Federal Taxation 2011

Question 1 (a): Discuss the significance of distinguishing a profession from an employment for income tax purpose? An employment income derived from an employment which an arrangement made for the performance of service by an individual to a firm or an individual. An employee is to be instructed and control by the employer in conducting work and duties. Anyone who has undertaken an employment, and earned income is to be taxed under section 4 (b) of the Income Tax Act 1967. A profession income means a person's earnings are results from a series of engagements, moves from one to another at own will. Qualifying these two conditions in mentioned before this is considered exercising a profession but not an employment. For example, case law of Davies v Braithwaite. Miss Braithwaite is an actress whom engaged under various separate contracts to take part in stage plays and perform in films. She argued that various contracts between her and the theatrical producers were contracts of service but not an employment contract. The Revenue agreed to her point. employments were something like offices and likened them to posts. His view was that where a professional person does not contemplate obtaining a post and staying in it, but contemplates a series of engagements and moving from one to the other, then each engagement is a mere engagement in the exercise of the profession. Rowlatt J.

Profession is also considered as self-employed. The rewards which a self-employed person receives should assessable under business income section 4 (a) of the Income Tax Act

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1967. Chargeable income under section 4 (a) comprises form of money received from turnover (sales or services rendered), insurance recoveries, compensation for loss of income and interest income. Moreover, employment income and self-employed / profession remunerations are distinguish by few tax and non-tax advantages. (Chong Kwai Fatt, 2010) Distinguishing a profession from an employment for income tax purpose is:
a) Relationship to offices (Contract of service v Contract for service)

b) Loss relief c) Relief for capital expenditure d) Deduction of expense e) Basis period f) Non-resident deriving Malaysia income

(a) Relationship to offices For an individual who assessed to employment income, his relationship to office or company is work for both of it and receives salary or remunerations. Therefore, the office/company is master while the individual is servant. The relationship of employee to office is subsisting and permanent, defined hours of work, while a company operates relied on employee to generate income. This is contract of service. This statement supported by the following quote. An office is a position or post which goes on without regard to the identity of the holder of it from time to time Harman LJ saying at p. 49 (40 TC 11). Source of income of employment is generated through its services contributed to office, received from the holding of office such as director.

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In the other hand, a profession is person who carrying on a business or a professional such as accountant or engineer. Income from contract for service is assessable as business income. In law, a profession bound by a contract or an agreement. Individuals must not be engaged to work through an independent contractor status unless the tests. Independent contractor arrangements are most appropriate for a short-term period to undertake specific (and specialized) consultancy work. (University of Waikato) Illustrate an example: Bob is an accountant who runs his own practice. His own office and staff are engaged by a company to formulate an internal audit program at a remuneration of RM 3,500 per month. This income will not be deemed employment income. It will be income derived from the exercise of a profession service. (b) Loss relief An employment taxpayer is somewhat risk free. He receives compensation for loss an employment, which is termination of contract of service. This compensation for loss of employment is taxable but exemption of RM 10,000 is given for each completed year of service with same employer or companies in the same group. By the way, compensation for loss of employment including an amount paid to the employee to restricting his right after cease his employment to engage to another employment in similar kind. However, employment income is not business income; any loss would be permanent loss. In the other hand, a profession taxpayer may enjoy and utilize loss compared to employment taxpayer. Expenses exceed gross income of a source is adjusted loss. The Income Tax Act allows adjusted loss to be set off against aggregate income. Unabsorbed loss may carry forward if it

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cannot be fully set off during the year of basis. Therefore, the balance can be to next year of assessment to be set off. (c) Relief for capital expenditure There is no relief for employment taxpayer. However, individual taxpayer may enjoy personal relief, parents medical relief, child relief, subscription, and purchase of books relief at certain rate and amount. A profession taxpayer is eligible to claim capital expenditure. This amount is deductable against adjusted income of business in arriving at statutory income. Capital allowance can claim by a person who carrying on a business, incurred qualifying expenditure and the assets used in business. Capital allowance consists of initial allowance and annual allowance. Initial allowance can claim when the asset first used in the business in year basis year. Annual allowance can claim annually at certain rate until the amount of qualifying capital expenditure being fully claim. Various types of assets has different rate of annual allowance. In this question, a profession taxpayer is concern rather than a business taxpayer. For example, a lawyer, John, owns a firm may claim several assets for year of assessment 2010 may enjoy the initial allowance and annual allowance as below table.

