Professional Level Skills Module, Paper P6 (MYS) All statutory references are to the Income Tax Act 1967, as amended, unless otherwise stated.

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2 Professional Level Skills Module, Paper P6 (MYS) Advanced Taxation December 2011 Answers All statutory references are to the Income Tax Act 1967, as amended, unless otherwise stated. 1 Golden Land Sdn Bhd Best Taxation Services 8, Professional Street Kuala Lumpur 9 December 2011 Chairman, Board of Directors, Golden Land Sdn Bhd, 10, Yellow Brick Road, Bandar Emas Dear Sir, Distribution of profits and real property gains tax As instructed, I append below the tax implications of the proposed distribution of the accumulated profits and the real property gains tax treatment of recent property transactions by Golden Land Sdn Bhd (GLSB). (a) Distribution of the company s profits In view that the shareholders would like to see a full distribution of the accumulated profits, three methods may be considered: (i) Paying a dividend Given the available imputation credit of RM10,000, a net dividend of RM30,000 or gross dividend of RM40,000 may be paid. As the dividend will be paid in cash and to ordinary shareholders, it will qualify as a franked dividend carrying with it an imputation credit. This means that shareholders receiving the dividend will be able to claim a s.110 set-off for income tax purposes. It should be noted, however, that the statutory income from such a franked dividend will re-enter a corporate shareholder s income tax computation at the total income stage. Therefore, no part of such a franked dividend income is available to absorb either a current year business loss or any approved donations. After fully utilising the s.108 balance, the company can duly migrate to the single-tier system. As the retained earnings stand at RM6 million, the company may pay dividends up to RM6 million only. When distributing the remaining RM5 97 million the company will be paying single-tier dividend. Such dividends do not carry with them any imputation credits and are tax exempt in the hands of the shareholder-recipients. The balance of RM4 million (RM10 million cash less RM6 million retained earnings) will effectively be dividend-trapped or non-distributable by way of dividend, until such time as the company records sufficient retained earnings to support further dividend pay-outs. (ii) Reduction of capital The company may address the dividend trap issue, as discussed above, by applying to the court for permission to reduce its capital from RM6 million to RM2 million. If the court grants approval, the RM4 million cash thus unlocked may be returned to the shareholders. As the distribution is a return of shareholder s capital, it will be capital in nature in the hands of the recipients, and therefore need not be reported for income tax purposes. (iii) (iv) Liquidate and distribute the residue Lastly, the company may pay the franked dividend to fully utilise the s.108 balance of RM10,000, thereafter it may liquidate or wind up the company, paving the way for a distribution of the remaining RM9 97 million cash. The franked dividend represents gross income and is fully subject to income tax. The distribution after the liquidation represents a return of the capital invested by the shareholders. It is therefore capital in nature to the recipients. Such a distribution after liquidation need not be reported for income tax purposes. Relative merits of each method and our recommendation The distribution of a dividend is the cheapest method as paying a dividend is a normal function of a company. At any rate, the balance of imputation [s.108 balance] credit should be utilised in full whichever method is adopted so as to pass on the full tax credit to the shareholders. A capital reduction involves an application for court approval. It will involve legal expense and uncertainty of the outcome. However, combined with a distribution of franked and single-tier dividends, it does afford the company continued existence to carry on its intended plans and activities. 13

