Professional Level Options Module, Paper P6 (MYS) All statutory references are to the Income Tax Act 1967, as amended, unless otherwise stated.

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2 Professional Level Options Module, Paper P6 (MYS) Advanced Taxation (Malaysia) June 2011 Answers All statutory references are to the Income Tax Act 1967, as amended, unless otherwise stated. 1 Buatan Sdn Bhd Excellent Tax Services 1, Goode Street Kuala Lumpur 6 June 2011 The Financial Controller Buatan Sdn Bhd Kilang Road Kajang Dear Sir, Income tax for the year of assessment 2010 and the allowance for increased exports Further to our meeting on 3 June 2011, we set out below our report on the tax aspects of Buatan Sdn Bhd (Buatan) for the year of assessment 2010 as instructed. (a) Eligibility for the allowance for increased exports Buatan qualifies for the allowance for increased exports because it fulfils all the requisite conditions as listed below: It is a company resident in Malaysia. It is directly engaged in the manufacturing of furniture. It exports a manufactured product i.e. furniture, in the basis period for a year of assessment. Furniture, the manufactured product exported by Buatan, is not a specifically excluded product [per Schedule of PU(A) 128/1999 as amended by PU(A) 309/2002]. Its manufactured product (i.e. furniture) has attained the minimum thresholds (30% or 50%) of value added. Buatan has not been granted any tax incentives for the year of assessment Therefore Buatan is not excluded from claiming the allowance for increased exports as it does not enjoy any tax incentives [under the Promotion of Investments Act or Schedule 7A of the Income Tax Act] in the year of assessment Buatan is eligible for the allowance for increased exports for the first time in the year of assessment 2010 because this is the first year of assessment it has registered an increase in exports over the exports of the immediately preceding basis period, i.e. that for the year of assessment Computation of chargeable income for the year of assessment 2010 Please refer to the attached computation of chargeable income for Buatan for the year of assessment (i) Computation, absorption and exemption of the allowance for increased exports Computation The allowance for increased exports is based on the increase in exports recorded in the year of assessment 2010 over the preceding year. The increase is RM450,000. As Buatan has attained more than 50% in value added, the allowance is 15% of the value of the increased exports i.e. 15% of RM450,000 which yields an allowance of RM67,500. Absorption The allowance is set off against the statutory income from the furniture manufacturing business, but it is restricted to 70% of the statutory income each year. Thus the amount that may be absorbed in the year of assessment 2010 is restricted to RM49,000 (70% of RM70,000). The balance of RM18,500 may be carried forward to be similarly set off against 70% of the statutory income of the manufacturing business in future years until the allowance is completely absorbed. There is no time limit to the carry-forward of any unabsorbed allowance as long as the manufacturing business source continues to subsist. Exemption As soon as an amount of allowance for increased exports is absorbed, the said amount may be credited into an exempt account and a tax exempt dividend may be paid out of the exempt account to the extent of the available credits therein. Such an exempt account must be maintained and kept updated to track the crediting of exempt income and the debiting of the distribution of exempt dividends, until the credits are fully utilised. Shareholders who receive such tax exempt dividends are exempted from income tax in respect of such dividends. A corporate shareholder may similarly credit such exempt dividend into its exempt account and on-pay exempt dividend to its own shareholders. However, there is only a two-tier exemption allowed, i.e. the exemption benefit cannot be passed on to another subsequent corporate shareholder. 13