Asset own Office equipment, furniture and fittings Motor vehicles Computers and information technology equipment

Initial Allowance 20 % 20 % 20 %

Annual Allowance 10 % 20 % 40 %

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Small value asset (law books) (each asset RM 1,000) (max RM 10,000) 100% -

Balance of capital allowances claim in current year may carry forward to next year and subsequent year until the access amount is fully set off. However, when Johns business ceased, the unabsorbed capital allowances would be permanent loss and it cannot be transfer to another business source. (d) Deduction of expense In KPMG publications, the deductions that allowable to individual are very limited. Section 33 said that expenses are deductable only if they are wholly and exclusively incurred in exercising to the production of employment income. Moreover, the expenses that deductable must be incurred in the performance of employment duties. In some event, expenses incurred by an employee in the performance of duties are often not bearable and some is reimbursed by the employer. Some expenses that employee can claim includes:a) Entertainment expenses b) Motor vehicle expense c) Subscription An employee is given entertainment allowance and able to claim it under section 33 (1). This expense should incur in entertaining the clients or customers of his employer only if the employer requires and the entertainment is in the course of performing his duties. Moreover, the section 38A said that the amount of total deduction must not exceed the amount of entertainment

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allowance. The Inland Revenue Board requires some information for considering entertainment expenses claims:a) Date and place of entertainment b) Person entertained on each occasion c) Amount spend on each occasion d) Nature of business and the outcome Next, an employee is allowed to enjoy car allowance. The car allowance is assessable to tax as part of employment income but it will be a deduction when he discharges his duties. Lastly, a professional subscription is deductable if it is in purpose of enhance or retain employee's professional qualification and enable him to continue derive income from the profession. Apart from employment income, profession income has more concession being given to certain expense deductable. Section 33 and Section 34 of Income Tax Act 1967 said that expenses that are deductable in profession income are wholly and exclusively incurred in generating and production of income only. In Commissioner of Income Tax Bombay v M/S Walchand & Co PVT. LTD, a case related to the respondent appealed to increase the remuneration off the Directors and claim for deduction where the judge Shah. J enumerated the following statement at head note: In applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of the business, reasonableness, of tile expenditure must be adjudged from the point of view of the businessman and not of the Revenue. An employer in, fixing the remuneration of his employees is entitled to consider the extent of his

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business, the nature of the duties to be performed, and the special altitude of the employee, future Prospects of extension of the business and a host of other related circumstances. The rule that increased remuneration can only be justified if there be corresponding increase in the profits of the employer is erroneous. [217F-218B] 218B] Specific expenses that allow deducting for profession taxpayer includes:a) Interest expense on loan This deduction is allowed when the loan is employed in the production of gross income and it is laid out of assets that used for production of business. b) Rental Section 33(1)(b) said that rental payable by taxpayer in respect the land or property occupied by him for the purpose of producing gross income would be allowed to a deduction. c) Bad debt Profession taxpayer may enjoy a deduction for bad debt if the specific debtors are identified, debts are partly or wholly irrecoverable and the debts had been reasonably estimated to be bad debt. d) Employees Provident Fund (EPF) contributions Employees are required contribute 11% of their income to the EPF under EPF Act 1991.

e) Development cost or website The Act gives annual deductions of 20% over a period of 5 years. Overall, profession taxpayer has more advantage and flexible in income tax paying compared to employment income.

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Questions (1) (b) Explain and illustrate the badges of trade. Badge of trade is a criterion that distinguishes a trading from investment for taxation purpose. However, badge of trade is ambiguous in define. The tax authorities can use the badge of trade to argues that taxpayer did engage in an adventure of trade and it is assessable to business income. While the taxpayer may also rely on same badge of trade to argues that he is just merely realizing an investment which it is capital in nature and not assessable to business income. (Choong Kwai Fatt 2010). These arguments will eventually rest with the decision of judges of court. Several test need to be done to decide whether the gain could be classified as income or capital. Badge of trade considered few criteria:a) The subject matter
b) The intention/motive of profits tax items c) The period of ownership d) The transaction frequency

The subject matter Property or manufactured commodities are the subject matters of trading transactions. Transaction involves the acquisition and disposal of items are likely to consider as carrying on a trade. For example, a company purchases a land and planned to build a car park building. However, the land was unused for two years after the transaction due to contractual matter. The company disposes the land to a farmer and earns RM 50,000 after the transaction. The earning of RM 50,000 is taxable and not a capital receipts. If the land is concerned has been used in the

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business, the sales will be capital and non-taxable. However, this case illustrated that the land has been unused before the transaction; the companys earning is to be chargeable. The intention/motive of profits tax items Intention or motive to sales in short term may be considered as trading transactions. There must be a sufficient evidence to indicate an investment motive from a transaction to avoid tax assessable. For example, a businessman Mr. Chin has bought 2000 bottles of beers from manufacturer and tried to re-sale it for upcoming Christmas. Tax authority said that the beers transaction is assessable to business income. Mr. Chin argues that the beers were purchase for his own consumption and for Christmas family party. However, the tax authority does not accept his argument. The quantity and the nature of the products purchased was not reasonably to be considered for own consumption. Quantity of 2000 bottles is not possible to be serving in a family party and it is likely to be re-sale during upcoming Christmas. Therefore, it is considered to adventure in the nature of trade. The period of ownership The longer the owner holds a land o property after purchased, the more likely to be consider as personal used rather than re-sale. However, the period of ownership is inconclusive. For example, Mr. Tong bought a land from his neighbor, Mr. Kumar. Mr. Kumar urgently needs money to finance his son's college fees in next year. Mr. Kumar offered Mr. Tong a land which own by Mr. Kumar for 8 years. After the transaction, Mr. Kumar's earning is not taxable if Mr. Kumar proves that the earning was to finance his child's education fees. After 4 months, the market price of the land increased 10%. Mr. Tong sold the land to a furniture manufacturer. In this scenario, Mr. Tongs earning is liable to business income as it is considered to trade the property by realized it in short term.