3 The liquidation path similarly involves court and compliance processes and, therefore, is potentially expensive. As the company has amassed RM10 million cash compared to its retained earnings of RM6 million, liquidation represents an effective and quick route to fully distribute its profits to the shareholders. However, it also imperatively means that the company will terminate its very existence. None of these three methods has the effect of increasing the tax liability of the shareholders. The dividend method is the least expensive but results in only a partial distribution of the available cash. The liquidation method is effective in distributing the cash but is the most drastic, as it necessarily means the demise of the company. Under these circumstances, the dividend and reduction of capital method appears to be the best method, as it facilitates the full distribution of the cash to the shareholders, yet at the same time allows the company to continue its commercial life. Real property gains tax (RPGT) During the year 2011 GLSB has undertaken several real property transactions. We attach a computation (see Appendix attached) of the RPGT payable by the company of RM127,500 for the year of assessment In particular, we would like to highlight the following aspects of the RPGT treatment: (i) Allowable loss on the sale of the commercial shop lot It is provided in the RPGT Act [s.7(4)(a)] that an allowable loss shall be allowed as a deduction to reduce the total chargeable gain of a person for the year of assessment in which the disposal was made. The allowable loss arising from the sale of the shop lot is therefore deductible against the chargeable gain on the disposal of the city land, as both transactions occurred in the same year of assessment, i.e In this case, there is sufficient chargeable gain from the city land sale to completely absorb the RM87,000 allowable loss in the year of assessment (ii) The construction and destruction of the showroom building, and the insurance compensation subsequently received The construction of the showroom building in 2009 at a cost of RM935,000 represents an enhancement cost after the acquisition of the city land. Ordinarily, the sum would have been deducted from the sale price [paragraph 5 of Schedule 2, RPGT Act]. In this case, however, as the building was completely destroyed in the fire prior to the disposal of the city land, the enhancement cost is not reflected in the state or the nature of the asset at the time of disposal [paragraph 5(1)(a), Schedule 2 of the RPGT Act]. The RM935,000 is therefore not deductible in arriving at the disposal price. On the other hand, the insurance compensation received is clearly to be deducted from the acquisition price as stipulated in the law [paragraph 4(1)]: any sum received by him under a policy of insurance for any kind of damage or injury to or the loss, destruction or depreciation of the asset. Hence arises an inherently double jeopardy kind of situation where the cost of constructing the showroom building does not reduce the disposal price, and yet the insurance compensation received goes towards reducing the acquisition price. (iii) Proceeds from the compulsory disposal of one-tenth of the land to the Government This falls under the disposal of an asset as a result of compulsory acquisition under any law [paragraph 3(f), Schedule 2]. This means the disposal price is deemed to be equal to the acquisition price, which renders it as a no-gain-no-loss transaction. The acquisition price is RM107,000 (10% of RM2 million + 10% of RM70,000 10% of RM1,000,000), and the disposal is deemed to be at RM107,000 (even though RM450,000 has been received from the Government). There is therefore no RPGT liability in respect of this transaction. (iv) Disposal of the property in Singapore and remittance of the proceeds to Malaysia RPGT is not applicable to the disposal of the Singapore property because it is not land situated in Malaysia. Section 2 of RPGT Act defines real property to mean any land situated in Malaysia and any interest, option or other right in or over such land. The proceeds from the sale of the Singapore asset are capital in nature. When remitted to Malaysia, the amount is not subject to RPGT. Note, however, that it is not exempt income [under paragraph 28, Schedule 6], therefore it may not be credited into an exempt account (for foreign income received in Malaysia) for the purposes of distributing a two-tier exempt dividend. We hope that the above explanations serve to clarify and help in your deliberations. Please do not hesitate to contact us if you require further assistance. Yours faithfully,... Principal Consultant Best Tax Services 14

