MEMBER FIRM OF BAKER & MCKENZIE INTERNATIONAL Tax Kuala Lumpur Client Alert November 2015 Imposition of withholding taxes in the context of the digital economy Like many other jurisdictions, Malaysia imposes withholding taxes on certain types of payments made to non-residents by residents. In Malaysia, the Income Tax Act 1967 ("ITA") provides for the deduction of withholding tax at prescribed rates by the person making the payment (the "payer"). The payer must withhold part of the payment, and then, remit the sum withheld to the Inland Revenue Board of Malaysia ("IRB") within one month after paying or crediting the payment. The prescribed rate for withholding tax depends on the type of payment that are being made (e.g, royalties, interest, and special classes of income as ascertained by the ITA). In addressing issues raised by the digital economy, the IRB has issued guidelines on the taxation of electronic commerce, which considers, among others, when withholding taxes on royalties are justifiable. However, the guidelines has at times been applied in a somewhat inconsistent manner. In a recent yet to be reported High Court case, a taxpayer, represented by Wong & Partners, challenged how the IRB viewed the cross-border supply of digital goods and services. The Case The taxpayer is a resident company of Malaysia, and provides online or web classified advertisement services. During the course of its business, it had made payments to non-residents to obtain various software, software development services, analytics results (i.e., data consumption patterns), and access codes to database websites. The taxpayer had outsourced different aspects of its business for cost-related reasons. These payments came under the scrutiny of the IRB, which resulted in an audit of the taxpayer's accounting books. The IRB took the position that the taxpayer should have withheld tax on the payments it had made, and issued a decision letter to the taxpayer stating, among others, that withholding taxes are applicable to the payments. Unsatisfied, the taxpayer applied for judicial review to challenge the IRB's decisions. IRB's Arguments The IRB contended that the payments made by the taxpayer to the nonresidents are a form of royalty, which should be subject to royalty withholding tax. The IRB stated that "if the owner of a patent or design allows the use of any right and retains the right, the payment for the right to use of the said patent or design is to be treated as royalty". The IRB also argued that the taxpayer had failed to observe normal litigation procedure by bringing a tax dispute directly to the High Court instead of the Special Commissioners of Income Tax. www.wongpartners.com For further information please contact Adeline Wong +603 2298 7880 firstname.lastname@example.org Dato' Mohd Arief Emran Arifin +603 2298 7925 email@example.com Kae Jeen Wong +603 2298 7855 firstname.lastname@example.org Jason Liang +603 2298 7983 email@example.com Kellie Allison Yap +603 2299 6923 firstname.lastname@example.org Level 21, The Gardens South Tower, Mid Valley City, Lingkaran Syed Putra, 59200 Kuala Lumpur Imposition of withholding taxes in the context of the digital economy Taxpayer's Submissions It was submitted on behalf of the taxpayer that the IRB had unfairly categorised the "royalty" payment to non-residents, when in actual fact the payments were not made for the right to use copyrights, nor for the supply of know-how. The taxpayer highlighted that the IRB's own guidelines states clearly that payments made for the purchase of products are not subject to royalties withholding tax. In this instance, the taxpayer had not acquired any right to use copyrights. Instead, the taxpayer had purchased software (e.g., Adobe, Microsoft Office and other non-customised software which had been developed for a broad range of users), as well as data transmitted in the form of digital signals. A distinction should also be made between contracts for the supply of knowhow and the provision of services. Under the ITA, payments received for the supply of know-how are classified as royalties. The suppliers in this instance had applied their skills and knowledge to perform software development and other services for the taxpayer, and the payments to the suppliers could not properly be regarded as being made for the supply of know-how. Moreover, the services had been performed by the suppliers in Singapore and not in Malaysia (under the ITA, services fees paid to non-residents are not subject to withholding tax if the services are performed outside Malaysia). In response to the IRB's attempt to challenge the legality of the judicial review on grounds of inappropriate forum, the taxpayer argued that it had grounds to seek a judicial review of the IRB's decision. This is since it is evident from a plain reading of Sections 109 and 109B of the ITA that the alleged withholding taxes amount and penalties are to be characterised as a debt due to the IRB and not a tax chargeable. The usual route of appeal to the Special Commissioners of Income Tax may collapse depending on the IRB's future actions, which are entirely out of the taxpayer's control. As such, there is no viable alternative route of appeal available to the taxpayer. High Court's Decision The High Court ruled in favour of the taxpayer on both the merits of the case as well as the manner in which the taxpayer brought the motion to court. It is clear from the grounds of decision that the High Court agreed with the taxpayer's arguments. As at the time of writing of this client alert, the High Court has yet to make available its written judgment to the public. It is also important to note that the IRB has appealed to the Court of Appeal against the High Court's decision. Conclusion The High Court's decision on this matter has been long awaited and is much welcomed. The decision is consistent with the position in many other tax jurisdictions, and effectively results in Malaysia taking a rights-based approach to the tax treatment of software, digitised goods, and other digital articles, including rights to access online databases or online subscriptions. Essentially, payments that do not involve the transfer of copyright rights are to be considered payments for goods, i.e., the payments are to be treated as business income and not as royalties. The High Court also recognised the distinction between contracts for the supply of know-how and the provision of services. Hence, depending on the factual matrix of individual cases, the IRB can no longer classify payments as know-how royalty payments unless the contract involves the impartation of special knowledge and the supplier does not play any part in the application of it to the payer's circumstances. ©2015 Wong & Partners. All rights reserved. Wong & Partners is a member firm of Baker & McKenzie International, a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organisations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. 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