3 (ii) Tax savings in the year of assessment 2010 and potential tax savings in future arising from the allowance. Buatan will be able to save taxes of RM12,250, being 25% of the amount of the allowance absorbed of RM49,000 in the year of assessment However, as the approved donation would otherwise have qualified for a larger deduction, the effective tax saving is reduced by up to RM4,900 (10% of RM49,000). The balance of RM18,500, when absorbed in future, will save a further RM4,625 assuming a tax rate of 25%. Further, if Buatan continues its uptrend in exports and continues to attain the prescribed threshold of value added content, the allowance for increased exports will continue to apply in the years to come and bring a continuous stream of tax savings at the prevailing tax rate. (iii) Tax treatment of unabsorbed business loss brought forward and current year business loss As seen in the tax computation, the unabsorbed business loss brought forward from the manufacturing business can be set off against the current year statutory business income from the manufacturing business. The current year business loss incurred by the retail business can also be set off against aggregate income made up of all sources of income other than the franked dividend. Tutorial note: in both cases any unabsorbed amount could have been carried forward and set off against the total statutory income from all businesses in future years. (iv) Tax treatment of the approved cash donations The approved cash donation is deductible against aggregate income after deducting the current year business loss. The amount deductible is restricted to 10% of aggregate income, i.e. RM3,100. The unabsorbed donation amount, whether due to the above restriction or due to an insufficiency of aggregate income, cannot be carried forward. (v) Tax treatment of Malaysian franked dividend income During the transition from the imputation system to the single-tier system, Malaysian franked dividends are taxable. However, there is a different treatment prescribed for such dividends. The statutory income (i.e. after deducting any allowable expenses) from such dividends only enters the computation at the total income stage. This results in dividend income not forming part of the aggregate income. It follows that no part of the dividend income is available to absorb either the current year business loss or the approved donation. As before, imputation credit by way of s.110 set-off continues to be available against the tax charged to arrive at the tax payable. We hope that the above explanations serve to clarify Buatan s tax position. Should you require further clarifications or our assistance in preparing the claim for the allowance for increased exports, please do not hesitate to contact us. Yours faithfully,... Principal Consultant Excellent Tax Services 14

4 Appendix Buatan Sdn Bhd Chargeable income for the year of assessment 2010 RM RM Statutory income from manufacturing business 70,000 Computation of allowance for increased exports: FOB value of exports in YA2010 1,450,000 FOB value of exports in YA2009 (1,000,000) Value of increased exports 450,000 Exports attained at least 50% value added: Therefore 15% of value of increased exports 67,500 Restricted to 70% of statutory income (49,000) Unabsorbed allowance for increased exports carried forward 18,500 Less allowance for increased exports (49,000) Statutory income from business 21,000 Less unabsorbed business loss brought forward (10,000) Statutory income from business 11,000 Add franked dividend income Add interest income 20,000 Aggregate income 31,000 Less current year retail food business loss (15,000) Less approved cash donation RM80,000 restricted to 10% of aggregate income (3,100) 12,900 Add franked dividend income 100,000 Total/chargeable income 112,900 2 Tanah Sdn Bhd (a) To: Miss Nah, Tanah Sdn Bhd From: Tax Adviser Date: 6 June 2011 Report on the proposed disposal of shares in Tanah Sdn Bhd As instructed by you, I present herewith my report on the above matter. (i) Whether Tanah Sdn Bhd (Tanah) is a real property company (RPC) at specified dates An RPC is defined as a controlled company which acquires real property or RPC shares whereby the defined value of real property and/or RPC shares owned at the relevant date is not less than 75% of the value of its total tangible assets. With the definition in mind, the status of Tanah as an RPC at the following dates is determined as follows: 1 March 2008 As at incorporation on 1 March 2008, Tanah did not acquire or own any real property or RPC shares. Therefore, Tanah was not an RPC on 1 March December 2008 On 1 December 2008, Tanah acquired the orchard land. As Tanah was owned by two shareholders at the time, it was a controlled company. The total tangible assets amounted to RM3 5 million, of which RM3 million related to the orchard land. This means the real property constituted 85 7% of the company s total tangible assets. As both criteria were fulfilled, Tanah became an RPC on 1 December December 2009 On 20 December 2009, Tanah sold ten acres of its orchard land to Mr Ta and on the same day Miss Nah acquired all of Mr Ta s shares in Tanah. As Tanah disposed of real property on 20 December 2009, the RPC status of Tanah needs to be re-assessed. As at 20 December 2009, Tanah was still a controlled company as Miss Nah owned 100% of the company s shares. 15

