The pandemic has, among other things, necessitated and facilitated the mushrooming of small businesses or freelancing in many fields, such as instructing (dance, yoga, fitness), teaching (private tuition, music, piano, art, painting), beauty and grooming (make-up beautician, hairdressing, hairstyling), ICT (computer programming, webmaster, web design, data-entry), professional service (accounting, writing up accounting records, design, architectural), writing (feature writing, journalism, script-writing, copy-writing), creative (acting, voice talent, photography), food (baking on order, catering), delivery (online orders of goods and services) and accommodation (short and medium-term stays, staycation).
In this article, I hope to give you a comprehensive but high-level round-up of the relevant tax issues:
A. Select the entity structure: Sole proprietorship, partnership, limited liability company or limited liability partnership (LLP)
B. Understand the tax treatment of a business source: Recognition of income, tax deductible expenses, eligibility for capital allowances, business losses and proforma tax computation
C. Be aware of the tax compliance requirements: Keep records and issue receipts, and pay tax instalments
A. SELECT THE ENTITY STRUCTURE
First, you have to decide on your business entity. There are four available options:
From the tax perspective, there is no separation between you as an individual and you as a sole proprietor. Whatever you pay yourself, either in the form of remuneration, allowances or benefits, such amounts are not tax deductible in arriving at the statutory income from the sole proprietary business.
A “partnership”, that is, a conventional partnership, means an association of any kind (including joint ventures and syndicates) between parties who agree to combine their rights, powers, property, labour or skill for the purpose of carrying on a business and sharing the profits therefrom.
In Malaysia, a partnership is not treated as a chargeable person for tax purposes. The partnership serves as a conduit for the partners, who are directly taxable on their respective share of partnership income. That said, a partnership is required to furnish an annual tax return in respect of its business based on which each partner’s share of the divisible income is determined.
The share of partnership income (or loss) attributable to each partner is then taxable (or deductible) in the name of the individual partners. Any salary, allowance or interest paid to a partner is treated as his income from the partnership business, much like the sole proprietor.
One considerable downside to a partnership as a business structure is the unlimited liability each partner is exposed to in connection with the liabilities arising vis-à-vis the partnership AND the other partners. So, do tread carefully when adopting this entity structure.
Limited liability company
A company is an incorporated entity, that is, a body corporate, with its own legal and tax identity quite separate and distinct from its shareholders. It can sue and be sued. It has perpetual succession and has unlimited capacity in acquiring, owning, holding and developing or disposing of properties.
The company is a chargeable person in its own right for tax purposes. A shareholder who is a director and is remunerated by the company for performing functions is treated as an employee of the company. Reasonable director’s remuneration, allowances and bonuses are treated as employment income from tax perspectives, that is, they are taxable as employment income to the director, and are deductible in arriving at the company’s adjusted income provided the deductibility tests are satisfied.
The liability of the shareholders is limited (hence the name “limited liability company”) to their capital contributions. Nevertheless, the directors (note: directors, not shareholders) who hold at least 20% of the ordinary share capital are jointly and severally held responsible for the company’s tax responsibilities and tax debts under certain circumstances.
Effective Jan 1, 2014, under the single-tier system, the company is subject to tax in respect of its chargeable income, and this is the final tax. Dividends distributed to its shareholders out of the profits (retained earnings) are tax exempt in the hands of the shareholders.
Limited liability partnership (LLP)
The LLP was introduced in 2013, inter alia, to address the earlier-mentioned unlimited liability exposure under the partnership entity. It also provides another option for businesses and entrepreneurs to run their operations in a more competitive manner.
Essentially, an LLP is a hybrid business structure that combines the features of an incorporated company and a partnership. The following are some of its characteristics:
• It is a legal person at law, that is, it is a body corporate and possesses a legal personality separate from that of its partners.
• It can sue and be sued in its own capacity.