4 Appendix Golden Land Sdn Bhd Real property gains tax Year of assessment 2011 RM RM Sale price of the city land 3,500,000 Less Enhancement cost: construction of the showroom building nil Disposal price 3,500,000 Purchase cost of 90% of the city land: 2,000,000 x 90% 1,800,000 Add Legal fees and stamp duty (90% x 70,000) 63,000 Less Insurance compensation received (90% of RM1,000,000) (900,000) Acquisition price (963,000) Chargeable gain 2,537,000 Less Allowable loss from sale of shop lot (87,000) 2,450,000 Acquisition date 2 March 2008 Disposal date 21 November 2011 Disposal in the Fourth year RPGT at 15% 367,500 Less Exemption [under PU order 486]: A/B x C = (RPGT at 15% RPGT at 5%)/RPGT at 15% x chargeable gain = (367, ,500)/367,500 x 2,450,000 = 245,000/367,500 x 2,450,000 (1,633,333) Chargeable gain 816,667 RPGT at 15% 122,500 2 Learned Group of companies (a) (i) Whether Reading Sdn Bhd and Kopi-O Sdn Bhd qualify for group relief. Reading Sdn Bhd and Kopi-O Sdn Bhd will be eligible for group relief, because: they are both resident in Malaysia and incorporated in Malaysia; they are related companies as defined, as they are 100% (more than the minimum 70%) held by a third company which is resident in Malaysia (Learned Bhd); they have been related companies throughout the basis period for the current year of assessment and for the immediately preceding 12 months; they each have a paid up ordinary share capital of RM18 million, greater than the stipulated minimum threshold of RM2 5 million at the beginning of the basis period; they both have a 12-month basis period ending on the same day, 31 December; and they have current year business loss and defined aggregate income. Also, in the basis period, neither company has enjoyed any tax incentives, such as pioneer status, investment tax allowance, reinvestment allowance, shipping incentive, incentive for approved food production, acquisition of proprietary rights and acquisition of foreign-owned company. (ii) Group relief that can be claimed in the year of assessment 2011 Claimant company Reading Sdn Bhd (Reading) would be the claimant company as it has profits to absorb the surrendered loss. Relief is given against the company s defined aggregate income, which is obtained by deducting from the aggregate income Reading s own current year loss, any deduction under Schedule 4 or 4B, approved donations and assorted deductions for gifts and contributions for public benefit. Reading does not have any of these deductions in the year of assessment Its statutory income from business for the year of assessment 2011 is RM6 million. Therefore, Reading s defined aggregate income for the year is RM6 million. Surrendering company Kopi-O Sdn Bhd (Kopi-O) would be the surrendering company as it has incurred a current year adjusted loss of RM10 million in the year of assessment Up to 70% of the surrendering company s adjusted loss (less any loss absorbed against aggregate income) in the basis period may be surrendered. For the year of assessment 2011, as Kopi-O does not have any other sources of income, the amount that may be surrendered is RM7 million (RM10 million x 70%). 15

5 However, this amount is subject to the amount of defined aggregate income of the claimant company, therefore the maximum amount of relief that can be claimed is RM6 million. To: Group Managing Director, Learned Group of companies From: Tax Adviser Date: 9 December 2011 Report on the proposed acquisition of shares or assets of Artful Sdn Bhd As instructed by you, I present herewith my report on the relative merits of Learned Bhd (Learned) acquiring the entire shareholding of Artful Sdn Bhd (Artful) or Kopi-O Sdn Bhd (Kopi-O) acquiring the 500 pieces of artwork from Artful. (i) (ii) (iii) Tax deductibility of the loan interest A RM30 million loan will be raised to finance the acquisition of shares or purchase of the art pieces. If Learned acquires the entire share capital of Artful, it will represent an investment in a wholly-owned subsidiary. The loan interest would be related to the dividend income produced from the said investment. As Artful is a newly-incorporated company, any dividend from it will be a single-tier dividend. Such a dividend will be exempt from tax in the hands of Learned, but the more significant implication is that any interest incurred on borrowing to acquire the shares will not be tax deductible. If Kopi-O were to acquire the 500 art pieces, they would constitute inventory in the business activity of dealing in art pieces. The dealing in art pieces may be argued to be part and parcel of the garden café business as the art works will be displayed and sold in the café premises. Even if the dealing in art pieces is deemed a separate business source, the art pieces would still constitute inventory of the separate business of art dealing. Loan interest incurred on money borrowed to acquire inventory is patently tax deductible, as it is incurred directly in an integral business activity: therefore it is wholly and exclusively incurred in the production of gross income from sales. Tax treatment of the initial cost of the 500 art pieces and the basis of inventory valuation at the end of the basis period. If Learned acquires the entire share capital of Artful, it will have effectively acquired full control of Artful, but the 500 art pieces remain with the same owner, i.e. Artful. Upon commencement of operations, Artful would be able to charge the initial cost of the art works as an expense in its income statement as the cost of purchasing inventory. If Kopi-O acquires the 500 art pieces directly, the cost can similarly be charged to its income statement as the cost of purchasing inventory for the business. In both cases, the basis of valuation of inventory is the same, i.e. [under s.35(3)] at market value at the end of the basis period (which is 31 December 2011). However, as the art pieces are physically tangible assets and are not immovable properties, stocks, shares or marketable securities, an election may be made to value the inventory at cost plus expenses in bringing the inventory to its current condition and location. Treatment of the initial losses incurred If Learned acquires the entire shareholding of Artful, and Artful incurs a loss in the initial 12 months, the said loss is the current year adjusted loss of Artful, not Learned. Artful would be able to carry forward any unabsorbed loss to offset against its statutory income in future years. If Kopi-O were to acquire the 500 art pieces and run the business of art dealing either as part of the garden café business or as a separate business source, the initial loss of the art dealing business again constitutes a current year loss. Such a loss may be deducted from the aggregate income of Kopi-O. Any unabsorbed amount may be carried forward to be deducted against the statutory income from all businesses of Kopi-O. (iv) Eligibility of the initial losses for group relief purposes If Learned acquires the entire share capital of Artful, the initial loss of Artful may not be surrendered under the group relief provisions in the year of assessment This is because Artful, although a 100%-owned subsidiary by 31 December 2011, is not a related company throughout the basis period for that year of assessment and the 12-month period immediately preceding that basis period. On the other hand, if Kopi-O acquired the 500 art pieces, it immediately forms part of an existing business or a new business of Kopi-O, an existing company that is a related company in the year of assessment 2011 as well as the year of assessment Thus any current year loss of Kopi-O may be surrendered under the group relief provisions. I hope the above clarifies the position and helps you in deciding the course of action to adopt for this venture. End of Report 16