5 However, the proportion of real property to total tangible assets was RM5 million to RM9 million (RM5 million + RM4 million) which gives 55 6%. This proportion is well below the requisite 75%, thus, Tanah ceased to be an RPC on 20 December (ii) Whether RPC shares 300,000 shares acquired when Tanah was incorporated on 1 March 2008 As Tanah was not an RPC on 1 March 2005, the shares acquired on that day by Miss Nah were not RPC shares. 300,000 shares held when Tanah acquired the orchard on 1 December 2008 When Tanah acquired the orchard land on 1 December 2008, it fulfilled the requirements for an RPC (controlled company and more than 75% of total tangible assets in real property). The 300,000 shares acquired on 1 March 2008 became RPC shares on 1 December Miss Nah is deemed to have acquired 300,000 RPC shares on 1 December ,000 shares acquired from Mr Ta on 20 December 2009 As Tanah disposed of real property on 20 December 2009, its status as an RPC was reassessed and the proportion of real property to total tangible assets fell well below 75%, thus, Tanah ceased to be an RPC on that day. The shares acquired on 20 December 2009 when Tanah was no longer an RPC are therefore not RPC shares. (iii) Computation of the real property gains tax liability on the disposal of all shares in Tanah Sdn Bhd on 15 June 2011 for RM12 million Of the 1 million shares disposed of, only the 300,000 shares deemed to have been acquired on 1 December 2008 are RPC shares. Based on the principle once RPC shares, always RPC shares, the 300,000 shares did not cease to be RPC shares even though Tanah ceased to be an RPC on 20 December The acquisition price of the 300,000 shares on 1 December 2008 is computed as follows: A/B x C = (number of shares deemed to be chargeable asset/total shares of Tanah) x defined value of real property = 300,000/1,000,000 x RM3 million = RM900,000. Real property gains tax is computed as follows: RM Disposal price 12 million x 300,000/1,000,000 3,600,000 Less acquisition price (900,000) Chargeable gain 2,700,000 Less exemption of the greater of RM10,000 or 10% of chargeable gain (270,000) 2,430,000 Acquisition date 1 December 2008 Disposal date 15 June 2011 Disposal in the third year RPGT at 20% = RM486,000 Exemption [under PU order 486]: A/B x C = (RPGT at 20% RPGT at 5%)/RPGT at 20% x chargeable gain = (486, ,500)/486,000 x 2,430,000 = 364,500/486,000 x 2,430,000 (1,822,500) Chargeable gain 607,500 RPGT at 20% 121,500 (c) (d) Whether Mr Ta acquired and disposed of RPC shares Mr Ta is deemed to have acquired RPC shares on 1 December 2008 when Tanah became an RPC. He disposed of his 700,000 RPC shares on 20 December As this date is before 1 January 2010 when the real property gains tax (RPGT) was reinstated, he would not have been subject to RPGT. Whether Tanah Sdn Bhd is subject to real property gains tax in respect of the disposal of the ten acres of orchard land As the date of disposal of the real property (the ten acres of orchard land) was 20 December 2009 i.e. before the reinstatement of RPGT on 1 January 2010, Tanah would not have been subject to RPGT. Difference in income tax treatment of Tanah Sdn Bhd after Big Guy Bhd takes over the shares Before the takeover by Big Guy Bhd (Big Guy), Tanah has a paid up capital of RM1 million and, being held by individual/s, it has not been part of a group. After the takeover, it is wholly held by Big Guy which has a paid up capital of RM100 million. 16