• It has perpetual succession, that is, it may carry on perpetually, unlike a trust (for which there is a rule against perpetuity).
• The existence, rights and liabilities of an LLP are not affected by any change in its partners.
• It has unlimited capacity in acquiring, owning, holding and developing or otherwise disposing of properties;
• As a body corporate, it can do acts and things as bodies corporate may lawfully do.
Tax-wise, the LLP is treated as a chargeable person in its own right. Reasonable and pre-determined remuneration paid to the partners is tax deductible to the LLP and taxable in the hands of the partners as employment income. Distributions of an LLP’s profit to the partners are not taxable in the hands of the partners, similar to the case of dividends distributed by a company. (See Table 1 on Page 10.)
B. UNDERSTAND THE TAX TREATMENT AS A BUSINESS SOURCE
Recognition of income
Any receipt due for rendering services, supplying goods or for the use of amenities in the course of business constitutes revenue or income to the business and is subject to tax. The question of capital versus revenue may crop up from time to time. For instance, if the business disposes of the car or any other asset which has been used in the business activity, the gain or loss from such a disposal is capital in nature. Therefore, any gain would not be taxable and any loss would not be tax deductible.
Business income is taxable on the receivable or accrual basis. This means that as soon as the invoice is issued, the amount becomes receivable as a debt from the customer or client. Such a debt must be recognised as income on the day it arises. The amount is taxable even if the customer has not paid the bill.
Additionally, if any amount is paid in advance for services, such amount must also be brought to tax in the period it is received.
If there should be any doubtful debt or bad debt, the amount of such business/trade debt may be claimed as a deduction since the debt has been recognised as gross income and had been subject to tax.
Mr Aei designs business logos for clients. Upon procuring custom from Cafe Biz to provide logo designs, Aei received a RM1,500 deposit on Oct 28, 2019.
On completion and delivery of the requisite designs on Jan 5, 2020, Aei raised the invoice for RM6,000 on Jan 5, 2020. The balance of RM4,500 was paid by Cafe Biz only on April 30, 2021.
The RM1,500 should be recognised as gross income for the financial year ended Dec 31, 2019, as the RM1,500 was received on Oct 28, 2019.
The remaining RM4,500 became receivable on Jan 5, 2020, as the debt arose on that date. Hence, RM4,500 should be included as gross business income for the year ended Dec 31, 2020, although it was only received on April 30, 2021.
Tax deductibility of expenses
Regardless of the type of entity structure adopted, a business source of income generally has a wider scope of expenses which are tax deductible. Examples are office expenses, office rental, staff salary, cost of repairs and maintenance of business assets, and interest on loans for working capital and business assets.
The tests for tax deductibility of expenses are:
1. The expense must be revenue (not capital) in nature;
2. The expense must have been incurred, not merely anticipated, estimated or contingent;
3. The expense must be incurred in the current year (basis period), not the previous year nor the following year;
4. The expense must be wholly and exclusively incurred for the relevant income source;
5. The expense arises in the course of (rather than in order to) deriving the business income; and
6. The expense must not be specifically prohibited under the Income Tax Act.
All six tests must be fulfilled before an expense qualifies for tax deduction.
For the sole proprietor, there is often the question of whether a given expense item is wholly related to his business activity, or is a part of it related to his private use? The example below illustrates the issue.
Miss Talented, a freelance piano teacher, derives income from conducting classes in her home, in a music school and at her students’ homes. She drives to the music school twice a week and to her students’ homes as well. She has maintained a log book for such trips and came up with a total of 2,000km thus travelled in a typical month. The total mileage travelled as per the car’s odometer is 3,000km for the same period.
Petrol and car maintenance (road tax, car insurance, tyre change, servicing and repair) expenses fulfil all six tests and are therefore tax deductible.
However, as 1,000km is apparently related to non-business usage, Miss Talented would reasonably claim only two thirds of her total car maintenance bills as a business expense. The remaining one-third is private or domestic in nature, which is not tax deductible against business income.For more on common expenses, see Table 2 on Page 10.
