Tax incentives for research and development in Malaysia

This article collates and discusses the provisions in the Income Tax Act 1967 (the Act) and the Promotion of Investments Act 1986 (PIA) to promote candidates’ understanding of the interplay of the income and deductions relating to the various research and development (R&D) activities or expenditure. While reading this article, candidates are expected to refer to the relevant provisions of the Act, the PIA, and Public Ruling 5 of 2020 relating to qualifying R&D activities and Public Ruling 6 of 2020 relating to special R&D deductions.

Incentives discussed in this article

This article discusses the incentives in place to encourage the carrying out of R&D activities in Malaysia, namely:

• Approved R&D expenditure
• Contract R&D company
• R&D company
• In-house R&D

Background

R&D incentives

Section 34(7) of the Act provides for a single deduction for expenditure, non-capital in nature, on scientific research related to the business and directly undertaken by any person or on his behalf. With effect from 1 January 2021, the qualifying person must be resident in Malaysia.

This measure of single deduction was apparently not sufficiently attractive.

In an effort to springboard Malaysia higher up the value chain and increase the quality of its exports of manufactured goods, the government has actively promoted and encouraged R&D activities in the country. In addition to research grants, the government has provided a suite of tax incentives as follows:

Capital allowances
In addition to the incentives above, paragraph 37B of Schedule 3 of the Act provides for industrial building allowances for a building used in approved research, used by a contract R&D company or used by an R&D company. Qualifying building expenditure includes any capital expenditure incurred on the alteration or renovation of rented premises to carry out research activities.

Paragraph 37D of Schedule 3 of the Act similarly provides for capital allowances in respect of capital expenditure for plant and machinery used for the purpose of approved research, even where the research is not related to the business activity.

Definition of research
Section 2 of the PIA defines research and development to mean:

‘… any systematic or intensive study carried out in the field of science or technology with the object of using the results of the study for the production or improvement of materials, devices, products, produce or processes but does not include:

(a) quality control of products or routine testing of materials, devices, products or produce

(b) research in the social sciences or the humanities

(c) routine data collections

(d) efficiency surveys or management studies, and

(e) market research or sales promotion.’

The objective of the research must be in accordance with the needs of the country and must be beneficial to the Malaysian economy.

With effect from 28 December 2018, a definition of R&D has been inserted in section 2 of the Act. Below is a tabulated comparison of the two definitions, with differences indicated in bold:
 

Under the definition in the Act, the scope of research and development is somewhat more specific while routine, cosmetic or stylistic modifications and changes to materials, devices and processes are specifically excluded as research and development.

Related company
The term ‘related company’ is often used in R&D incentives. It is defined in the PIA as follows:

‘… in relation to a company, a related company means a company:

(a) the operations of which are or can be controlled, either directly or indirectly, by the first-mentioned company;

(b) which controls or can control, either directly or indirectly, the operations of the first-mentioned company;

(c) the operations of which are or can be controlled, either directly or indirectly, by a person or persons who control or can control, either directly or indirectly, the operations of the first-mentioned company.

Provided that a company shall be deemed to be a related company of another company if:

• at least 20% of its issued share capital is beneficially-owned, directly or indirectly, by that other company; or
• at least 20% of the issued share capital of that other company is beneficially owned, either directly or indirectly, by the first-mentioned company.’

In short, in relation to a company, a related company includes:

(a) its subsidiary;

(b) its holding company, 

(c) a subsidiary of its holding company; and

(d) associated company.

This means that, prima facie, all companies in the same group of companies and direct associates are related companies for the purpose of R&D incentives.

Public ruling
The tax authorities issued Public Ruling 5 of 2020 relating to qualifying R&D activities and Public Ruling 6 of 2020 relating to special R&D deductions to clarify relevant issues such as examples of what is research, what is not research, criteria for approval, and what constitutes qualifying research expenditure.

Approved R&D expenditure

This incentive measure under section 34A of the Act provides for a double deduction to a person resident in Malaysia in respect of qualifying research expenditure (which is revenue in nature) related to a research programme undertaken by a business entity. The double deduction is made in arriving at the adjusted income of the business.

With effect from 1 January 2021, the amount of expenses on R&D incurred outside Malaysia in a basis period shall not be more than 30% of the total expenses on R&D incurred by the resident person in the basis period.¹

If the 30% threshold is breached in any basis period, only single deduction of the R&D expenses incurred in the basis period is allowed.

Please note that the research programme must have prior approval by the Minister of Finance. Also, it is not necessary for the subject matter of the research programme to be related to the business activity carried out by the company.

