-agreed ratio, and losses, if any, will also be borne based on agreed terms. This refers to a leasing arrangement where the bank leases the asset to the lessee at agreed lease rentals. This refers to a sale and purchase agreement whereby the bank acquires the asset and sells this to the borrower on a deferred sale basis. The borrower pays for the assets in installments which would cover the bank s cost as well as a profit element. Tax Exemption for Islamic Financial Institutions on Transactions in International Currencies International Islamic Banks, International Takaful Operators and International Currency Business Units are now exempt from income tax in respect of statutory income from their businesses and from Qualifying Ringgit Account investments. (Note that the entities concerned must be approved by the Central Bank). The exemption applies from the years of assessment 2007 to An International Islamic Bank is defined as an Islamic bank licensed under the Islamic Banking Act 1983 which carries on an Islamic banking business in any currencies other than Ringgit Malaysia. to the business of the categories of qualifying persons mentioned above. The above exemption is given pursuant to the Income Tax (Exemption) (No.12) Order 2007 What is the Impact of This Exemption? Clearly, the exemption is attractive to the qualifying financial institutions and encourages such institutions to undertake Islamic transactions in international currencies. Conventional banks which have been granted approval by Bank Negara to operate Islamic 3

4 banking windows would qualify under (b) of the ICBU definition for the exemption. The Exemption Order requires that separate accounts be maintained with respect to the exempt activities and other sources of income. This would clearly be necessary in order to accurately compute tax exempt income. Several conventional banks have already obtained Bank Negara s approval to operate Islamic banking windows, while others have actually set up separate Islamic banks. Where an Islamic bank is established, it is imperative that procedures and policies be implemented to ensure that all transactions are Syariah-compliant. Conventional banks undertaking Islamic banking activities through windows would also need to implement such procedures and policies to ensure that the activities undertaken by these windows are in compliance with Syariah principles. Implementing such procedures within a conventional bank may be more onerous and difficult to manage than in a stand-alone entity. Further, Bank Negara s presentation and disclosure requirements for Islamic financial transactions would need to be adhered to and reference would also need to be made to the international reporting standards promulgated by the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI). Additionally, policies would need to be formulated to ensure that proper procedures are implemented for accounting and reporting of Zakat. Tax Exemption for Special Purpose Vehicles (SPVs) issuing Islamic Securties. SPVs which are established for the purpose of issuing Islamic securities are exempt from income tax in respect of their statutory income derived from the issuance of such securities. Islamic securities for the purposes of this exemption refers to securities approved by the Securities Commission, which adopt the principles of Mudharabah, Musyarakah, Ijarah or Istisna (This exemption is granted pursuant to the Income Tax (Exemption) (No.14) Order 2007) Tax Deduction for Expenditure on the Issuance of Islamic Securities A deduction will be given for expenditure incurred on the issuance of Islamic securities approved by the Securities Commission pursuant to the principles of Mudharabah, Musyarakah, Ijarah and Istisna. The deduction will be given for the years of assessment 2008 to Expenditure incurred on Islamic securities issued pursuant to any other Syariah principles approved by the Minister of Finance will also be deductible for the years of assessment 2007 to (These deductions are available pursuant to the Income Tax (Deduction for Expenditure on Issuance of Islamic Securities) Rules 2007). Labuan Several new orders have been gazetted to extend the preferential tax treatment for individuals working in Labuan to the year of assessment These are as follows: Non-citizen individuals will be exempted from income tax in respect of directors fees received from an offshore company. This exemption will be effective from the year of assessment 2007 until 2010 (Income Tax (Exemption) (No.3) Order 2007). Non-citizen individuals working in a managerial capacity with a Labuan trust company or offshore company will be exempted from income tax in respect of 50% of their employment income from these companies (Income Tax (Exemption) (No.4) and (No.7) Order 2007). A Malaysian citizen will be exempted from income tax in respect of 50% of the gross housing and Labuan Territory allowances received from exercising employment in Labuan with the Federal or State Government, a statutory body or an offshore company (Income Tax (Exemption) (No.5) Order 2007). A person providing qualifying professional services to an offshore company will enjoy an exemption on 65% of the statutory income from that source. In this context, qualifying professional services is defined to mean legal, accounting, financial or secretarial services and includes services provided by a Labuan trust company. The exempt income will be credited to an exempt account from which exempt dividends can be paid (2-tier exemption) (Income Tax (Exemption) (No.6) Order 2007). The Government has been focusing some attention on Labuan as it appears to be losing its competitive edge as an international offshore financial centre. Further, several countries with which Malaysia has entered into double tax 4