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The transaction frequency Frequency of trade plays a test for determines trade. "one transaction of buying and selling a thing does not make a man a trader, but i it is repeated and becomes systematic, then he becomes a trader and the profits of the transaction, not taxable so long as they remain isolated, become taxable as items in a trade as a whole" said Pickford v Quirke (13 TC 251) at page 263. Question 2. The accounting profit or loss shown in the income statement is not accepted by the tax authorities to determine the companys tax liabilities. Explain. Tax authorities do not accept the accounting profit or loss in income statement because a companys financial account must be constructed based on audit format and submission of the Form C. Some of the expenses that incurred in profit and loss account are non-tax deductable. In tax computation, these non-allowable expenses should have added back. There are four groups of non-allowable expenses:a) Accrual expenses Accrual expenses including general provision for bad debts, warranty cost, depreciation and unrealized exchange loss. These expenses are not incurred in real, however companies will record them in profit and loss account because these expenses is recorded based on accrual basis and not on cash basis. Here are some examples to illustrate accrual expenses that not accepted by the Act. For example, provision for bad debt. Provision of bad debt is an account that a company record on their liability account and treated it as uncollectable and uncertain debt to be recover

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from debtors. This is a remote possibility of payment having to be made. Unless the company could identified the debtors and reasonably estimate the debt is bad, the provision of bad debt can be granted to tax deduction. b) Capital expenditure Section 39 of the Act does not allow a capital expenditure deduction for a company. Capital expenditure includes staff pension, cost of setting up roof for car park and entrance fees to club. Although a company will argue that the expenses are satisfies the wholly and exclusive test in Section 33, therefore it should be deductable. However, tax authorities may re-evaluate the expenses by several test, to make sure those expenditure is revenue or capital in nature. Any expenses related to fixed capital is capital expenditure while circulating capital is revenue expenditure. Fixed capital is non-deductable. For example, stock listing expenditure. Stocks of a company are fixed capital, which the owner-the company owns it to turns profits by issue it to stockholders. Therefore, expenses that incurred for stock listing is nondeductable. In the other hand, expenses that expand or modified the business structure are capital expenditure, and they are non-deductable. For example, wall re-painting of Company. c) Expenses to investment income These expenses need to be adding back in adjusted income because the expenses will set off by the source of income of investment in later. Therefore, the expenses are not deductable.
d) Prohibited expenses by Section 39

Companys expenses are no all deductable for tax purpose. Some expenses are prohibited by Section 39 of the Act such as remuneration to employees family, leave

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passage expenses, money withdrawn as capital, private expenses and domestic expenses. These expenses are not allowed to claim in the Act. Therefore, tax authorities have to make sure a appropriate adjustment to arrive adjusted income. Although there are some expenses are non-deductable, there are also some expenses are granted to be deductable. Revenue expenses that qualified for double deduction are given twice the amount as deduction in arriving at the adjusted income. In order to qualify double deduction, the tax authorities should make sure that the expenses are revenue expense, not prohibited by Section 39 of the Act, revenue expenses for approved training such as Malaysian Industrial Development Authority or Minister of Finance and so on. . Lastly, if a company incurred net loss before taxation, the amount will be deducted from the adjusted income statement. A company could not declare tax free by the reason of loss incurred in their Profit and Loss statement. Again and conclusion, tax computation of a company would not simply assessed by profit and loss statement, but it should be construct based on audit account by The Companies Act 1965. Web referenced: HM Revenue and Customs (Marc 2001) ESM7020 - Case Law: Davies v Braithwaite. Source retrieved from the World Wide Web: http://www.hmrc.gov.uk/manuals/esmmanual/esm7020.htm KPMG publications. Taxation of Individual (Chapter 6, page 68). Source retrieved from the World Wide Web: http://www.kpmg.com.my/kpmg/publications/tax/tm/chapter6.pdf
Shah. J. Commissioner Of Income-Tax, ... vs M/S. Walchand & Co. (Pvt.) Ltd., ... on 17 March, 1967 Source retrieved from the World Wide Web: http://www.indiankanoon.org/doc/418471/

University of Waikato (2004) Independent Contractor (Contract for Service) Policy. Source retrieved from the World Wide Web: http://www.waikato.ac.nz/hrm/internal/policy/independcontract.shtml Book referenced: Chong Kwai Fatt

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Malaysia Taxation Principals and Practice, 2010 Sixteenth Edition. (Chapter 5, Para 4.0).