BUSINESS INCOME

Learning Objectives You should learn from this topic: Definition of business Badges of trade Gross income from business Distinction between capital and revenue receipts Derivation of business income

Learning Objectives (Cont’d) You should learn from this topic: Commencement of business Basis period of business income Adjusted and statutory income from business

Business Income Section 4(a) income: Gains or profits from a business

Business “Business" includes profession, vocation and trade and every manufacture, adventure or concern in the nature of trade, but excludes employment [S 2, ITA 1967]

Business income A profession Requiring a skill-intellectual or manual Case: CIR v Maxse

????? VOCATION The way in which a person passes his life. Eg. Betting systematically Case: Partridge v Mallandaine :BILLAM V GRIFFITH

Business income TRADE A commercial undertaking with the intention to make profit.

Trade Busy Multitudes of transactions Repetitive

Trade –Determining factors in Malaysian Courts BADGES OF TRADE 10

Badges – why? Taxable or not Income tax -4(a) or capital gains. Capital gains – not taxable

Badges of Trade Guide to establish the existence of 'trade' or 'an adventure or concern in the nature of trade' in a particular case Income tax? Trading receipt Capital gain from disposing investment Income tax?

10 Badges of Trade Intention/motive of taxpayer Subject matter of transaction Length/period of ownership Frequency of transactions Formation of organization Financing arrangement Alterations/supplementary work on the asset Circumstances leading to the sale Method of disposal Accounting evidence/treatment

1. Intention/Motive of Taxpayer Badges of Trade 1. Intention/Motive of Taxpayer Where the subject matter was held for resale at profit (profit-making motive), the profits earned should be treated as business income Since acquisition Subsequent change or

2. Subject Matter of Transaction Badges of Trade 2. Subject Matter of Transaction Asset which can only bring benefit to its owner by realization is more likely to be subject of trading than asset which produce income or can be used or enjoyed during possession

3. Length/Period of Ownership Badges of Trade 3. Length/Period of Ownership The longer the holding period of the subject matter, the greater the possibility that it was held for investment, instead of for resale at profit A quick resale may point towards the transaction being in the nature of trade

4. Frequency of Transactions Badges of Trade 4. Frequency of Transactions Where the same type of asset is repeatedly bought and sold, there is strong indication that trading activities are being carried out An isolated transaction with some characteristics of trade could be considered as an adventure in the nature of trade

5. Formation of Organization Badges of Trade 5. Formation of Organization It is presumed that the main purpose for forming companies or partnerships is to carry on business Disposal of an asset by company, partnership or syndicate is more likely to be a business venture, compared to situation where the asset was disposed of by individual

6. Financing Arrangement Badges of Trade 6. Financing Arrangement Where a person borrows more than he could normally afford to buy an asset, there is indication that he hopes to resell the asset at a profit within a short period of time The shorter the period of financing, the higher the probability that the transaction constitutes business transaction

7. Alterations/Supplementary Work on the Asset Badges of Trade 7. Alterations/Supplementary Work on the Asset Supplementary work to enhance the marketability of the asset would indicate the presence of a trade or an adventure in the nature of trade Processing Packaging Modificaiton Renovation

8. Circumstances leading to the sale Badges of Trade 8. Circumstances leading to the sale A forced sale prompted by emergency need for fund, compulsory acquisition by government or some private factors would not constitute a trade Proceeds from the sale of stock in trade under hard pressed situation would still be treated as normal business income

Badges of Trade 9. Method of Disposal Organized activities undertaken in promoting the subject matter will indicate the existence of a profit-making undertaking Extensive advertisement Setting up sales office Employment of sales staff

10. Accounting Evidence/Treatment Badges of Trade 10. Accounting Evidence/Treatment Current asset - stock in trade Non current asset Held for long term investment/own use Held for resale Business income Capital gain

Summary of Badges of Trade Business income Capital gain 1 Intention of taxpayer Profit-making Investment 2 Subject matter Subject of trading Income producing or for personal enjoyment/use 3 Length of ownership Short period Long period 4 Frequency of transactions Repetitive One-off

Summary of Badges of Trade (Cont’d) Business income Capital gain 5 Formation of organization Company, partnership or syndicate Individual 6 Financing arrangement Borrowed fund (short term) Own fund or long term loan 7 Alterations on the asset With alterations Without alterations 8 Circumstances leading to the sale Free will Forced sale

Summary of Badges of Trade (Cont’d) Business income Capital gain 9 Method of disposal Active (organized activities) Passive (ad hoc) 10 Accounting treatment Current asset (stock in trade) Non current asset The badges/factors needs to be considered collectively to ascertain the nature of a transaction

Badges of Trade - Example 1993: A company acquired an oil palm plantation & operated plantation business subsequently 2000: Applied to convert part of the plantation land from agricultural use to residential use 2003: Obtained approval for the conversion. Constructed some basic infrastructure, subdivided the land into bungalow lots, advertised & set up a sales team to promote the bungalow lots

Badges of Trade – Example (Cont’d) 2005: Sold all the lots at a gain of RM18 million. The lots were classified as non current asset in the company's account prior to the sale. The gain was reflected as an extraordinary gain in its accounts Required: Argue whether the gain of RM18 million is assessable to income tax.