5 agreements (DTAs) have in recent years excluded Labuan from the scope of the DTAs. Therefore, the Government is taking heed and there are indications that changes may be introduced to the relevant legislation, and these are likely to be announced in the forthcoming 2008 Budget or even earlier. Decision Impact Statements The Inland Revenue Board (IRB) has recently issued three Decision Impact Statements setting out its opinion on tax cases heard at the Court of Appeal. The Decision Impact Statements do not amount to public rulings, but instead these serve to make public the IRB s position on these cases. Decision Impact Statements are therefore useful and are indicative of the IRB s move to be more transparent in its efforts to encourage tax compliance. However, from a legal perspective, the case law precedents remain and taxpayers are not therefore obliged to follow the IRB s view in the Decision Impact Statements and are not required to disclose this in the filing of their tax returns. However, as the IRB has made its views public, taxpayers should note that where the IRB is aware of the fact that taxpayers have followed case law precedent with which the IRB disagrees, the IRB is likely to challenge these in court. Decision Impact Statements have been released for the following cases: - Exxon Chemical (M) Sdn Bhd v. Ketua Pengarah Hasil Dalam Negeri ( KPHDN) - Penang Realty Sdn Bhd v. KPHDN - Teruntum Theatre Sdn Bhd v. KPHDN The IRB disagreed with the decisions of the Court of Appeal in the Exxon and Penang Realty cases. Double Tax Agreements Malaysia signed a double tax agreement (DTA) with the Seychelles in December This was gazetted mid last year, but it is effective in Malaysia from 1 January However, the effective date applicable to petroleum income tax (for Malaysia) is 1 January A DTA was also signed with Venezuela in August 2006, which has recently been gazetted (in May 2007) and is currently pending ratification. In addition, it is useful to note the following DTAs which are at various stages pending ratification, as well as those currently under negotiation. The status of DTAs as of 31 May 2007 is listed below: DTAs gazetted but not ratified Chile Iran Morocco Myanmar Saudi Arabia** Syria Venezuela Zimbabwe * New Agreement ** Full Agreement DTAs signed Kazakhstan Spain DTAs initialed Bosnia Brunei Germany * Oman Yemen DTAs under negotiation Brazil Canada* Finland* India* Laos Mexico Norway* Portugal Qatar Russia* South Korea* Tunisia Uruguay Ukraine 5

6 INTERNATIONAL China Significant Changes to the Tax Regime China has recently implemented several significant tax changes, many of which impact Foreign Investment Enterprises (FIEs). Prior to these changes, FIEs and domestic enterprises were subject to different tax treatment, with significant benefits for FIEs, many of whom enjoyed effective tax rates of close to zero as a result of tax holidays and reinvestment credits. Since the changes, many of the incentives previously enjoyed by FIEs have now been removed, although a five-year interim period is permitted for existing incentives, after which the incentives will not be available. It is plausible that incentives may still be available for certain promoted industries or that new incentives will be formulated for such industries. Further, certain international tax concepts including thin capitalization, controlled foreign company (CFC) rules and arm s length pricing have been introduced into the tax regime in China. Malaysian companies operating in China and other multi-nationals doing business in China who have enjoyed incentives will need to revisit their investment structures in China. India Special Economic Zones (SEZs) One of the attractions of India as an investment location has been the existence of SEZs which offered a variety of direct and indirect tax incentives. However, there have been serious concerns about revenue leakage to the Government as a result of SEZs and the Government is currently reviewing the broad scope of rules which apply to SEZs. To this end, it has set up an Empowered Group of Ministers (EGoM) to study the impact of SEZs on the economy as a whole. The EGoM has made several recommendations, some of which have been enacted. The EGoM has effectively recommended that the area for multi-product SEZs be restricted in size to 5,000 hectares, which will affect developers who have planned large multi-sectors SEZs. Many of the changes and rules apply to developers/contractors of SEZs rather than businesses operating in SEZs. These rules are to ensure that