Income from illegal activities – is it taxable?

ILLEGAL income arises from illegal activities. It is an act which the law disapproves of, or completely bans. There are two types of activities:

First, where normal income-producing activities become illegal because of non-compliance with licensing requirements or acting in contravention of a ban instituted by law.

Second, income from the carrying on of systemic crimes such as burglary or theft.

The common illegal activities in Malaysia could be found in illegal logging, trafficking of cigarettes, drugs and subsidised fuel, illegal gambling, organised crime, bribery, etc.

What is the law?

The Malaysian Income Tax Act (ITA) taxes all income that is accrued in, derived from or received in Malaysia. The ITA is silent on illegal income. Therefore, reading the general provisions of the ITA, and based on the principles established in the case of Director-General of Inland Revenue (DGIR) vs LTS, it was concluded that notwithstanding the illegality of the contract, the income of the taxpayer was liable to tax.

Malaysia tends to follow the other common law jurisdictions such as the UK where in majority of such cases the statutory provisions are read literally. Here the approach is to look at the words of the tax legislation and if the tax legislation allows organised business activity to be taxed, then such income will be taxed. The taxpayer may be prosecuted for the offence and at the same time taxed upon the profits arising from the illegal activities. The issue of morality does not arise in this type of situation.

The position in Malaysia is notwithstanding whether the transaction is illegal, immoral or ultra vires, it is taxable in Malaysia as long as the characteristics of the activities constitutes income, it could be taxed under Section 4(a) as business income or Section 4(f) if it is casual in nature such as burglary or bribery.

Deductibility of expenses

It is clearly established in the Malaysian case of DGIR vs LTS that if the illegal income is brought to tax, the taxpayer is also entitled to deductions on expenditure that is incurred in the production of that income subject to any special provisions in the ITA that prohibits such deductions. Fines, penalties, and similar payments which are not incurred in the production of income will not be tax deductible.

Unfortunately, bribery to obtain and maintain contracts is not uncommon in Malaysia. This phenomenon is part and parcel of the requirement to obtain business or to carry on servicing an existing business.

In such instances, the Inland Revenue Board (IRB) is willing to exercise its discretion to allow deductions of such payments provided the person receiving the bribery is identified by the taxpayer. As far as the IRB is concerned, one party must pay the tax: either the payer or the recipient.

It is not uncommon for the payers to try and hide such illegal payments under other legitimate descriptions such as project costs or material costs or under other descriptions. This approach is dangerous as it tantamount to falsifying information and can amount to willful default or fraud.

Such an event will invite higher penalties as much as 100% or may be subject to prosecution in the courts which can result in higher penalties up to 300% of the tax undercharged, or a maximum jail term of three years, or both.

Income from illegal activities is not spared from the tax net in Malaysia.

This article was contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai.