COMPANY MATTERS: There are pros and cons to setting up a company to hold your investment property
Property investors are often perplexed about the tax implications of using a company to hold their investment properties. Doing so can bring some advantages but the pluses and the minuses need to be weighed carefully. The advantages: A 20 per cent income tax rate. This can give a useful tax saving when personal tax rates are high.
As the highest personal tax rate is currently 26 per cent, there is a potential one per cent advantage even when the company pays tax on all of its income at the principal rate of 25 per cent. But the real advantage is seen when the company is entitled to use the small company rate of 20 per cent on the first RM500,000 of chargeable income.
For a company to be eligible for the lower rate in any year, it must be an independent company with a paid up ordinary share capital of not more than RM2.5 million at the beginning of its accounting year. When the alternative to company ownership of an investment property is ownership by an individual with a substantial income, there is a potential for tax saving of at least RM30,000 every year (RM500,000 x (26%-20%)).
Example: Mr. Goh, a successful lawyer earning RM1 million every year is contemplating the purchase, as an investment, of a suite of offices. He expects to derive a rental income of RM600,000 per annum after deducting expenses of RM200,000. As the top slice of his income, this would attract a tax liability of RM156,000 (RM600,000 at 26 per cent).
However, if Mr. Goh were to set up a company to hold the asset, the company could expect to pay tax of RM125,000 (RM500,000 at 20 per cent plus RM100,000 at 25 per cent). There would be no further tax implication if the company paid out the after-tax income to Mr. Goh as a dividend.
Another plus (perhaps) – income spreading. Until fairly recently, a property investment company could also be used to spread income around within a family if the shareholdings were arranged so as to give each member the right to dividends. When the dividends came with a tax credit (26 per cent at present rates), shareholders who were taxable at lower rates could claim a tax repayment.
Unfortunately that no longer works as virtually all dividends are now single-tier dividends which come with no tax credit.
Some spreading can still be achieved where a company is able to pay out directors’ fees and claim a tax deduction for them. This would be beneficial when some directors were paying tax at low rates. However, it is easier said than done because a personal investment holding company is usually unable to claim more than a token tax deduction (the permitted expenses deduction) for directors’ fees or indeed any other expenses of management and administration.
A more substantial tax deduction may be possible when the company is eligible to be taxed on the basis that it is carrying on a business of letting properties. In default, the company is treated as carrying on a passive investment activity. The business basis may be achieved by:
(i) Obtaining a listing for the company’s shares;
(ii) Providing a sufficient amount of active maintenance and support services for tenants to reinforce an implied presumption that the company’s activities are active and not passive.
Even this will only achieve the objective if the company avoids being classified as an investment holding company. More effective tax relief for losses and expense deductions. It is not only the advantages of income spreading that investors hope for when seeking to classify their rents as business income. Other tax saving opportunities such as use of loss reliefs, capital allowances and improved expense deductions are open to them.
For more information, readers can refer to Declaring rents as business income – the pros and cons, in the March 23, 2012 issue of NST RED.
The drawbacks: The 20 per cent rate does not apply when the company is involved with another company which has a paid up ordinary share capital of more than RM2.5 million and either company owns more than 50 per cent of the paid-up ordinary share capital of the other; or a third company owns more than 50 per cent of the paid-up ordinary share capital of both of them.
Only the limited permitted expenses deduction is given to a non-listed company which is taxed as an investment holding company. This deduction is given for a proportion of specified expenses including directors’ fees, wages and salaries, management fees and various other professional fees as well as rent and expenses of maintaining an office.
The proportion is calculated by reference to the different types of income of the company but the proportion can never exceed five percent of the gross income from dividends, interest and rent chargeable to tax. (Exempt income is disregarded).
Consequently, the scope for paying tax-deductible directors’ fees is minimal. Space constraints do not allow for setting out the whole calculation but the following generalised example might help.
Example: Mr. Goh in the example given above would like the company to pay his wife (who has no other income) a directors’ fee of RM109,000. Even if a tax deduction for the company couldbe justified, it would not amount to more than RM40,000 ((RM600,000 + RM200,000 x 5%). Mr. Goh’s wife would pay tax of RM14,325 (being the tax on RM109,000 minus the personal relief of RM9,000) on her director’s fee, but the company would get maximum tax relief of RM10,000 (RM40,000 at 25 per cent). Not only is there no tax saving, there is a net cost of RM4,325.
An unlisted company may be classified as an investment holding companyfor any year unless it is able to show that it is not. It can do so by satisfying the requirement that its activities do not consist mainly in the holding of investments. If it is not able to satisfy that requirement, then it may still qualify by showing that less than 80 per cent of its gross income (whether exempt or not) is derived from such activities.
Satisfying the first requirement will depend mainly upon how the company describes itself in its statutory reports. The second test, which must be examined every year if necessary, is a matter of calculation. For this purpose, rents from properties where maintenance and support services are actively provided are ignored.
Example A: Expatriate Realty SdnBhd, an unlisted company, describes itself as a property investment company. Its gross income for the year to 31, March 2012 consisted of:
Although the activities of Expatriate Realty Sdn Bhd seem to consist mainly in the holding of property investments, it is not an investment holding company for tax purposes for the year of assessment 2012 because its gross income from investments, RM55,000, does not amount to 80 per cent of its gross income (RM20,000+RM55,000).