Business Commencement and Cessation

by Choong Kwai Fatt 10 Sep 2002

Introduction The Malaysian Income Tax Act 1967 (The Act) divides classes of income into 6 categories, as defined in section 4 of the Act. These are: gains or profits from a business, for whatever period of time carried on; gains or profits from employment; dividends, interest or discounts; rents, royalties or premiums; pensions, annuities or other periodical payments not falling under any of the foregoing paragraphs; gains or profits not falling under any of the foregoing paragraphs. Income from a business source is a pertinent source in the Act as it has been accorded many preferential tax treatments. It contributes at least 60% of the total revenue collected by the Government. Thus, it is important to understand when a source of business income commences and when it ceases. Commencement of business Business in Malaysia can be categorised into trading, manufacturing and service providers. There are different types of business operation such as sole proprietors, partnerships, trusts and co-operatives but the most commonly is the use of a company. (These are known as business operators). The tax implications of the commencement of business are: a. Basis period The commencement date will trigger the basis period for taxation. Generally, the basis period of a financial year of 12 months will be the basis year of assessment for taxation. The financial year for 1.3.2001 - 28.2.2002 will be the year of assessment 2002 for taxation. The business operator is advise to close the accounts for a 12 month period running from the commencement date in order to avoid any tax adjustment of the basis period because of overlapping profits. The Act has been amended to ensure that the adjusted income from the overlapping period will not be taxed twice. The Act also allows the basis period from the commencement date to 31 December to form the basis period for the first year of taxation. A business operator who commences in business on 12.2.2002 and closes his accounts on 31st December, would have 12.2.2002 - 31.12.2002 as the basis period for the year of assessment 2002. Thereafter 1.1.2003 - 31.12.2003 will form the basis period for the year of assessment 2003. 31st December is a convenience year-end for business operators who happen to commence business part way through a month. b. Expenses Revenue expenses that are wholly and exclusively incurred 'in the production' of income will be tax deductible against the gross income. The phrase 'in the production of income' means that the business source must exist and have commenced. Any expenses incurred prior to commencement will not be tax deductible. These expenses are preparatory in nature or incurred in order to produce income. c. Current year loss Where the revenue expenses exceed gross income, a current year loss can be declared. This current year loss can be deducted from aggregate income (of both business and non business sources), the excess amount can be carried forward indefinitely to future years but the set off is restricted to business statutory income and not other sources of income. Upon commencement of business, the revenue expenses will be deductible and recorded as a current year loss in the event that there is no income generated. The availability of the current year business loss means that the operator will have lower income tax payable in the current year, or future years (if losses are carried forward). d. Disposals of assets The disposal of an asset before the commencement of business source is treated as a capital transaction. The gain would be a capital gain while loss is a capital loss. In the case of property developer, the land disposed at gain before commencement will be a capital gain. (HT Devt Sdn Bhd v KPHDN, 1996) The concept of 'trading stock' only crises once a business has commenced. Trading stock is the asset that an operator acquires with the intention to resell at profit. Therefore, the tax authorities will impose income tax on the trading stock disposed of. The test The ascertainment of the commencement date is a question of fact, supported by documentary evidence. A trading business is said to commence its business when it opens its door to the public. This is straightforward. The same applies to a service provider who opens his door to the public, ready to render their services. The question of income generation is of no relevance. Example 1 Bags Trading Sdn Bhd was incorporated on 1.1.2002 to operate a supermarket in Bukit Limau, Selangor. In February 2002, the company signed a tenancy agreement for its business premises, purchased plant and machinery, trading equipment, recruited its staff and placed orders for the various products to be sold. The retail stocks arrived on 1.4.2002 and were arranged on the shelves. The supermarket was opened to the public on 9 April 2002. The first sale was made on 10 April 2002. The Menteri Besar Selangor opening the supermarket was on 1.6.2002. Required: State, with reasons, the date of commencement of business. A retail business such as a supermarket commences business when it opens its doors and offers its goods for sale to the public. Thus the date of commencement would be 9.4.202. The fact that sales were made only on 10 April does not affect the date of commencement. Further, the Menteri Besar Selangor opening is merely ceremonial and does not affect the date of commencement. The difficulty in determining the date of commencement arises with manufacturing businesses. Manufacturing businesses acquire raw materials, process them into completed products and then sell these to either trading businesses or directly to customers. The trading stock consists of raw materials, work in progress and finished products. The test to ascertain the commencement date was laid down in CIT v Saurashtra Cement and Chemical Industries Ltd. (91 ITR 170). If there is more than one manufacturing process in order to produce the finished product, then manufacturing