On 29 June 2020, the Federal Court in IBM Malaysia Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (01(f)-37-11/2019(W)) dismissed the taxpayer's appeal against the decision made by the Director General of Inland Revenue ("DGIR") in the form of an Advance Ruling under Section 138B of the Income Tax Act 1967 ("ITA"). As at the time of writing, the Federal Court's written grounds of judgment are not available.
IBM Malaysia Sdn Bhd ("IBM")1 carries on the business of distributing software. IBM Ireland Product Distribution Limited ("PDL"), one of the companies within the IBM Group, maintains a significant software development capacity and has engaged in substantial software development. Incorporated in Netherlands, PDL does not have any offices or establishment in Malaysia.
IBM and PDL contemplated entering into a software distribution agreement ("the Agreement") through which IBM would be granted the right to distribute the software programmes developed and owned by PDL in Malaysia in consideration of a distribution fee payable by IBM. On 12 April 2016, IBM made an application to the Inland Revenue Board of Malaysia ("IRB")2 under Section 138B of the ITA, seeking an Advance Ruling as to whether the distribution fee payment to be made by IBM to PDL, a non-resident, is a royalty and thus subject to withholding tax. On 7 June 2016, the IRB issued its Advance Ruling to IBM, stating that the distribution fee payable by IBM to PDL is a royalty and thus subject to withholding tax under Section 2 of the ITA ("Advance Ruling").
On 1 September 2016, IBM filed an application in the High Court for leave to issue judicial review proceedings seeking the court's intervention to quash the Advance Ruling. The High Court, on 19 September 2016, granted leave to IBM to issue judicial review proceedings and an interim stay order pending the substantive hearing. IBM and PDL then executed the Agreement on 31 December 2016.
What is an Advance Ruling?
Before proceeding further to examine the Courts' decision, it will be helpful at this stage to briefly explore the history of "Advance Ruling".
The ability to apply for an Advance Ruling was first introduced in the Budget 2007 speech delivered in September 2006.3 In this speech, the then Prime Minister and Minister of Finance, YAB Dato Seri Abdullah bin Abdul Haji Badawi said as follows:
24. An efficient system of tax administration is also vital to ensure the smooth and effective implementation of national development policies and strategies. To ensure greater compliance with tax legislation, tax administration must be simple and transparent, and it must be business and client friendly. Tax guidelines will be simplified and ambiguities in the laws, clarified. In this regard, the Government proposes:
First: the establishment of a customs tribunal to consider appeals on decisions made by the Director General of Customs;
Second: the Royal Malaysian Customs and Inland Revenue Board (IRB) to issue advance tax rulings to ensure certainty of tax treatment and transparency in tax administration;
This intent was followed through by way of an amendment to the ITA4. Section 138B of the ITA was introduced to provide that an Advance Ruling may be applied for and obtained from the DGIR on the DGIR's interpretation of how any provision of the ITA applies to a proposed arrangement that a person is seriously contemplating.5 The Income Tax (Advance Ruling) Rules 2008 ("AR Rules") were then gazetted which outlined the scope, procedure and fees imposed in relation to the issuance of an advance ruling. Subsequently, the IRB issued the Guidelines on Advance Rulings ("AR Guidelines") to set out the scope and nature of an Advance Ruling in detailed. The AR Guidelines were updated by the IRB on 10.6.2016.
Those to whom Advance Rulings have been issued are required to disclose in their tax returns: (i) the issuance of the Advance Ruling; (ii) whether or not the Advance Ruling has been relied on in preparing and providing the tax returns; and (iii) any material changes to their arrangements to which the Advance Rulings apply ("the Disclosures").
It was also provided that an Advance Ruling issued by the DGIR is final6 and binding7 in nature and that no appeal shall be lodged by any person against any Advance Ruling.8
The High Court's Decision
The issues for determination by the High Court were: (i) whether the Advance Ruling was a decision which was binding upon IBM; (ii) whether IBM's application for judicial review was premature; (iii) whether the domestic appeal remedies under the ITA were available to IBM; and (iv) whether the distribution fee payable under the Agreement was a royalty.