6 3 Buku Sdn Bhd (a) (i) Income tax treatment of the RM300,000 expended in acquiring the shares of Holdings Bhd. Although the purpose of acquiring the shares in the holding company is to provide the shares as a benefit to its employees, the shares at that point represent an investment in shares. The RM300,000 thus expended in the year of assessment 2011 should be treated as a capital expenditure and is not tax deductible. (ii) Tax deductibility of the cost of the shares transferred under the share option scheme. On 8 March 2011, 1,000 shares were taken up by employee A. The cost to Buku Sdn Bhd (Buku) of the shares given as an employee s benefit is [RM2,000 (RM3 1) x 1,000 shares]. This amount is incurred by Buku in the course of carrying out its business. Therefore the RM2,000 is tax deductible for the year of assessment On 2 July 2011 and 20 July 2011, employee B and employee C exercised their options and took up their share entitlement. The cost to Buku is RM32,000 [(6,000 x (3 1)) + (10,000 x (3 1))]. Similarly, the RM32,000 will be tax deductible to Buku for the year of assessment 2012 as it falls in the basis period commencing 1 July (c) Computation of share benefit and the year of assessment Employee A Exercised on 8 March 2011 RM Market value on the day of exercising option 5 50 Market value on the first day of the option period 4 60 The lower 4 60 Amount paid per share (1 00) Value of benefit per share 3 60 Number of shares taken up 1,000 Value of share benefit 3,600 The benefit is taxable in the year of assessment Employee B Exercised on 2 July 2011 RM Market value on the day of exercising option 6 00 Market value on the first day of the option period 6 80 The lower 6 00 Amount paid per share (1 00) Value of benefit per share 5 00 Number of shares taken up 6,000 Value of share benefit 30,000 The benefit is taxable in the year of assessment Employee C Exercised on 20 July 2011 RM Market value on the day of exercising option 4 50 Market value on the first day of the option period 4 50 The lower 4 50 Amount paid per share (1 00) Value of benefit per share 3 50 Number of shares taken up 10,000 Value of share benefit 35,000 The benefit is taxable in the year of assessment Tax treatment of the gain on the subsequent disposal of the option shares Any gain or loss arising on the subsequent disposal of the shares is capital in nature. Therefore, any gain is not taxable. 17

