FOREIGN SOURCE INCOME

Malaysia adopts a territorial system of income taxation.

Scope of charge

The chargeability of income is governed by Section 3 of the Income Tax Act, 1967 (ITA) which states that “income shall be charged for tax for each year of assessment (“YA”) upon 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 connotes the source of income must be in Malaysia.

Income accrued in or derived from Malaysia will be taxed at the time of accrual or derived notwithstanding the fact that the income may not have been received in Malaysia.

Section 3 of the ITA extends its territorial scope to include foreign source income received in Malaysia from outside Malaysia. Foreign source income refers to income which is accrued in or derived from a tax jurisdiction outside Malaysia.

With effect from YA 2004, foreign source income derived from sources outside Malaysia and received in Malaysia by any person (other than a resident company carrying on the business of banking, insurance or sea or air transport) is not subject to Malaysian income tax.

Derivation of business income

Derivation of business income is defined in Section 12 of the ITA.

Pursuant to Section 12(1)(a) of the ITA, so much of the gross income from the business as is not attributable to operations of the business carried on outside Malaysia shall be deemed to be derived from Malaysia.

Section 12(1)(a) serves as a residual section, to tax whatever gross income that is not attributable to operations of business carried on outside Malaysia would be deemed Malaysian derived income. The scope is wider than merely to treat gross income that is attributable to business operations carried on in Malaysia. 

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.  

If the business consists wholly or partly of the manufacturing, growing, mining, producing or harvesting in malaysia of any article, product, produce or other thing, the gross income from the sale of such articles, etc., outside Malaysia in the course of carrying on business shall be deemed to be derived from Malaysia. This is provided under Section 12(1)(b)(i).

Where such articles, products, etc are exported in the course of carrying on the business and Section 12(1)(b)(i) does not apply, then the market value of the article, product, etc. at the time of export shall be deemed to be gross income derived from Malaysia [Section 12(1)(b)(ii)].

Operations of business carried on in Malaysia

Determining the locality of the source of income can be complex and contentious. There is no universal rule 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 profits and of the transactions which give rise to such profits.

Some of the factors that should be taken into consideration to determine whether a business is carried on in Malaysia are:

• Whether contracts are concluded in Malaysia;
• Whether stocks are maintained in Malaysia from which orders are fulfilled;
• Whether the passing of ownership and risk of trading stocks in Malaysia;
• Whether proceeds of sales are received in Malaysia;
• Whether services are rendered in Malaysia.

These factors are not conclusive on their own and must be considered collectively.

In general, a direct physical presence of a person (through the incorporation of a branch or incorporation of a company) in Malaysia clearly establishes the carrying on of a business in Malaysia.

Changes Effective From 2022

In the 2022 Budget announcement, it is proposed that with effect from 1 January 2022, foreign-sourced income (FSI) of Malaysian tax residents (both companies and individuals) which is received in Malaysia will be subject to tax. There will be a transitional period from 1 January 2022 to 30 June 2022 where FSI remitted to Malaysia will be taxed at the rate of 3% on gross income. FSI remitted to Malaysia will be taxed at the prevailing tax rate from 1 July 2022 onwards.

Further to feedback received from various parties on the proposed removal of the income tax exemption on FSI received in Malaysia by Malaysian tax residents, the Ministry of Finance (MOF) has issued a media release dated 30 December 2021 and has agreed to exempt the following FSI received in Malaysia by Malaysian tax residents based on the following category and substantive conditions:

This exemption will be effective from 1 January 2022 to 31 December 2026. Other than as mentioned above, FSI is subject to tax in Malaysia when received in Malaysia by Malaysian tax residents with effect from 1 January 2022.

For the category of individual taxpayers, the Government grants exemption to all individuals except those carrying out partnership business in Malaysia, which will be subject to tax for the FSI received in Malaysia. Whereas, the category of non-residents (individuals, companies, etc.) still remain eligible for income tax exemption.

Following the announcement made by MOF on 30 December 2021, the following Exemption Orders have been gazetted on 19 July 2022.

1. Income Tax (Exemption) (No. 5) Order 2022 – Exemption of FSI received by resident individuals
2. Income Tax (Exemption) (No. 6) Order 2022 – Exemption of FSI received by resident companies, LLP and individual in relation to a partnership business in Malaysia

Based on the Exemption Orders, the following categories and sources of FSI received in Malaysia from outside Malaysia are exempted from tax from 1 January 22 to 31 December 2026.

The income exempted shall have been subjected to tax of a similar character to income tax under the law of the territory where the income arises.

For dividend income, the dividend shall have been subjected to tax of a similar character to income tax under the law of the territory where the income arises and the highest rate of tax of a similar character to income tax charged under the law of the territory which the income arises at that time is not less than 15 per cent.

The IRB has subsequently issued the Guidelines on Tax Treatment in relation to Income which is Received from Abroad on 29 September 2022 to explain what constitutes foreign source income, how it will be taxed or exempted, and any deductions or relief available.

The qualifying conditions for foreign source dividend income to be exempted are:-

1. The dividend income has been subjected to tax in the country of origin where the income arises (Note 1); and
2. The headline tax rate is at least 15% (Note 2); and
3. Comply with the economic substance requirements (Note 3).

Note 1:

The dividend income has been subjected to income tax or withholding tax in the country of origin, or subjected to the underlying tax in the country of origin, or the underlying profit is not subjected to tax due to:

• Unabsorbed losses or capital allowances;
• Capital gains;
• Tax rules under the tax consolidation regime in the country of origin; or
• Enjoyed tax incentives in compliance with substantive requirements in the country of origin.

Note 2:

Headline tax rate refers to the highest corporate tax rate in the country of origin in the year when the foreign dividend income is received in the country of origin. The headline tax rate is not necessarily the actual tax rate imposed.

Note 3:

A resident company, resident LLP or resident individual in relation to a partnership business in Malaysia shall be regarded as having economic substance if it has:

• employ adequate number of employees with necessary qualifications to carry out the specified economic activities in Malaysia; and
• incur adequate amount of operating expenditure for carrying out the specified economic activities in Malaysia.

As the mode of operation varies from industry to industry, it is neither feasible nor appropriate to specify any minimum thresholds for the economic substance requirement depends on the fact of each case. Factors that will be taken into account include:

• the number of employees having regard to the nature of the relevant activities, e.g. whether it is a capital or labour-intensive industry;
• whether the employees are employed on a full-time or part-time basis; and
• whether office premises have been used for undertaking the relevant activities and whether the premises are adequate for such activities.

The qualifying conditions for all foreign source income received by resident individuals to be exempted are:-

1. The foreign source income has been subjected to income tax or withholding tax in the country of origin; or
2. Not subject to tax in the country of origin due to:-

• The foreign income is not subjected to tax under the tax system;
• Has not reached the taxable threshold;
• The foreign income is exempted due to tax incentive;
• The foreign dividend income has been subjected to underlying tax;
• The underlying profit of foreign dividend income is not subjected to tax due to:
• Unabsorbed losses or capital allowances;
• Capital gains;
• Tax rules under the tax consolidation regime in the country of origin; or
• Enjoyed tax incentives in compliance with substantive requirements in the country of origin.