On 27 March 2018, the High Court9 allowed IBM's application for judicial review. The grounds are summarised as follows:
- The Advance Ruling was final and binding on IBM and therefore was a decision amenable to judicial review. IRB's contention that the Advance Ruling was merely an opinion of the DGIR as opposed to a decision as IBM could have opted not to follow the Advance Ruling was not accepted;
- The judicial review application was not premature as the Advance Ruling had "altered and deprived [IBM] of its right by subjecting the distribution fee to withholding tax as [IBM] will suffer financial detriment and will have to pay tax";
- There were no alternative domestic appeal remedies available to
IBM and judicial review was the only remedy available:
- there was no alternative remedy under Section 99 of the ITA10 available to IBM. The right of appeal under Section 99 ITA 1967 did not arise as there was no assessment made, nor was there any service of the notice of assessment; and
- the right of appeal under Section 109H(1) of the ITA 196711 did not arise as no amount was due from IBM to the IRB; and
- The IRB had failed to apply and take cognizance of the established principle expounded in Director-General of Inland Revenue v Euromedical Industries Ltd  CLJ (Rep) 128 that in the event of any inconsistency between the double taxation agreement ("DTA") and the ITA, the DTA must prevail over the ITA. The definition of royalty under the DTA between Malaysia and Netherlands as well as Paragraph 11 of the Organisation for Economic Co-operation and Development's ("OECD") commentary (cited Damco Logistic Malaysia Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (2011) MSTC 30-033) which addressed the difference between contract for provision of services and a know-how contract was adopted. In this case there was no transfer, grant or the use of know–how or proprietary rights in consideration of the distribution fee. The distribution fee was not for the right to reproduce the software programs but was the cost of purchasing the PDL's software, which IBM would in turn distribute and resell with a mark-up in Malaysia. Thus, the distribution fee payable to PDL by IBM under the Agreement was not a royalty.
The IRB appealed against this decision to the Court of Appeal.
The Court of Appeal's Decision
On 30 May 2019, the Court of Appeal allowed the IRB's appeal
and set aside the High Court's decision.12 The grounds of the Court of Appeal are
summarised as follows:
- IBM's application for judicial review of the Advance Ruling
- Although the Advance Ruling was unfavourable to IBM by treating the distribution fee payable to PDL as royalty, it had not adversely affected IBM until IBM had filed its tax return and tax was assessed. Until then, the Advance Ruling remained at best, the IRB's view on the tax treatment for the distribution fee payable by IBM to PDL with no tax liability;13
- The Advance Ruling was a decision that did not have any tax implication as there was no assessment made by the IRB. In other words, IBM had not been adversely affected by the Advance Ruling;14
- Although the Advance Ruling was final and binding,
"[The AR] does not leave [IBM] without a choice whether or
not to be bound by it as contended by the [IBM]".
Reference was made to paragraph 12.1 of the Guidelines on Advance
Rulings issued by the IRB ("the
Guidelines") which reads15:
Once an Advance Ruling is issued, it is considered final irrespective of whether it is advantageous to the person or not. No further correspondence or enquiry will be entertained and no appeal can be made against the Advance Ruling. In the case of a disadvantageous Advance Ruling, the person has the choice of not carrying out the proposed arrangement. On the other hand, if the proposed arrangement is effected, then the Advance Ruling has to be complied with. The applicant can make an appeal objecting to the tax treatment stated in the Advance Ruling under the normal provision for appeal stated in section 99 of the ITA. That means the objection is against the notice of assessment made";
- By paragraph 12.1 of the Guidelines, IBM had a choice whether or not to follow the Advance Ruling. IBM could have chosen to abandon the proposed business transaction in light of the unfavourable Advance Ruling.16 In effecting the proposed business transaction, IBM had chosen to be bound by the Advance Ruling and thus, it had to comply with the Advance Ruling;17
- There was an appeal remedy available to IBM under Section 99 of
the ITA . However, IBM did not avail itself of this right. The
Court of Appeal reasoned that:
- IBM did not comply with Paragraph 14(1) of the AR Rules18 by performing its obligations under the ITA and Paragraph 15 of the AR Rules by making the Disclosures in its tax return. Despite IBM being unhappy with the unfavourable Advance Ruling, it was still required under the ITA to file its tax return for YA 2016.19 Had IBM made the Disclosures in its tax return for YA 2016, IBM could have appealed against the notice of assessment under Section 99 of the ITA20 to the Special Commissioners of Income Tax ("SCIT") and ventilate the issues pertaining to the tax treatment stated in the Advance Ruling before the SCIT;21
- Remedy by way of judicial review should not be available if other remedies existed, except in very exceptional circumstances;22
- The main grievance of IBM was the treatment of distribution fee payable to PDL as royalty. It was a matter of interpretation of law, which was not an exceptional circumstance which warranted a judicial review application.23 The proper forum to ventilate the issue, was before the SCIT by filing an appeal against the notice of assessment under Section 99 of the ITA; and
- IBM was using the backdoor to appeal against the Advance Ruling which was final and such act, which circumvented the function of the SCIT, was an abuse of court process and ought not be allowed.24
Dissatisfied with the Court of Appeal's decision, IBM obtained leave to appeal to the Federal Court.
The Federal Court's Decision
On 29 June 2020, the Federal Court dismissed IBM's appeal.