Qualifying expenditure includes:

• raw materials used in the research project
• technical services
• travelling and transportation costs
• salary and allowances of research personnel
• maintenance costs of research buildings and equipment, and
• rental of equipment, machinery or buildings used for research.

In this regard, it is pertinent to note that payment of royalties, licensing fees, etc, will not qualify as these represent ‘purchased’ research. The thrust of research incentives is that the research activity must be carried out in Malaysia.

Where a pioneer company which is tax resident in Malaysia carries out an approved research project during its tax relief period, it can elect to defer the deduction of the qualifying research expenditure to the post-pioneer period so as to reap the full benefit of the double deduction. The mechanism for this is the R&D expenditure charged to the revenue statement during the tax relief period (TRP) is added back, thus increasing the adjusted (therefore exempted) income during the TRP. The company can elect for the R&D expenditure during the TRP to be given a single deduction after the TRP [section 34A(4A)].

Contract R&D company

A 'contract R&D company' is defined under section 2 of the PIA as a company which:

• provides R&D services
• in Malaysia
• only to companies other than its related companies.

In other words, a contract R&D company provides its services only to non-related companies – ie all third-party independent companies.

A contract R&D company is eligible for either one of the incentives below:

1. Pioneer status – exemption of 100% (instead of the standard 70%) of the statutory income for five years from its production day; or
2. ITA – 100% (instead of the standard 60%) of qualifying capital expenditure incurred within ten years (instead of the normal five years) to be set off against 70% of the statutory income.

Note that both the pioneer status and the ITA offer enhanced benefits. Additionally, any unabsorbed losses and capital allowances may be carried forward to the post-tax relief period.

To make it even more attractive to users of the R&D services provided by a contract R&D company, any person who pays for the use of services of a contract R&D company will be eligible for a double deduction of such payments under section 34B of the Act.

R&D company

An R&D company is defined under section 2 of the PIA to mean a company which:

• provides R&D services
• in Malaysia
• to its related companies or any other companies.

Note that while a contract R&D company must render its services only to unrelated parties, an R&D company may render its services to related companies.

An R&D company does not qualify for pioneer status: it is eligible for ITA only. The ITA available is 100% of qualifying capital expenditure incurred within 10 years set off against 70% of statutory income.

Any unabsorbed losses and capital allowances may be carried forward pursuant to the relevant provisions in the Act. 

Any person, who is a tax resident of Malaysia, who pays for the use of services of an R&D company and who is not a related company, qualifies for a double deduction of such payments under section 34B of the Act. This means that if a company is likely to provide R&D services to one or more related companies, the related companies will not qualify for a double deduction for the R&D expenditure. Nevertheless, such related-company users may avail themselves of the single deduction for scientific research available under section 34(7) of the Act.

Hence, when a group of companies embarks on establishing an R&D entity to cater to its R&D needs, it is well-advised to consider the relative merits of either going for the ITA incentive for the R&D company or opting for the double deduction for the users of the R&D services in respect of the R&D fees under section 34B. Please see the illustration below:

Illustration

XYZ Group of companies intends to establish an R&D company (R&D Co) to cater for the burgeoning R&D needs of the group companies. In the first three-year plan, R&D Co will incur RM2 million of qualifying capital expenditure (QCE) on a factory, machinery and equipment to carry out R&D services for a highly profitable fellow subsidiary Zee Sdn. Bhd. (Zee) which will pay R&D fees of RM3 million evenly over three years to R&D Co. Zee is a resident company in Malaysia.

The XYZ Group wants to know whether R&D Co should apply for ITA incentive.

Computation of tax savings for the XYZ group in the first three YAs – click here

In-house R&D

Section 2 of the PIA defines in-house research as:

• R&D
• carried on in Malaysia
• within a company for the purpose of its own business.

The incentive available for such in-house research is ITA at 50% of qualifying capital expenditure incurred within 10 years. The ITA is set off against 70% of statutory income.

It should be noted that there is no mutual exclusion stipulated for the two incentive measures of

• in-house R&D and
• approved research.

A company may therefore apply for approved research to obtain a double deduction for the R&D expenditure under section 34A of the Act, and at the same time apply for in-house R&D incentive under the PIA. There is no double claim as the in-house R&D incentive provides for ITA in respect of qualifying capital expenditure while the section 34A double deduction is expressly for non-capital expenditure.

R&D Incentives summarised – click here

Reference
(1) The IRB clarified, post-Budget, that the 30% threshold is applied in each basis period, rather than on the basis of each approved R&D project.  

Written by a member of the ATX-MYS examining team