LHDN proposes new ruling: the purpose of foreign software decide whether withholding tax applies

LHDN has released a draft Public Ruling on how payments to foreign companies for software should be taxed. The draft is not final yet and the exemption order it relies on has not been gazetted.

When a Malaysian business pays a foreign company for the use of software, the payment can be treated as a royalty. A royalty paid to a foreign company is subject to withholding tax of 10%. This means the Malaysian payer holds back part of the payment and pays it to LHDN instead.

The draft sorts software payments into three zones. The green zone covers personal use, and business use purely for internal support work such as payroll, HR, accounting and internal documents. These payments can be exempted from withholding tax under the exemption order. The red zone covers payments where the business gets the right to copy, distribute or modify the software, or where the software is used directly in the main business that earns its income. These payments are subject to withholding tax. The yellow zone covers packages that mix several items, which must be split and treated item by item.

So does the purpose decide? Partly. Purpose plays a big role, but the rights given under the agreement also count. Under the draft, a business with only normal user rights can still fall into the red zone if the software is used to serve paying clients. LHDN's examples include a hospital patient records system, a digital advertising platform, a generative AI tool used to prepare client reports, a legal research database and a streaming service offered to hotel guests.

The draft also states that the contract name, the invoice wording and the server location do not decide the outcome. What counts is the actual rights given and how the software is actually used.

If tax that should be withheld is not paid, the draft says the amount is increased by 10% and becomes a debt to the Government. The software cost also cannot be claimed as a tax deduction until the tax and the increase are paid. Once the new order takes effect, the payment date, not the contract date, decides which rules apply.

The final position will depend on the official Public Ruling and the exemption order when they are published.

If you wish to focus on running and growing your business, our CFO advisory team can take care of your accounting, payroll, tax planning, e-stamping, corporate secretarial and compliance matters for you. Feel free to WhatsApp us at 010-246 2151.