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Time to Act Fast: Changes to the Malaysian Tax Treaties Impacts Existing Structures
- Double Taxation Relief (The Federal Republic of Germany) Order 2010
- Double Taxation Relief (The Republic of Indonesia) (Amendment) Order 2006
These Orders implement interesting changes to the tax treaties. Both treaties now exclude Labuan from their scopes and incorporate changes to the withholding tax rates. Additionally, in the case of Germany, the Order changed a previous treaty benefit that provided that technical fees paid to German residents was not subject to withholding tax. For multinational groups with German entities, the German entity was often the vehicle of choice for the provision of services to Malaysia. This tax planning opportunity has been somewhat narrowed by the protocol.
Taxand Malaysia reviews the changes to the treaties with Taxand Germany and Taxand Indonesia to identify the impact on existing investment structures involving Labuan and to advise why businesses need to act quickly as a result.
The details of the changes to the treaties are as follows:
The new Order changes many important features of the Malaysia - Germany treaty. It is, therefore, important to review certain transactions between German and Malaysian parties. The key changes are as follows:
- Permanent Establishment (PE):
- The time-frame under which a PE will arise in respect of a construction, installation or assembly project has been extended from 6 months to 9 months.
- A new provision has been introduced in the Business Profits Article (Article 7 paragraph 4) that allows the state where a PE is situated to estimate the profits allocable to the PE in the absence of appropriate accounting data or other relevant information. This regulation emphasises the increasing relevance of the issue of allocating profits to PEs.
- Withholding tax rates:
- There has been a reduction in the withholding tax rates for royalties and interest to 7% and 10% respectively from the previous treaty rates of 10% and 15%.
- Before the Order, the recipients of dividends had their withholding tax rate reduced to 5% if they held at least 25% of the share capital of the paying corporation. The Order reduces this 25% ownership requirement to 10%. It should be noted, however, that Malaysia does not impose any withholding taxes on dividend payments to non-residents. Furthermore, dividend income derived from non-residents is exempt from tax in Malaysia.
- Technical Services
- Article 12 of the treaty, which previously only covered royalties, now covers both royalties and technical fees. The portions of the Article relating to technical fees essentially replicate most of the other technical fees Articles found in the treaties that Malaysia has signed with other countries. Technical fees, for the purposes of the Article, refer to "payments of any kind to any person, other than to an employee of the person making the payments, in consideration for any services of a technical, managerial or consultancy nature". Article 12 provides a reduced withholding tax rate of 7% for both royalties and technical fees.
- With regard to technical fees, Malaysian domestic legislation (Section 4A, Income Tax Act, 1967 (ITA)) provides that income of a non-resident derived in Malaysia from the provision of technical services will attract withholding tax. The fees would be deemed to be derived from Malaysia where the services are performed in Malaysia and where the responsibility for payment of the fees lies with the Government or a state/local authority or a resident, or where the fees are charged as an expense or outlay against a business carried out in Malaysia. Although the legislative provision giving rise to this tax on non-residents uses the term 'technical', the relevant provision is widely construed by the tax authorities (whose view has been endorsed by the Courts) and applies to most services (both technical and non-technical), with the exception of routine day-to-day administrative services. Therefore, where a non-resident provides technical, management or other such services in Malaysia, the income derived therefrom would be deemed to be derived from Malaysia and would attract withholding tax under domestic law at the rate of 10%. This is notwithstanding the fact that the non-resident does not have a permanent establishment in Malaysia. The responsibility for deducting the withholding tax rests with the party paying the fees.
- Prior to the new Order coming into effect, the treaty between Malaysia and Germany effectively provided residents of Germany with an exemption from Malaysian tax on technical fees derived from Malaysia (except where the German resident was deemed to have a permanent establishment in Malaysia). The earlier version of the treaty did not have an article covering technical service fees and the "Other Income" Article (Article 21) was somewhat unique (as compared with the same article in Malaysia's other tax treaties). Article 21 provided that items of income that were not covered under the other Articles of the treaty would only be taxable in the country of residence of the recipient. Hence, technical service fees paid to residents of Germany would only be taxable in Germany. This loop-hole has now been plugged, and German residents providing services in Malaysia will be subject to withholding tax. The withholding tax on the technical fees is creditable against German tax payable on such income pursuant to Article 23 paragraph 1(b). To the extent that the technical fees are attributable to a German company, the profits (including the technical fees) are subject to corporate tax of 15% in Germany. Although the source tax of 7% is creditable against the tax payable in Germany, the newly introduced withholding tax is disadvantageous for German tax payers who are not in a tax paying position (e.g. due to losses) or who are individuals paying tax at a rate lower than 7%. The newly introduced withholding tax on technical fees will also increase the administrative burden on persons rendering technical services.
- Exclusion of Labuan from the scope of the treaty
- The other important change to the treaty is that companies that are taxed under the preferential tax regime in Labuan are now excluded from the scope of the treaty. (Labuan is an island that forms a part of Malaysia but offers a preferential tax regime to companies incorporated in Labuan under the Labuan Companies Act, 1990 and which fall within the scope of the tax legislation for Labuan (i.e. the Labuan Business Activity Tax Act, 1990 (LBATA)). Companies in Labuan that fall outside the scope of the LBATA are taxed under the ITA. It should also be noted that Labuan companies that fall within the scope of the LBATA can also irrevocably elect to be taxed under the ITA.
The following sets out the key changes to the tax treaty with Indonesia:
- Withholding tax rates:
The withholding tax rates on royalties, dividends and interest have each been reduced to 10% from the previous rates of 15%.
- Exclusion of Labuan from the scope of the treaty
Similar to the new German treaty, the benefits of the Indonesian treaty will not be available to companies entitled to the preferential tax regime in Labuan. Therefore, investment structures involving Labuan that have sought to rely on the tax treaty between Malaysia and Indonesia must be reviewed.
The changes to both the German and Indonesian treaties will have an impact on investment structures involving Labuan. Such structures will need to be reviewed quickly.
In the case of Germany, the use of German companies to provide services in Malaysia will no longer be a viable option in planning for withholding taxes. However, the inclusion of technical fees in the new Article 12 combined with the 7% withholding tax rate still offers an avenue for planning in the form of a lower withholding tax rate (as compared to the domestic rate of 10%) as well as certainty that such fees are covered in the treaty. However, the withholding tax levied will create an additional administrative burden for taxpayers. While the withholding tax is creditable against the tax charged in Germany such that the overall tax burden should not increase, the impact must be assessed on a case by case basis. Typically, the benefit of the credit in Germany will only arise where the German party is taxable. The reduced withholding tax rates on royalties and interest are welcomed and will benefit group entities with operations in both countries.
From an Indonesian perspective, the reduced withholding tax rates make Malaysia more attractive as a holding entity for investments into Indonesia. Furthermore, Malaysia does not impose tax on foreign-sourced income and does not impose withholding tax on dividend payments. This makes Malaysia an attractive intermediary entity for structuring investments into Indonesia. Likewise, the reduced withholding tax rates would be beneficial for Indonesian investors with business operations and investments in Malaysia.
Your Taxand contacts for further queries are:
T. +603 2032 2799
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