7 4 Foreign investor (a) Computation of exempt income and total income under pioneer status and investment tax allowance Pioneer status Year of assessment Total RM 000 RM 000 RM 000 RM 000 RM 000 Adjusted income Nil 5,000 10,300 15,100 Less capital allowance Nil (1,800) (800) (800) Statutory income Nil 3,200 9,500 14,300 70% thereof Nil 2,240 6,650 10,010 Less pioneer loss Nil (700) Nil Nil Exempt income credited to exempt account Nil 1,540 6,650 10,010 18,200 Pioneer loss carried forward (700) Nil Nil Nil 30% deemed total income 960 2,850 4,290 8,100 Investment tax allowance (ITA) Year of assessment Total RM 000 RM 000 RM 000 RM 000 RM 000 Adjusted income Nil 5,000 10,300 15,100 Less capital allowance Nil (1,800) (800) (800) Statutory income (SI) Nil 3,200 9,500 14,300 ITA brought forward Nil Nil ITA current year (60% x qualifying capital expenditure) 600 1,800 Nil Nil Less Utilised (restricted to 70% of SI) Nil (2,240) (160) Nil (2,400) ITA carried forward Nil Nil Nil Statutory income Nil 960 9,340 14,300 Less loss brought forward Nil (700) Nil Nil Loss carried forward (700) Nil Nil Nil Nil Total income Nil 260 9,340 14,300 23,900 Comparison of incentives and recommendation Analysis Exempted income Total income RM 000 RM 000 Pioneer status 18,200 8,100 ITA 2,400 23,900 In this case, the tax saved under pioneer status is far greater than that saved under the investment tax allowance incentive because of the relatively low level of capital expenditure compared to the level of profits. The incentive measure that is recommended is thus definitely pioneer status. 5 White Knight Sdn Bhd (a) Anti-avoidance provisions under s.140 Section 140 provides that where the Director General believes that any transaction has the direct or indirect effect of: altering the incidence of tax; relieving any person from tax or from having to file a tax return; evading or avoiding tax; or hindering or preventing the operation of the Act, he may disregard or vary or make adjustments to the transaction to counteract the intended effect. Arguments that might be used in an appeal In appealing against the invocation of the anti-avoidance provision, the following arguments may be put forward: Synergy The merging of the two distribution businesses was based on commercial synergy: combining the established brand name and the excellent distribution network of Distress Sdn Bhd (Distress) with the new dynamic management team and the tested profit-churning business model of White Knight Sdn Bhd. 18

8 Commercial substance The takeover of Distress s share capital and operations has commercial substance. The business was actively carried on, making the best use of existing structures and assets. Legal form The transaction was properly executed and had good legal form. Such a legal form cannot be pushed aside just because it yielded the tax advantage of utilising unabsorbed losses and capital allowances. Choice principle When conducting commercial affairs, taxpayers have a choice of adopting one measure over another. When their choice(s) lead to a tax advantage, that does not necessarily mean the taxpayer is evading tax. Commercial reality Takeovers and mergers of businesses are normal in commercial life: it is a commercial reality. Not a sham The transaction was not a sham: it was carried out and acted upon. It was not undertaken solely and exclusively to reap a tax advantage. If the transaction was stripped of the tax advantage, it still stands and carries on. 19

9 Professional Level Skills Module, Paper P6 (MYS) Advanced Taxation December 2011 Marking Scheme Marks 1 (a) Distribution of profits to shareholders Paying a dividend Franked dividend, amount and imputation credit 1 + Deemed total income and significance 1 Pay balance in single-tier dividend, amount, exempt treatment 1 + Balance is dividend trapped 1 5 Capital reduction Involves court process 1 Pay-out: nature and treatment 1 2 Winding up Utilise 108 balance first 1 Distribution after liquidation: nature and treatment + 2 Relative merits Assess each method Conclusion and recommendation 1 4 RPGT computation for YA2011 (i) Allowable loss Provision for deduction of allowable loss 1 Why loss is deductible in this case and how deducted 1 + Fully absorbed 3 (ii) (iii) (iv) Construction, destruction and insurance compensation Construction cost is enhancement cost, normal treatment + 1 Destruction and why becomes non-enhancement cost Insurance compensation and treatment + 1 Sum up situation as unfavourable 1 6 Compulsory disposal to the Government Provision disposal price deemed equal to acquisition price + 1 Calculations 1 Conclusion of non-liability 3 Disposal of Singapore property and remittance RPGT not applicable, reason Remittance to Malaysia, nature, not taxable to RPGT Cannot be credited into exempt account, reason 1 Available 5 Maximum 4 21