6 Therefore, differences in the tax treatment would be as follows: 1. Claim for capital allowances Tanah will no longer be able to have an unrestricted claim of 100% capital allowance in one year of assessment in respect of its small value assets. The 100% claim will be restricted to qualifying plant expenditure of RM10,000 each year. 2. Income tax rates Previously, Tanah would have been able to avail itself of the 20% rate on its first RM500,000 of chargeable income. Following the takeover by Big Guy, the standard rate of tax of 25% will apply for every Ringgit of chargeable income. The first year of assessment when such differences in treatment will take effect will be the year of assessment This is because the criteria are assessed as at the beginning of the basis period. As at the beginning of the year of assessment 2011, Tanah was not held by another company with a paid up capital of more than RM2 5 million. However, as at 1 July 2011, the beginning of the basis period for the year of assessment 2012, Tanah will be wholly owned by Big Guy, thus disqualifying it from its previous preferential tax treatment. End of report 3 Green Gold Sdn Bhd (a) (c) (d) (e) Deductibility of feasibility studies and other preparatory expenses related to the establishment of the mill If the mill project is carried out by Green Gold as an extension of its plantation, it can be argued that the plantation activity and the mill activity are part of the same business of producing palm oil for export. As such, the cost of any feasibility studies and other preparatory expenses may arguably be claimed as expenses against the existing plantation business. If the mill project is treated as a new business, the feasibility etc expenses are not deductible as they would be pre-operating. If the mill is put under the new company, such expenses will clearly be pre-operating and preliminary in nature, hence not deductible. Pricing of the palm fruits supplied by the plantations to the mill If the mill is placed under Green Gold, the transfer of palm fruits from the plantation to the mill is an internal process and need not be transacted at a price. However, the new company and Green Gold will be two separate legal entities. Transfer pricing issues will arise and it is important that a proper pricing structure, taking into account market value, is put in place regarding the transfer of the palm fruits from Green Gold to the new company. Deductibility of loan interest If Green Gold borrows RM100 million to set up the mill itself, the loan interest incurred will be deductible as the interest is incurred on money borrowed and laid out for assets used in the business. If it borrows money to form the new company, it will either invest it as equity in the new company or on-lend it to the new company. Interest restriction will apply to Green Gold. In the case of an investment in equity, the loan interest will not be deductible against dividends from the new company under the single-tier system. If Green Gold on-lends to the new company, the interest expense is deductible against any interest received from the subsidiary. However, it must take care to charge a market rate of interest to avoid any transfer pricing attack from the revenue authorities and to enable it to recoup its own interest expense against the interest received on the subsidiary loan. [Tutorial note: If the new company borrows any money itself, with possibly Green Gold acting as guarantor, the interest will be deductible. However it will further increase the loss expected to arise in the initial two years.] Capital allowances If the plantation and mill activities are carried out under Green Gold, the capital allowances on the investment in the mill building, plant and machinery will be deductible against the profit from the company s combined business operations. In the case of the new company, the capital allowances claimed will have to be carried forward as the initial years are expected to be loss-making. This will result in tax inefficiency, with Green Gold having to pay tax while its subsidiary has substantial unrelieved capital allowance. Initial losses If the mill is operated under Green Gold and the two activities are treated as a single source, any loss arising from the mill will be automatically offset against profits from Green Gold s existing business. If the mill operation is treated as a separate business source WITHIN Green Gold, then any loss recorded for the mill will be a current year loss and so will be deductible from the company s aggregate income from all other sources for the year of assessment. If the mill is operated by the new company, the current year adjusted loss sustained by the new company can be surrendered to Green Gold under group relief. However, the amount surrendered is restricted to 70% of the loss for the year. The remaining 30% must be carried forward. This will be tax inefficient as Green Gold will continue to pay tax on its chargeable income. 17