Eligibility for capital allowances
Capital allowance is the tax term for depreciation or “wear and tear allowance”. With reference to the standard format for tax computation above, this is a deduction from adjusted income to arrive at the statutory income.
Such a deduction is not available to employment income. For instance, an employee is not allowed any capital allowance for the car he drives to work. However, an individual running his own business is able to claim capital allowances in respect of his car, which he uses to run around to carry out his business.
Generally speaking, only a business source is eligible for capital allowance in respect of “machinery and plant” owned by the business and used in the business. While “machinery” has a straightforward meaning, “plant” is capable of a wider interpretation. Any unabsorbed capital allowance can be carried forward to be set off against the same business in future.
EXAMPLES OF ASSETS USED IN THE BUSINESS
Some examples of assets (machinery and plant) used for a business are:
• Computer systems (computer, printer, scanner) and notebooks;
• Telephones, mobile phones, personal digital assistants;
• Motor cars, motorbikes, vans;
• Musical instruments (in the case of a music teacher);
• Cameras and related equipment (in the case of a freelance photographer);
• Ovens, chafing dishes, cooking and kitchen appliances (in the case of a baker or caterer).
• Furniture and fittings such as chairs, tables, lounge sets for the work area.
Different activities would involve different processes, modes of delivery and forms of deliverables, thereby necessitating different expenditures and requiring different assets, hardware and software. This will directly have an impact on what expenses are deductible and what kind of assets/hardware/apparatus are eligible for capital allowances.
Capital allowance for business assets are typically written off at the rate of 20% as an initial allowance (first year allowance) and the annual recurrent rates of 10%, 14% or 20%. If the asset costs RM2,000 or less, the business may claim 100% write-off in the first YA.
This is a highly technical area, so do consult with your tax adviser regarding the claim of capital allowance.
Only a business is eligible to chalk up losses to be set off against other income or future income. For instance, if a business incurs a loss of RM10,000 in the first year of business, such a loss may be deducted from any other income such as employment income, rental income or dividends the proprietor earned during the year. If the loss cannot be fully utilised, the loss may be carried forward to be deducted against business income in future.
Whatever the business entity adopted to run the business, the ability to carry forward unabsorbed loss and unabsorbed capital allowance is available. With effect from the YA 2019, business losses are allowed to be carried forward for seven YAs after the YA in which the losses were incurred.
C. BE AWARE OF TAX COMPLIANCE REQUIREMENTS
KEEP FULL RECORDS AND ISSUE RECEIPTS
Full and proper records of all business transactions, expenditure, receipts, and so on, should be kept to facilitate the computation of tax liability. Set up a system and develop the habit of recording the entries on a periodic (daily, weekly) basis.
Such business records should be kept for seven years after the year is over. For instance, records for 2021 should be kept until Dec 31, 2027.
Also, remember that you are obliged to issue receipts if your annual turnover from the sale of goods exceeds RM150,000, or your annual revenue from performance of services exceeds RM100,000. The receipts you issue should be printed and serially numbered and you should retain a duplicate in your records.
Employment income is subject to pay-as-you-earn tax deductions at source, that is, the employer is obliged to deduct tax payments for the tax authorities from the monthly payroll.
The tax on business income of the sole proprietor is payable on a six-instalment basis based on an estimated tax provided by the tax authorities. In the case of the company or the LLP, the monthly tax instalments are based on its own tax estimates furnished in advance of the year of assessment.
Consult the expert
What I have written merely touches on some salient aspects. A lot of important details and issues are unavoidably left out. If your business activity is gaining momentum and things are really looking good, I would strongly urge you to consider consulting with a tax expert to get things sorted out and put proper systems in place.
Yong Siew Chuen has wide experience in Malaysian taxation. She now focuses on tax training and coaching.