As the Federal Court's written judgement is not yet available, the reasons leading up to the dismissal of the IBM's appeal at Federal Court remain unknown. In the meantime, the Court of Appeal's decision remains as the authority in relation to Section 138B of the ITA.25
The Court of Appeal's decision does however raise a number of concerns:
- First is the issue of whether the Advance Ruling had adversely effected IBM upon its issuance or whether a taxpayer is only adversely effected if and when an assessment is issued by the IRB. The authors note that upon issuance of the Advance Ruling and upon IBM deciding to ahead with the arrangement, a legal obligation arose on the part of IBM to withhold an amount at a prescribed rate within one month after paying or crediting the distribution fee. Therefore, arguably, IBM is adversely affected by the Advance Ruling well before an assessment is issued. The question that thus arises is whether this decision is then precedent to argue that a taxpayer is only ever aggrieved upon the issuance of an assessment.
- The second significant concern that arises from the Court of Appeal's decision is the finding that because there is an option for the taxpayer to abandon the transaction, that there is therefore no final decision. This finding seems to ignore the fact that if the taxpayer prefers to proceed with the transaction, then that ruling is final and binding. If so, surely the Advance Ruling should be amenable to judicial review in the event that the Advance Ruling is irrational or illegal.
- Also, as it is a prerequisite that the Advance Rulings will only be issued for arrangements that are "seriously contemplated" by the applicants26, the arrangement is one that is likely to be at an advance stage such that 'opting' to drop it is not likely to be without adverse effects to the taxpayer.
- The sum of the Court of Appeal's decision appears to be that the Advance Ruling is a decision of the IRB which is final and binding and yet unappealable. The effect of the Court of Appeal's decision is that the IRB will have latitude to make any decision in the form of Advance Rulings and such decisions will not be amenable either to appeal or judicial review. The only option open to the taxpayer, even if there may be legitimate grounds to challenge the Advance Ruling, is to abandon that business venture.
- The Court of Appeal's decision has resulted in a rather perilous situation for a taxpayer. Even if the IRB issues an Advance Ruling which is ultra vires and illegal in nature, the taxpayer, if it wishes to proceed with its business plan, must comply with such Advance Ruling and thereafter make the Disclosures in its tax return and await potentially many years for a notice of assessment to be issued in order to be able to appeal against the Advance Ruling. In this regard, it is not implausible that the IRB may never issue a notice of assessment.
On a final note, the authors note that the Court of Appeal dismissed the appeal on the ground that the judicial review proceeding was premature - the Court of Appeal therefore did not consider the merits of the case which was whether the distribution fee payable to PDL by IBM under the Agreement was a royalty payment under Section 2 of the ITA. Had the Court of Appeal done so, it may have arrived at the conclusion that the Advance Ruling was in direct contravention of the Federal Court's decision in Euromedical (supra).
In the final analysis, it would seem that a taxpayer should seriously consider whether to apply for an Advance Ruling as the prejudicial effect of an adverse outcome appears to outweigh any advantage that the initial intent of an Advance Ruling was meant to achieve.
1. IBM was the Applicant at the High Court, the Respondent at the Court of Appeal, and the Appellant at the Federal Court.
2. The IRB was the Respondent at the High Court, the Appellant at the Court of Appeal, and the Respondent at the Federal Court.
3. Paragraph 24, page 6 of the 2007 Budget Speech dated 1 September 2006.
4. Section 26 of the Finance Act 2006.
5. AR Guidelines, paras 1 and 2.
6. The AR Rules, para 16(1).
7. Explanatory Notes to Clause 26 of the Finance Bill 2006; The AR Guidelines, paras 4.1 and 4.2.
8. The AR Rules, para 16(2).
9.  1 LNS 1010.
10. Section 99 (1) of the ITA reads: "A person aggrieved by an assessment made in respect of him may appeal to the Special Commissioners against the assessment by giving to the Director General within thirty days after the service of the notice of assessment or, in the case of an appeal against an assessment made under section 92, within the first three months of the year of assessment following the year of assessment for which the assessment was made (or within such extended period as regards those days or months as may be allowed under section 100) a written notice of appeal in the prescribed form stating the grounds of appeal and containing such other particulars as may be required by that form."
11. Section 109H(1) of the ITA reads: "A payer referred to in sections 109, 109B or 109F may, within thirty days (or any period extended by the Director General) from the date an amount is due to be made to the Director General under that section, appeal to the Special Commissioners by reason that such amount is not liable to be paid under this Act and the provision of this Act relating to appeals shall apply accordingly with any necessary modification."
12. Ketua Pengarah Hasil Dalam Negeri (LHDN) v IBM Malaysia Sdn Bhd  1 CLJ 776.
13. Ibid, at paragraph 42.
14. Ibid, at paragraph 42.
15. Ibid, at paragraphs 48 and 49.
16. Ibid, at paragraph 51.
17. Ibid, at paragraph 52.
18. The AR Rules, para 14(1).
19. Ibid, at paragraph 55.
20. See endnote 10 above.
21. Ibid, at paragraph 61.
22. Ibid, at paragraph 58.
23. Ibid, at paragraph 60.
24. Ibid, at paragraph 62.
25. See Petronas Penapisan (Terengganu) Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (2014) MSTC 30-078 (HC).
26. The AR Rules, para 2(3).
Originally published 08 March 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.