7 4 Kawan REIT (a) Tax computation for the year of assessment 2010 RM Net profit before tax 5,580 Less: interest income (separate source) (50) 5,530 Add: Interest on mortgage loan (related to assets laid out for the business) Trustee s fee (not incurred in the production of business income) 70 Manager s remuneration (incurred in the production of business income) Mall operations expenses (incurred in the production of business income) Depreciation (a provision, not incurred) 450 Adjusted income 6,050 Less: capital allowance (600) Statutory income from business 5,450 Statutory income from interest (exempted) Aggregate income/total income 5,450 90% of total income = RM4,905 Distribution of RM5,000 exceeds 90% Distribution occurred on 18 February 2011 i.e. within two months after the close of the financial year on 31 December Therefore, entire total income is eligible for exemption (5,450) Chargeable income Tax charged/tax payable Tax treatment of the distribution in the hands of resident unit holders Resident individuals Kawan REIT would have to withhold tax at 10% from the distribution made to all individuals. This tax is the final tax payable to the Inland Revenue Board. The resident individual will not be required to report this income in his annual tax return. Resident companies No tax has to be withheld from distributions made to resident companies. The amount distributed to a resident company must therefore be reported in the company s annual tax return and it will be taxed at the appropriate rate applicable to the recipient company. 5 Tangki Sdn Bhd (a) The RM3,000,000 from the export of water tanks Tangki Sdn Bhd (Tangki) carries out a business of manufacturing the water tanks in Malaysia. The export of the 1,000 units to the foreign country is incidental to its business carried out in Malaysia. Moreover, [pursuant to s.12] the gross income from the sale of its products to a place outside Malaysia is deemed to be gross income derived from Malaysia. From the Malaysian perspectives, it is not foreign-sourced. Because the income is derived from Malaysia, whether or not the amount was remitted to Malaysia is not relevant. The RM3,000,000 should therefore be included as part of the gross income of Tangki from the business of fabricating and selling water tanks in Malaysia. The RM600,000 installation profit remitted to Malaysia in 2010 The activity that gives rise to the income is the activity of installation of the 1,000 tanks. This took place entirely in the foreign country during the four months, i.e. was wholly outside Malaysia. This activity is not incidental to its business carried out in Malaysia. Therefore, the profit arising from this activity is foreign-sourced and is not derived in Malaysia. Upon its remittance to Malaysia, it is tax-exempt [pursuant to paragraph 28 of Schedule 6]. As Tangki is a Malaysian resident company, it is entitled to credit such foreign remittance into an exempt account from which an exempt dividend may be distributed to its shareholders. 18

8 (c) (d) The RM70,000 received by the Malaysian engineer for work on the installation project in the foreign country The Malaysian engineer physically exercised his employment during the four month project, not in Malaysia, but in the foreign country. His duties in the foreign country were not incidental to his duties in Malaysia because he was employed exclusively for the project. Therefore, the RM70,000 was not derived in Malaysia: it was foreign-sourced. As the remuneration was credited to his bank account in Malaysia, the employment income was remitted to Malaysia. The RM70,000 foreign-source income is therefore eligible for tax exemption [under paragraph 28 of Schedule 6]. The RM50,000 received by the foreign engineer for the work on the installation project in the foreign country The foreign engineer did not exercise employment in Malaysia: he carried out his duties exclusively in the foreign country during the four months. Therefore, his employment income of RM50,000 was not derived from Malaysia. He is therefore not subject to Malaysian income tax in respect of the RM50,000 received from Tangki. 19

9 Professional Level Options Module, Paper P6 (MYS) Advanced Taxation (Malaysia) June 2011 Marking Scheme Marks 1 (a) How Buatan qualifies for allowance for increased export Resident company Directly engaged in manufacturing Exports a manufactured product Product not in excluded list Attained prescribed threshold of value added 1 Not excluded because does not enjoy any tax incentives in YA Correctly identify YA2010 as first qualifying YA and reason Tax computation for YA2010 (i) Computation Calculation based on increase over preceding year exports 1 15% of value of increased exports of RM450, Corresponding items in tax computation in Appendix (4 x ) 2 Absorption Set off against statutory income 1 70% of statutory income 1 Can carry forward the balance unabsorbed, indefinitely Corresponding items in Appendix (3 x ) 1 Exemption mechanism Absorbed amount to exempt account 1 Exempt dividend may be paid out of exempt account Shareholders receive exempt dividend Two-tier exemption only 1 13 (ii) Tax savings Compute tax saving for YA Potential saving on the balance of allowance 1 Effect on donations deduction 1 Future increases in exports and potential savings 1 4 (iii) Tax treatment of business losses Treatment of unabsorbed loss brought forward 1 Treatment of current year loss 1 Corresponding items in Appendix (2 x ) 1 3 (iv) Treatment of approved donation Deductible after current year loss, from aggregate income 1 Restricted to 10% of aggregate income 1 Corresponding item in Appendix No carry forward ability 3 21