the development and construction within SEZs are closely monitored. Canada Withholding tax on Reimbursements Under Canadian tax law, payments to non-residents in respect of fees, commissions or other amounts in respect of services rendered in Canada are subject to withholding tax. In a recent Canadian tax case, the question arose as to whether amounts paid to a nonresident service provider for out-of-pocket expenses and for the latter s travel to and from Canada were also subject to withholding tax. The court held that withholding tax applied for services and that this would mean payments which were income in nature to the recipient. It held that several of the reimbursements were not income in nature to the recipient, nor were the travel costs to and from Canada. These amounts were therefore not subject to withholding tax. However, travel within Canada amounted to income earned in Canada and hence withholding tax was applicable on such costs. This decision is interesting, particularly given the Malaysian Inland Revenue Board s (MIRB) wide interpretation of the Malaysian provisions in relation to withholding tax on fees for services rendered in Malaysia by non-residents. The MIRB has clearly expressed the view that out-of-pocket expenses and travel costs charged by non-residents are subject to withholding tax as these are inextricably linked to the provision of services. The argument that such payments are not income has not been accepted by the MIRB. U.S.A Tax Dispute Settlement Earlier this year, Merck & Co. Inc, a U.S.A based pharmaceutical giant, reached an agreement involving one of the largest tax dispute resolution payments to the Government of approximately USD 2.3 billion in federal taxes together with interest and penalties. The settlement resulted in a resolution of issues from the years To reach a settlement of this size, both parties had to cooperate and various strategies were adopted including the Fast Track Settlement Program. 6

7 The Fast Track Settlement program (FTS) aimed primarily at large tax liabilities adopts a customer-driven approach to tax dispute resolution at the earliest possible stage in the audit process. The FTS program involves the provision of an Independent Appeals Review of the dispute where both parties will be entitled to voice their concerns/issues. The aim behind the FTS is to use the mediation skills of the Independent Appeals Review and to reduce the length of time that it would otherwise take to resolve such disputes with the tax authorities. This approach seeks to ensure a mutually agreeable settlement to both parties, without recourse to the Courts. Indonesia Treaty Shopping - Case I The Indofood International Finance Ltd v. JP Morgan Chase Bank NA case which was recently heard by the Indonesian Supreme Court has given rise to great interest in tax circles. The facts of the case are briefly as follows: - Indofood International Finance Ltd. (Indofood) was incorporated as a special purpose vehicle (SPV) in Mauritius as a subsidiary of an Indonesian public company (IPC) to raise finance for IPC. - Indofood raised financing via JP Morgan, London in the international bond market. - The finance raised was then provided as a loan by Indofood to IPC, and interest payments from IPC to Indofood were subject to the reduced withholding tax rate of 10% based on the Indonesia/Mauritius double tax agreement (DTA). - Subsequently, the Indonesia/Mauritius DTA was revoked and the interest payments would no longer enjoy the reduced 10% rate. - JP Morgan suggested that a new SPV to replace Indofood be formed in the Netherlands (NCo); that the bonds owed by Indofood be novated to NCo; and that the loan owing from IPC to Indofood be assigned to NCo. - Indofood disagreed and a dispute arose between the parties. The case eventually came before the U.K. Court of Appeal on a few matters. The key point for tax purposes centred around the question of whether the new structure using NCo would also enjoy the same reduced withholding tax rates (available under the Netherlands/Indonesia DTA). The Court of Appeal held that the reduced withholding tax rate would not apply. The primary reason for this was because NCo could not be regarded as the beneficial owner of the interest paid to it by IPC. Under the Netherlands/Indonesia DTA, the reduced withholding tax rate applied where the recipient of the interest was the beneficial owner of that interest. Beneficial ownership may generally be taken to mean ownership for one s own benefit, rather than on behalf of another party. However, the Court of Appeal was influenced by the OECD model commentary which provides that in determining the question of beneficial ownership, one needs to consider the broader objective of the DTA which is essentially to avoid double taxation AND to prevent fiscal evasion and avoidance. On this basis, it was felt that the main reason in this instance for the new Dutch structure was to avoid the higher withholding tax liability without any true commercial substance to the arrangement. The SPV was set up merely to route the funds to IPC and for no other conceivable reason. It was therefore merely a pass-through vehicle