Posted Date: Sep 15, 2010
By: Richard Thornton
RENTS AS BUSINESS INCOME: BENEFITS & SNAGS
Holding properties to derive income from them is basically a passive activity so it is understandable that in most cases the income is treated as investment income. Nevertheless, investors are often aware that when rents are taxed as business income there are some potential tax advantages. What are those advantages and how can they be obtained?
More Scope for Expense Deductions
With passive lettings, each property must be considered separately. Expenses directly attributable to the letting of a property are eligible for deduction from the rents of that property but this leaves little or no scope for deducting expenses of a more general nature. Conversely, when rents are treated as business income, all eligible properties are treated as part of one single source of income, the ‘business’ of renting. Thus, expenses such as the cost of travel to and between the properties and other management and administration expenses can often be allowed as a deduction because they are incurred for ‘the business’. When the owner is a company, this can also apply to reasonable sums paid out as directors’ fees.
Deductions for Depreciation of Assets
When there is a business income source, deductions can be claimed for capital allowances on the cost of eligible assets used for the purposes of the business. This will apply to furniture and equipment in the case of furnished lettings and to assets used generally in connection with maintenance or management of properties. The rates at which capital expenditure can be written off vary according to the nature of the assets but, in many cases, the allowances are available at accelerated rates permitting a full write-off over a very short period. This contrasts with the method used for passive lettings which is to allow the cost of an asset bought to replace an existing one to be deducted from the rent but without giving any deduction for the cost of the original one (the “renewals basis”).
Relief for Tax Losses
Nobody plans to lose money but when a business does incur a loss, it is useful to have some way to obtain relief for it. Although a business of renting may produce a tax loss, it is more usual for the person concerned, whether an individual or a company, to be seeking relief for a loss sustained in another business. There are several ways in which this can be done. A current year loss can be offset against current year income but also a business loss sustained in an earlier year can be offset against the current income from a different business, such as the business of renting. There is also the possibility of tax relief by carry back of the loss where it occurs in 2009 or 2010.
Activity is Expected
Except for a company, the only way to qualify for business income treatment is for the owner to prove that ancillary or support services or facilities are being actively provided. Examples of the kind of services the tax authorities expect to see are security guards; air-conditioning (centralised or split units); supply of hot water; escalators and/or lifts; recreational facilities (clubhouse, gymnasium, tennis/squash/badminton courts, swimming pool, etc.); cleaning or housekeeping (including garbage disposal); maintenance of common property, garden, landscaping, exterior lighting and other external fixtures. However, it is not sufficient to provide them indirectly such as where the owner of a condominium unit gives his tenant the benefit of the services provided to him by a management corporation.
For a company, there is a natural presumption that whatever activity the company carries on is business, although the presumption may be rebutted. However, there is no such presumption in the case of an individual so the onus is on him to show that he has been actively involved. An individual is also at a disadvantage by comparison with a company because the special basis for classifying rents as business income which does not depend upon activity is only available to a company.
The Special Basis and Its Limitations
Although this basis is only available to a company, it is denied to a company which is an investment holding company or a company limited by guarantee which is taxed as a club.
Otherwise, eligibility for business income treatment on the special basis is determined solely by reference to the type(s) of property rented and without regard to whether the company has actively provided any services. One type of property eligible for this treatment is a special-purpose building owned by the company and provided for a commercial purpose such as a commercial complex, an office complex or shopping complex, or as a factory or warehouse.
More generally, the special basis is also available for the rents derived from a minimum of four properties of any or all of the following kinds in any combination; commercial units; shop houses; and residential properties. Except for shop houses, where each floor can be treated as one unit, only a property with a separate strata title is considered to be a unit. Property let to or occupied by a related or connected person is disregarded unless it is let for a rent which is not significantly less than the market rate.
Using a company will not guarantee success. It is very easy for a company renting out properties to be classified as an investment holding company. That would be unfortunate if relying upon the special basis for companies. As mentioned above, that basis is not available to an investment holding company. Even if relying upon ‘activity’ rather than the special basis to justify treating rents as business income, an unlisted investment holding company is at a disadvantage because the deduction available for management expense is very meager. Furthermore, the company’s income from renting is taxed in a special way which effectively prevents the set-off of tax losses. Readers might like to refer to the article “Should I use a Company to hold Investment Property” by the same author in the July 2010 issue.
The Problem: Ken Lim has been able to acquire and rent out four properties, two units of condominium and two terrace houses which are multi-occupied by students. He actively manages the rented terrace houses, arranging tenancies, collecting rents and providing maintenance, cleaning and garbage services. Ken has an unabsorbed loss of RM20,000 sustained in a failed business venture a few years ago and he would like to know whether he might qualify for some tax relief if he can treat the rents from one or more of his properties as business income.
The Solution: In the case of the two condominium units, all services are provided indirectly and the rents cannot be treated as business income. (Even though Ken has four residential properties, the special basis is unavailable because he is not a company). As to the terrace houses, all of the services that Ken provides seem to be ‘hands-on’ and they are probably sufficient to justify treating the rents from those properties as business income. He would be able to offset his unabsorbed losses against the net income from the two terrace houses until the losses are exhausted. Although Ken is not obliged to justify his treatment of the rents as business income to the Inland Revenue, he may be required to do so once he has made a claim to offset his losses.
Readers who wish to know more may refer to the two books mentioned below as well as to 100Ways to Save Tax in Malaysia for Small Businesses by the same author.
Richard Thornton is author of 100 Ways to Save Tax in Malaysia for Property Investors (ISBN978-983-2631-83-5) and 100 Ways to Save Tax for Malaysian Investors (ISBN978-967-5040-42-9) published by Sweet & Maxwell Asia. See http://malaysiaauthorindex.com/wiki/Richard Thornton. He is also a Fellow of the Chartered Tax Institute of Malaysia.
The two works referred to immediately above contain some valuable insights on how to achieve legitimate tax savings for investors in property and other assets as well as dealing with complex issues such as “When can an investor be taxed as a dealer?” and “Is it a good idea to use a company?” Written in clear simple language, the books contain helpful examples to explain how the tax planning ideas can be put into action. They can be obtained from most book stores, or from the author at firstname.lastname@example.org