Badges of Trade – Example (Cont’d) Arguments for business transaction: Intention of taxpayer The land was acquired for agricultural use but the intention has changed to profit-making by selling it as bungalow lot Formation of organization The sale is made by a company Alternations on the asset The marketability of the land has been enhanced by the process of conversion & construction of basic infrastructure

Badges of Trade – Example (Cont’d) Arguments for business transaction (Cont’d): Circumstances leading to the sale Not a forced sale Method of disposal The company advertised & set up a sales team to promote the bungalow lots Assessable to income tax

Badges of Trade – Example (Cont’d) Arguments for capital transaction: Length of ownership Long holding period (11 years) Frequency of transactions No previous dealing in land Accounting treatment The lots were classified as non current asset in the company's account Not assessable to income tax

Badges of Trade – Example (Cont’d) The gain of RM 18 million is assessable to income tax because the sale of bungalow lots constitute an adventure in the nature of trade

Gross Income from Business Debts arising in the course of carrying on a business - sale of stock in trade - provision of services rendered - use or enjoyment of any property Market value of goods exported in the course of carrying on a business Market value of stock in trade withdrawn for own use

Gross Income from Business (Cont’d) Dividend income of share dealing business Interest income of investment dealing business/money lending business (eg bank & finance company) Release/waiver of debt by creditor pertaining to expense previously been allowed as business deduction (eg rent payable)

Gross Income from Business (Cont’d) Recovery of bad debt which has previously been allowed as business deduction Insurance recovery where insurance expense has been claimed as business deduction (eg for loss of trading stock)

Gross Income from Business (Cont’d) Compensation for loss of income (eg upon cancellation of ordinary trade agreement which is normal incident in business) Realized foreign exchange gain arising from revenue transaction which forms part of normal business activities

Capital Receipts Proceeds from disposal of fixed assets Receipt for substantial restriction on business activities (restrictive covenant) Compensation for destruction of profit-making apparatus (eg termination of major business contract)

Derivation of Business Income Gross income from a business that is not attributable to operations of the business carried on outside Malaysia would be deemed derived from Malaysia

Derivation of Business Income (Cont’d) Business of manufacturing, growing, mining, producing or harvesting any article, product, produce or other thing in Malaysia: Income from sale made outside Malaysia would deemed to be derived from Malaysia

Derived from Malaysia Section 12 (1) a Gross income from the business as is not attributable to operations of the business carried on outside Malaysia *”operations of the business” is not defined in the Act

Carry on Business in Malaysia? Malaysian Source- how ascertained Place of concluding contract rendering services maintaining trading stocks where orders are regularly fulfilled passing ownership and risk of trading stocks from the seller to the buyer receiving sale proceeds

CASES CONSIDERED

Paid $15,000 Sold tiles Cost of production $7000 Profit on Paid $15,000 Sold tiles Cost of production $7000 Atas Sdn. Bhd.a company manufacturing tiles in Malaysia sold a batch to a customer in Finland for $15,000. The cost of manufacturing was $7,000. Thus the profit was $8000. Where should the profit be taxed? What are the issues you need to consider to support your argument.

Sale Price $15,000 Atas Sdn Bhd ( Branch ) Customer Sale Price $8,000 Finland ------------------------------------------------------------------------------------- Cost of production $7,000 Malaysia Atas Sdn. Bhd How much is attributed to Malaysia for taxation. What are the issues you need to consider?

Chunilal B Metha v Comissioner of Income Tax, Bombay Taxpayer was trading as a broker and speculator in cotton. Silver and other commodities He traded from his only office in Bombay The business was conducted in India,Liverpool, London & New York He entered into future delivery contracts with foreign parties No delivery of goods was ever undertaken- only the difference between buying & selling were settled. The profits were not remitted to India.

Revenue Contended taxable because : Directions were given from India to carry out the transactions There was exercise of skill & judgment in India Taxpayer Contended : Profits do not accrue or arise in India Privy Council decision: One must not look only at the place where the decision was made but more importantly, the place where the transactions took place. The purchase and sale took place in New York and the profits were in the hands of the broker in New York who held them on behalf of the taxpayer. It made no difference to the result whether the transactions were dealings in goods or differences.

CASE STUDY The taxpayer was a firm of brokers and speculators in cotton, silver and other commodities. The firms office was in Bombay The speculation business was done both directly and through other brokers. The taxpayer gave instructions to another firm of brokers SP & Co, whose business was in Bombay, to buy and sell cotton on the New York Exchange SP & Co gave instructions to brokers in new York to carry out the transactions Any profits arising were payable to the taxpayer in Bombay No privity of contract between the taxpayers and brokers in New York Profits were not remitted to India Q Is the taxpayer taxable in India assuming the laws are similar to Malaysia? The question that beckons is what exactly is foreign income.