commences at the commencement of the first stage of the manufacturing process. Documentary evidence is required to substantiate this date when the tax authorities carry out their tax audit. The acquisition of raw materials, employment of manufacturing staff and acquisition of plant and machinery are activities preparatory to the commencement of business. The expenses incurred are expenses in order to produce income and not 'in the production' of income. Example 2 Christ Bhd was incorporated in 1.10.2001 to manufacture palm oil products. The factory building was acquired in December 2001 and was substantially overhauled in February 2002. Plant and machinery was installed on 15.3.2002 and its employees reported for work on 1.4.2002. Technical personnel were sent for a two weeks training course. All raw materials needed for the manufacturing process were received on 4.5.2002. The manufacture of the first batch of components was commenced on 6.6.2002 and completed on 20.7.2002. The components were sold in September 2002. Required: State, with reasons, the date of commencement of business. The business of manufacturing commences when the company is in a position to start its first process of the production cycle that is 6.6.2002. Renovation work, installing of plant and machinery, recruitment and training of staff were preliminary work done in preparation for the commencement of business. The income from the goods sold was not relevant. Cessation of business Business cessation is also a question of fact. When the operator disposes of plant and machinery, the factory is said to have ceased business. The operator needs to document the cessation date for the inspection of tax audit team. The tax implication of the cessation of business is that revenue expenses incurred in the process of cessation of business are not tax deductible, affirmed by the Malaysian High Court decision, Ampat Tin Dredging v Director General of Inland Revenue (1982). These expenses especially legal fees, retrenchment or compensation expenses are said to be incurred in the cessation of business source and not in the production of income. Once the cessation date is established, any expenses incurred after this date are also not deductible. Any unabsorbed capital allowance available at the time of cessation will be lost. There will not be any tax relief available to the operator. The disposal of plant, machinery, factory or qualifying assets will trigger off balancing adjustments being either balancing charges or balancing allowances. The balancing charge will reduce the unabsorbed capital allowance while the balancing allowance will increase the unabsorbed capital allowances. Malaysian income tax does not impose tax on capital gains. Thus, the amount of balancing charge will be restricted to the actual allowance claim. (The initial allowance plus accumulated annual allowances, which is the 'C' amount.) The disposal of land which was held for long-term investment gives rise to a capital gain, which will be liable to real property gain tax, ranging from 30% to 5%, subject to the holding period of such landed properties prior to the sale. The disposal of trading stock will be liable to income tax at the market price of such stock. The Act does recognise the 'hardship' of imposing market value. It allows the operator to sell the trading stock below market value i.e. strictly based on 'sale consideration' if the following conditions are fulfilled: the disposer permanently ceased to carry on the business; the acquirer will accept the trading stock in this business; there is a valuable consideration. Trade debtors are disposed either at book value or below it. The loss on disposing of trade debtors below book value is a capital loss. To avoid such a loss, the disposer should take advantage of sec 34(2) of the Act, providing an additional specific provision for bad debts with supporting evidence such as bankruptcy or the liquidation of the trade debtor to secure the specific provision of trade debt as an expense. This will certainly reduce the taxable income of the year of cessation. (see Public Ruling 1/2002 on bad debts deductions.) Cessation of business does not however prohibit the carry forward of any unabsorbed business loss. The operator will continue to carry forward the amount to utilize against other business income or future business income, which it commences in a later period. In the case of company, it should be noted that the cessation of business source is distinct from the liquidation of company. A business operator may have more than one business source. The separation of business sources is a question of law, to be ultimately decided by the courts in the event of disputes. Business operators can have more than one trading business simultaneously and manufacturing business sources of 1, 2, 3… The segregation of business sources merely an administration matter but with one tax implication factor on capital allowances. Capital allowance on business one cannot be utilized against adjusted income of business two or vice versa. In the case of an asset is used in both businesses, then the capital allowance of the asset will be dividend among the businesses in accordance to a reasonable basis such as usage, gross income or agreed ratio as accepted by the tax authorities. In the case of company, the surplus from the cessation of business source return to the shareholders will be deemed as payment of dividend. Shareholders will be taxed accordingly. Unless the company undertakes capital reduction scheme approved by the Court or there is a liquidation of company, then such repatriation of profits to the shareholders will be capital gains, free from income tax. (CIR v Burrell, 9 TC 27) Conclusion Commencement and cessation of business is an important aspect in the Income Tax Act 1967. The understanding of it's consequence will no doubt reduce the income tax payable of the business operator. source: http://www.accaglobal.com/archive/sa_oldarticles/635924 BACK TO TOP