with no substance. While this case has attracted great interest in tax circles, it arguably does not establish any new precedent. It does not rule against treaty shopping per se, but instead requires that transactions routed through treaty countries which procure a tax advantage should be commercially driven and must have commercial substance. Treaty Shopping - Case II In another Indonesian case, PT. Indah Kiat Pulp & Paper Tbk v. U.S. Bank National Association et. al., the legality of transactions between an Indonesian company, Indah Kiat Pulp & Paper (IKPP) and its wholly owned Netherlands subsidiary (Indah B.V.) was disputed on the basis that the transactions were routed through Indah B.V. primarily for tax purposes. - Indah B.V. issued bonds to bondholders in various countries, the proceeds from which were routed to IKPP as a loan. - IKPP acted as a guarantor to the bondholders in respect of Indah B.V. s obligations to repay the bonds. - The interest payments on the loan from IKPP to Indah B.V. attracted withholding tax at the reduced rate of 10% pursuant to the Netherlands/Indonesia DTA. 7

8 - Several years later, the bonds were to be repaid by Indah B.V., who was unable to fulfill its obligations. - Redress was sought from IKPP as the guarantor, but the latter refused to honour its obligations, and challenged the legality of the transactions it had entered into with Indah B.V. - IKPP argued that the transactions were illegal and hence were null and void on the basis that the arrangements violated Indonesian tax law (as the structure was entered into purely to obtain the tax benefit of reduced withholding tax rates). Further, in this instance the guarantor was also the borrower which was contrary to Indonesian security laws. - The Supreme Court agreed that the structure was implemented solely to obtain a tax benefit, and therefore the agreements were void. The decision in the Indah Kiat case seems to come out more strongly against treaty shopping than the Indofood decision. Ultimately however, commercial substance was lacking in both cases, which is a key aspect in challenging tax avoidance cases. Taiwan Payment for Software The Taiwanese authorities have issued a tax ruling clarifying the tax treatment of payments to non-residents for software. The ruling provides that payments for standard unmodified software (e.g. shrink-wrapped software) which do not allow the buyer to reproduce, modify, transfer or publicly display the software would be treated as a purchase of goods and therefore the income to the non-resident would not be treated as a royalty subject to withholding tax. Further, purchases of standard unmodified software via resident Taiwanese distributors would also be regarded as a purchase of goods rather than payments of royalties. In this instance, the software would include programmes downloaded from the internet or purchased on discs which are installed by the distributors onto the purchasers hardware. Again, the purchasers would not be entitled to reproduce and modify the software, etc. Standard unmodified software typically refers to software that is not designed specifically for the user and which is acquired with the right to use this on an agreed number of computers, etc. Payments for such software would not therefore amount to royalties. The approach of the Taiwanese authorities is in line with the approach that has been taken in an increasing number of tax jurisdictions which essentially focuses on the difference between payments for use of software rather than payments for the underlying rights to the software. Payments which fall into the latter category would generally amount to royalties. The Malaysian tax authorities have yet to issue any rulings to clarify the treatment of such payments from a Malaysian tax perspective. TAXAND EVENTS 30 & 31st May 2007 TAXAND MALAYSIA held a successful workshop on Double Tax Agreements Effective Cross-Border Planning 18 September 2007 Forthcoming Seminar: Strategising for Growth Tax & Business Developments and the 2008 Budget Highlights. This seminar will include speakers from China and India to share their experience on tax and business matters in these fast-growing economies. This seminar will also address Malaysian developments including the Iskandar Development Region and the 2008 Budget. Details of the seminar will be released shortly DISCLAIMER: The information contained in this newsletter is intended only to be a guide. It must not be relied on in, or applied to, specific situations without previously seeking proper professional advice. Even if all reasonable care has been taken in its preparation, Taxand Malaysia Sdn Bhd and all the members of the Taxand Network do not accept any liability for any errors or omissions that it may contain before being issued, whether caused by negligence or otherwise, or for any losses, however caused, or sustained by any person or entity. Descriptions of, or references or access to, other publications within this publication do not imply endorsement of them. TAXAND MALAYSIA SDN BHD ( X) Suite 13A.05, Level 13A, Wisma Goldhill, 67 Jalan Raja Chulan, Kuala Lumpur, Malaysia T F E info@taxand.com.my 8