Income Tax or Real Property Gains Tax?

Article by Richard Oon

BADGES OF TRADE: Due to the huge gap in tax rates, it’s worth knowing whether the sale of your property falls under a trading activity subject to income tax or is merely a disposal of an investment property

So you’ve just sold your third property for the year, enjoying decent profits and your lawyers helped you to file the disposal of the property with the Inland Revenue Board (IRB) as Real Property Gains Tax (“RPGT”). You paid the tax at a mere 5 per cent RPGT rate, happy with yourself for the (still) sizable bundle of cash that you’ve made. Case closed. WRONG.

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Unfortunately, unknown to many, there are two laws that govern the taxation of property transactions in Malaysia. They are:

• Income Tax Act 1967 (“ITA”); and
• Real Property Gains Tax Act 1976 (“RPGTA”).

In practice, the IRB first considers if the gain from the disposal of a property is subject to Income Tax. Under the ITA, the onus is on the taxpayer to show, by producing evidence when required to do so, that the gain was not income and instead capital in nature, therefore only subject to RPGT.

The gain will be viewed as income if the transaction is a trade transaction (e.g. holding of properties as stocks for the intention of resale) or an adventure or concern in the nature of trade. If the gain is viewed as income by the IRB, then Income Tax will apply and if you’re a company, you will be taxed at corporate rates of 20 per cent or 25 per cent, or for individuals, at the individual’s income tax rate, graduating from 0% to 26%. Ouch.

Confused? Let me give you an example:

Let’s say you are one of those car-enthusiasts; you recently bought an old Mini and decided to do your own restoration work on it during your free time, figuring it will be a nice ‘babe-magnet’ to drive around in when it is refurbished. Job done and the old jalopy you bought for a couple of thousands of Ringgit turns out to be a real flashy piece of art. You’re pretty happy with the work that you’ve done on it. One of your friends thinks so too and wanted to take it off your hands for an attractive price. Realising there’s money to be made, you sold the car to your friend at a handsome profit. The profit made from the sale of this car will not be subject to Income Tax as it is merely selling an asset which you use for your personal enjoyment, hence a capital gain.

However, you figured that there’s money to be made here and since you can repeat this process over and over and make more and more money, you decided to buy a few more cars and do the refurbishment work on them with an intention to sell them for another round of profits. Once you undergo this process, you’re beginning to sound more and more like a car trader, aren’t you? In this situation, the gains made will be subject to Income Tax as this will appear to be your business undertaking.

Now, let’s put the above example in the context of properties. Just replace the word ‘car’ in the example above with the word ‘property’. Having done that, doesn’t that make you sound like a property trader? Wouldn’t Income Tax apply for the gains that you make on the properties you sell?

How to tell the difference?

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So when is the gain from the disposal of a property subject to Income Tax or RPGT? Nowhere in our tax laws is there a definition of what is income (subject to Income Tax) and capital gain (subject to RPGT). The distinction between these two classifications is so ambiguous that in Malaysia, there have been dozens of tax cases involving property transactions that have been brought to the courts by either the IRB or the taxpayer to decide whether the transaction is subject to Income Tax or RPGT. It is obvious why the IRB would want to assess gains on property transactions under Income Tax as compared to RPGT, as a property transaction being assessed under Income Tax would mean higher tax collections for the government!

So for the recently concluded property sale that you made, which tax would you be subject to? In order to properly determine this, one has to explore the facts of each individual case and also research into precedent case laws to determine if the transaction in question is categorised under capital gain (RPGT) or Income Tax.

When exploring each transaction’s facts of the case, one will need to apply the ‘badges of trade’ test, which is an internationally-accepted guide to assess if the disposal of the property is subject to Income Tax. As you can imagine, the badges of trade, which originally started with six ‘badges’, have expanded and evolved over time with the support of new case laws. Some of the tests are:
Was there a profit-seeking motive, i.e. was the property held as an investment or stock-in-trade? Obviously, disposal of properties held as stock will be subject to Income Tax. Take the property developer, for example. Properties are the property developer’s stocks and the gains from their disposal are subject to Income Tax.
What was the nature of the property, i.e. did it generate any rental income, used as personal dwelling or left vacant in anticipation of resale? Properties which generate rental would have the appearance of being held for investment while a property which is left vacant gives the impression that it will be sold for a quick buck.
How was the purchase of the property financed, i.e. via short-term or long-term borrowings? The purchase of investment properties are normally financed by long-term borrowings while speculative properties are normally financed using short-term funds such as bank overdraft.
How was the property acquired, i.e. was it an inheritance, bought through the open market or through an auction?
Was there sub-division of the property or additional work performed on the property prior to resale? Any additional work performed such as subdivision or conversion of land from agriculture to commercial use may be viewed as efforts to enhance the value of the property prior to resale and may be subject to Income Tax.
What is the frequency of transactions undertaken by the company/individual? Repetitive, frequent transactions may indicate trading in properties.
How was the property classified in the accounts of the disposer, i.e. as an investment property or development property?
Does the disposer possess any special organisation or special skills related to property transactions, or the property industry?
How long was the property held prior to resale, i.e. was it short-term or long-term? Properties held for long periods, say more than five years prior to sale, may indicate that the property was held as an investment.
What were the circumstances behind the sale of the property, i.e. was the property sold because of emergency need of funds, compulsorily acquired by the government or was it through active marketing activities?

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One has to be cautious to avoid getting ‘pinned’ by the badges of trade as this will point towards a transaction which is subject to Income Tax and not RPGT. This is especially so in the current tax regime where the RPGT rates are low and therefore, the IRB will attempt to capture more property transactions under Income Tax, where taxes can be considerably higher.

What if an assessment under RPGT has already been raised on the sale of a property? Would that mean you’re safe from exposure to Income Tax? The answer is NO. A couple of Malaysian case laws have affirmed that the IRB has the authority to discharge the RPGT assessment previously raised on the disposal of a property and substituting it with an Income Tax assessment. Yikes.

Now try applying the ‘badges of trade’ test against the example on the car-enthusiast above and see how many badges of trade would the subsequent venture of buying and refurbishing cars, attract.

Are you that car-enthusiast?

Richard Oon is the National Tax Director of TY Teoh International. TY Teoh International, with offices in Singapore, Johor, Kuala Lumpur, Perak, Penang and Labuan, is a member firm of the MSI Global Alliance, one of the world’s largest independent associations of accountancy and law firms.

Richard will be speaking on 23rd March, 2013 at EastIn Hotel, Penang. Click here to know more.

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