10 (v) Marks Treatment of franked dividend Franked dividend is taxable during transitional period 1 Statutory dividend income leap-frogged to total income 1 Implication: not available for absorption of loss and donation 1 Corresponding items in Appendix Section 110 imputation credit 4 Professional marks Format and presentation of letter 1 Clarity and effectiveness of communication 1 Appropriate use of appendix

11 Marks 2 (a) (i) Whether a real property company (RPC) Definition of RPC 2 On 1 March 2008: not RPC and reason + On 1 December 2008: RPC and reasons On 20 December 2009: ceased to be RPC and reasons (ii) Whether RPC shares On 1 March 2008: not RPC shares and reason + On 1 December 2008: RPC shares and reasons Deemed acquisition date 1 On 20 December 2009: not RPC and reason (iii) Computation of RPGT Identify RPC tranche 1 Did not cease to be RPC 1 Deemed acquisition price computation 1 Computation: Disposal price Exemption (greater of RM10,000 or 10%) 1 Disposal in the third year 1 Exemption for individuals [under PU order 486] 2 RPGT payable 8 Professional marks Format and presentation of the report 1 Clarity and effectiveness of communication 1 2 (c) (d) Mr Ta Deemed acquired RPC shares 1 No RPGT, reason + 2 Tanah No RPGT, reason 1 Difference in tax treatment Capital allowance Rates of tax 1 + Identify first year of assessment and reason

12 Marks 3 (a) Deductibility of feasibility studies and other preparatory expenses related to the establishment of the mill Expenses deductible against ongoing business with reason 1 Not deductible if new entity commencing new business with reason 1 2 (c) Pricing of palm fruits supplied by the plantations to the mill If internal process, no need for pricing 1 If separate entities, transfer pricing issues 1 Need for proper arm s length pricing policy 1 3 Deductibility of loan interest Interest deductible if laid out on business assets 1 Interest restriction Not deductible if invested as equity because of single-tier system 1 If on-lend loan to new company, market interest must be charged (d) Capital allowance Deductible if same source of business If new company, must carry forward, inefficient (e) Losses If part of same source of business, loss is absorbed 1 If separate business, current year loss against aggregate income 1 If separate entity, current year loss available for group relief 1 But only up to 70%, so tax inefficient

13 Marks 4 (a) Tax payable for the year of assessment 2010 Interest income excluded from taxable income and reason + Deductibility of mortgage interest and reason + Non-deductibility of trustee fees and reason + Deductibility of manager s remuneration and reason + Deductibility of mall operations expenses and reason + Non-deductibility of depreciation and reason + Eligibility for capital allowance and deduction from adjusted income 1 + Statutory income from interest * Aggregate/total income * Calculation of 90% of total income 1 Compare to actual quantum of distribution 1 Date of distribution within two months of close of financial year 1 Exemption of the entire total income 1 No tax payable 13 Note: half marks indicated with a * are awarded for the allocation of the appropriate description to the figure calculated, not for the figure itself. Tax treatment of the distribution in the hands of the recipient unit holders Resident individual: 10% withholding tax at source Final tax No need to report in the annual tax return Resident company: No withholding tax at source Distribution received must be reported in the annual tax return Taxable at appropriate rate applicable to the recipient company (a) RM3,000,000 for export of water tanks Carries out business of manufacturing in Malaysia, export sale is incidental to such Malaysian business + 1 Exports deemed derived in Malaysia, not foreign-sourced 1 + Once derived, irrelevant whether amount is remitted 1 Subject to tax in Malaysia as business income 1 5 (c) (d) RM600,000 profits from installation project Activity generating income took place wholly outside Malaysia 1 Installation activity not incidental to carrying on Malaysian business 1 Therefore foreign-sourced, not derived in Malaysia 1 Upon remittance to Malaysia, exempted 1 Exempt account and exempt dividend out of such account to shareholders 1 5 RM70,000 to Malaysian engineer Physically exercised employment in foreign country 1 Not incidental to duties in Malaysia 1 Not derived in Malaysia, foreign sourced 1 Income remitted to Malaysia, tax exempted 1 4 RM50,000 to foreign engineer Did not exercise employment in Malaysia Income not derived from Malaysia 1 Not subject to tax in Malaysia