10 Marks (c) Computation of RPGT Disposal price * Calculation of acquisition price + Deduct insurance compensation Chargeable gain * Deduction of loss at the right stage, amount Disposal in the fourth year Calculation of exemption [under PU order 486] with formula 1 RPGT rate correctly applied 5 Note: Half marks indicated with a * are awarded for the allocation of the appropriate description to the figure calculated, not for the figure itself. Professional marks Format and presentation of letter 1 Clarity and effectiveness of communication 1 Appropriate use of appendix

11 Marks 2 (a) Reading Sdn Bhd and Kopi-O Sdn Bhd and group relief (i) Whether companies qualify for group relief Do qualify Resident and incorporated in Malaysia 1 Related companies Meaning: 70%, resident company, Learned Bhd months basis period + preceding 12 months + Paid up capital exceeds RM2 5m threshold 1 Same 12 month basis period 1 Current year loss and defined aggregate income Not enjoyed any tax incentives 1 List of incentives 1 9 (ii) Relief in the year of assessment 2011 Correctly identify claimant Defined aggregate income 1 RM6 million, how arrived Correctly identify surrendering company 70% of loss RM7 million, restricted to defined aggregate income of RM6 million 1 4 Acquisition of shares or art works of Artful Sdn Bhd (i) Tax deductibility of the loan interest If Learned Bhd acquired investment Interest related to dividend income Single-tier dividend treatment, non-deductibility of interest + 1 If Kopi-O acquired inventory 1 Regardless same or separate business source Reason why interest is deductible 1 5 (ii) Tax treatment of the initial cost of 500 art pieces and the basis of inventory valuation at the end of the basis period If Learned not its expense but Artful s 1 If Kopi-O own inventory Cost of inventory deductible 1 Basis of valuation of inventory same for both scenarios 1 Market value 1 Can elect for cost plus, condition/location (iii) (iv) Treatment of the initial losses incurred If Learned not its loss Artful s loss, can be carried forward If Kopi-O Kopi-O s loss, can set off, can be carried forward The eligibility for group relief in respect of the initial losses If Learned cannot qualify, reasons If Kopi-O existing business, can set off, reason Professional marks Format and presentation of the report 1 Clarity and effectiveness of communication

12 Marks 3 Buku Sdn Bhd (a) (i) Income tax treatment of the RM300,000 expended in acquiring the shares of Holdings Bhd. Nature of transaction: investment in shares 1 Capital expenditure in year of assessment Conclusion: not tax deductible 1 3 (ii) Tax deductibility of the cost of shares transferred under the share option scheme, stating the year of assessment and the amount deductible. Nature changes when share option exercised 1 Employee s benefit calculation for employee A In the course of carrying out its business 1 Conclusion: RM2,000 is tax deductible Specify year of assessment as 2011 Similarly for employees B and C Amount, year of assessment (c) Value of benefit taxable and the year of assessment Value of benefit: Lower of market value on day of exercising option and market value on first day of the option period 2 Less amount paid per share Computation of value of benefit in each case ( x 3) 1 All three benefits taxable in year of assessment Tax treatment of subsequent disposal Gain or loss is capital in nature 1 Gain not taxable Foreign investor (a) Pioneer status and investment tax allowance computations Pioneer status (PS) Deduction of capital allowances ( x 3) 1 Carry forward of loss in YA1 Set-off of loss in YA2 1 70% of statutory income ( x 3) 1 30% is deemed total income ( x 3) 1 Total exempt income Investment tax allowance (ITA) Deduction of capital allowances (as for PS) 60% of qualifying capital expenditure for YA1 and YA2 1 + Set off against 70% of statutory income, the lower for YA2 and YA3 + + Carried forward ITA for YA1 and YA2 + Set-off of loss Total income Comparison of incentives and recommendation Relatively low level of capital expenditure compared to level of income 1 Lower exempt income and higher taxable income under ITA 1 Recommendation for pioneer status

13 Marks 5 (a) The provisions Types of transaction (1 x 4) 4 Ability to disregard, vary or make adjustments to counteract intended effect 1 5 Arguments that may be put forward 2 marks for each valid argument, maximum