HIGH COURT DECISION The profits arose in India because No privity of contract between the taxpayers and brokers in New York as the dealings were done between taxpayer and SP & Co in India SP & Co were directly responsible to the taxpayers and vice versa The taxpayer placed orders to buy and sell with SP & Co in India and not with the brokers in New York CASE: CIT Bombay v Govindram Seksaria

Accrue/Arise/Derive!!! Business income derived from Malaysia if section 12 applies Employment income derived from Malaysia if sect 13(2) and (3) apply Dividend & interest income derived from Malaysia if sections 14 & 15 apply Royalties, periodical payments & pensions if sections 15,16,17(1-3) apply Special classes of income if section 15A apply

STEPS TO FOLLOW Determine income type- business, rental… Ascertain the originating cause of income. What was done to obtain income Geographical location Review tax legislations in corresponding country. DTA determines who has right to tax & PE issues.

Commencement of business Commencement is when one finally embarks upon the activities directly related to the production of the business income as distinct from activities, which are merely or preparatory or preliminary

Commencement of Business Embarks on activities that are part of the income producing process Retailing – the day shop is opened for business Hotel – the day hotel is opened to public Manufacturing – the day factory is in a position to start manufacture Plantation – the day seeds are sown or seedlings are planted Acquisition of existing business – the acquisition date of business operation

Commencement - Significance Basis period Accounting period Deductibility of expenses Capital expenditure-deeming provisions apply

Basis Period of Business Income Companies Trust bodies Co-operative societies Others: Calendar year Financial year

Adjusted Income from Business RM Gross income xx Less: Deductible expenses (xx) Adjusted income* xx RM Net profit xx Add: Non-deductible expenses (xx) Adjusted income* xx

Adjusted & Statutory Income from Business RM xx RM xx (xx) Gross income Less: Deductible expenses Adjusted income Add: Balancing charge Less: Capital allowances Unabsorbed allowance b/f Current year allowance Balancing allowance Statutory income

Adjusted Loss from Business Deductible Expenses > Gross income Adjusted loss Adjusted income: Nil Adjusted loss (current year business loss) can be utilized to reduce the aggregate income from all sources in the same Y/A. Unutilized loss – c/f to subsequent Y/A to reduce the aggregate statutory income from all business sources

Unabsorbed Capital Allowance Statutory income is ‘Nil’ C/f unabsorbed capital allowance to subsequent Y/A to reduce the adjusted income of the same business source

Aggregate Statutory Business Income RM xx (x) Statutory income Business 1 Business 2 Business 3 Aggregate statutory business income Less: Unabsorbed business loss b/f Net aggregate statutory business income

Computation of Statutory Business Income - Example Results of Tony’s businesses for the y/e 31.12.05: Manufacturing business Adjusted loss Capital allowances Balancing allowance Balancing charge Unabsorbed capital allowances b/f Unutilized loss b/f RM (14,000) 1,700 300 5,000 1,200 1,000

Computation of Statutory Business Income – Example (Cont’d) Trading business Gross income Expenses deductible non-deductible Net profit Capital allowances RM 38,000 31,500 1,900 4,600 7,000 Required: Compute the statutory business income of Tony for the year of assessment 2005.

Computation of Statutory Business Income – Example (Cont’d) Tony Computation of Statutory Business Income Y/A 2005 Manufacturing business RM 1,200 1,700 300 RM Nil 5,000 (3,200) 1,800 Adjusted income Add: Balancing charge Less: Capital allowances Unabsorbed allowance b/f Current year allowance Balancing allowance Statutory income

Computation of Statutory Business Income – Example (Cont’d) Tony Computation of Statutory Business Income Y/A 2005 Trading business RM 7,000 (6,500) 500 RM 38,000 (31,500) 6,500 (6,500) Nil Gross income Less: Deductible expenses Adjusted income Add: Balancing charge Less: Current year capital allowances Utilized Capital allowances c/f Statutory income

Computation of Statutory Business Income – Example (Cont’d) Tony Computation of Statutory Business Income Y/A 2005 RM 1,800 Nil (1,000) 800 Statutory income Manufacturing business Trading business Aggregate statutory business income Less: Unabsorbed business loss b/f Net aggregate statutory business income

Learning Outcomes After studying this topic, you should be able to: Define what is meant by ‘business’ Apply the badges of trade to establish the existence of ‘trade’ or ‘an adventure or concern in the nature of trade’ Determine the gross income from business Distinguish between capital and revenue receipts

Learning Outcomes (Cont’d) After studying this topic, you should be able to: Explain how business income is derived or deemed to be derived from Malaysia Determine the date of commencement of business State the importance of commencement date of business Compute the adjusted income and statutory income from business