Tax and Legal Implications of Engaging Freelancers for Businesses in Malaysia
1) What are the tax risks for businesses when hiring freelancers instead of full-time employees?
In Malaysia, both freelancer and salaried employees must pay income tax. The key differences are; for full time employees, tax is automatically deducted monthly via Monthly Tax Deductible (MTD). For freelancers, they must declare and pay their own taxes as individuals with their monthly income.
The main tax risk for Malaysian businesses when misclassifying a worker as a freelancer is incurring substantial penalties and retroactive liabilities for unpaid mandatory contributions (EPF, SOCSO, EIS) and income tax deductions (MTD) if the Inland Revenue Board (IRB) or courts determine an employer-employee relationship actually exists.
2) How do tax authorities determine whether a freelancer arrangement should be reclassified as employment?
Malaysian tax authorities known as Inland Revenue Board (IRB) determine a worker's status by examining the substance of the working relationship, not just the contract's title, by using a multiple factors test in order to determine whether a freelancer should be reclassified as employment. The key determinant is the degree of control exercised by the hiring entity or the company itself.
Key factors and presumptions by Inland Revenue Board (IRB) that may lead to reclassification freelancer as an employment include:
1. Control and Direction: The company dictates the manner, time, and location of work, rather than the individual having autonomy instead of the employee discretion or choices.
2. Benefits: The individual receives typical employee benefits such as EPF, SOCSO, EIS contributions, annual leave, and medical benefits.
3. Payment Method: The individual is paid a fixed salary or wage, as opposed to project-based or commission-based fees.
4. Integration: The individual is an integral "part and parcel" of the organization, subject to annual appraisals and internal policies like regular employees.
5. Exclusivity and Business Risk: The individual works exclusively for one company, does not bear their own significant business risks, and cannot work for competitors.
6. Provision of Tools/Premises: The company provides the necessary tools, equipment, or requires work to be done on company premises.
3) What are the employer’s withholding or reporting obligations when working with freelancers?
Employers in Malaysia generally have no withholding or social security obligations for local freelancers or independent contractors who are hired by them. The freelancer is responsible for managing and paying their own income taxes and any social security contributions required by law.
For local freelancers, if the total monetary and non-monetary incentives paid to an agent, dealer, or distributor, which can include certain types of freelancers and exceed RM5,000 in a year, employers must prepare and provide them with a Form CP58 by March 31st of the following year for them to make reporting to Inland Revenue Board (IRB).
4) Are withholding taxes applicable when engaging cross-border freelancers?
Payments to non-resident freelancers for services performed in Malaysia may be subject to withholding tax, typically at a rate of 10% on royalties or potentially 30% for other income if no “Double Taxation Agreement” applies. It generally applies to special classes of incomes including technical, management, or consultancy services.
If the service is performed outside Malaysia; under the Income Tax (Exemption) (No. 9) Order 2017, income from technical or management services performed wholly outside Malaysia is exempt from withholding tax. Proper documentation (e.g., contracts, place of performance evidence) is crucial to support this exemption during an audit or declaration made to the Inland Revenue Board (IRB).
5) How do double taxation treaties impact taxation of payments to foreign freelancers?
Malaysia has “Double Tax Agreements” (DTAs) with over 70 countries, which may offer reduced Withholding Tax rates or exemptions. DTAs are bilateral agreements that allocate taxing rights between countries and to eliminate double taxation. This prevents a situation where both Malaysia (source country) and the freelancer's home country (residence country) impose full tax on the same income.
The DTAs typically stipulate that the freelancer's home country will provide a foreign tax credit for the taxes paid in Malaysia on the Malaysian-sourced income. The credit is usually limited to the amount of tax that would have been payable in the home country.
Generally, income for services (freelance/business income) is taxed only in the freelancer's country of residence unless they have a "permanent establishment" (PE) in Malaysia. The definition of a PE and other specific conditions vary by treaty.
DTAs provide clear rules for determining an individual's tax residency, which is crucial for determining how and where income is taxed. Tax treaty relief is not automatically granted. The foreign freelancer must actively claim the benefits by providing proof of residency (a tax residency certificate from their home country) and other required documentation to the Inland Revenue Board of Malaysia (IRBM).
6) What compliance documentation should businesses maintain when working with freelancers?
Businesses working with freelancers in Malaysia must maintain a comprehensive "contract for services" and ensure meticulous financial and tax record-keeping. These documents are crucial for legally distinguishing the relationship from standard employment and for tax compliance.
A detailed agreement is essential to outline the scope of work, deliverables, milestones, payment terms, and intellectual property (IP) ownership, and to explicitly state the individual is an independent contractor or freelancer and not an employee.
Businesses should maintain meticulous records of all payments made to the freelancer, as these documents may be reviewed in case of a legal dispute over worker classification. Also retain all invoices provided by the freelancer as proof of expense and for tax purposes. These invoices should include all required fields such as a unique number, the service description, and the applicable Service Tax amount or a note if exempt.
Proof of Overseas Tax Filing is needed if working with a non-resident freelancer. This is to proof that their income is attributed to operations outside Malaysia and taxed in their country of residence in order to ensure correct tax treatment in Malaysia.
7) What compliance requirements must companies meet when engaging freelancers?
If engaging foreign freelancers, the company must ensure they have the appropriate work permits or professional visit passes for work performed in Malaysia. Companies must accurately classify workers as independent contractors (operating under a "contract for services") rather than employees ("contract of service"). Misclassification risks significant penalties, including fines and orders for benefit compensation. The key difference lies in the level of company control over the individual's work, hours, and location.
A clear written contract is essential, detailing the scope of work, deliverables, timelines, payment terms, and confidentiality clauses. This agreement governs the relationship, as general labor laws (like the Employment Act 1955) typically do not cover independent contractors.
Companies are not required to make any statutory contributions like the Employees Provident Fund (EPF), Social Security Organisation (SOCSO), or Employment Insurance System (EIS) for freelancers. These are responsibilities of the freelancer themselves.
Companies do not typically withhold income tax (Monthly Tax Deduction or MTD) for independent contractors. The freelancer is responsible for filing their own taxes with the Inland Revenue Board (IRB). Companies should obtain necessary documentation from foreign contractors, such as a W-8 BEN form for US citizens.
Payments should be made against invoices submitted by the freelancer, following the schedule agreed upon in the contract, and ideally not processed through the company payroll system.
8) What are the legal and contractual best practices for structuring freelancer engagements to minimize tax risks?
To minimize tax risks in Malaysia, freelancers must use a genuine "contract for services" to establish self-employed status and maximize legitimate business expense deductions. Proper contractual wording and diligent record-keeping are critical to avoid misclassification as an employee, which has different tax implications.
Employers or businesses must clearly define "Contract for Services" and to ensure the agreement clearly states it is a "contract for services" and not a "contract of service" (employment contract). The contract should establish independence and grant the freelancer control over their work hours, location, and the method of delivery, without mandatory appraisals or leave procedures.
The contract must avoid exclusivity and stipulate that the freelancer is free to take on other clients (even if subject to non-disclosure restrictions regarding competitors).
The contract must also clearly outline the project's scope of work, duration, and payment terms, generally involving the freelancer submitting invoices for payment.
To clarify the liability and IP ownership, the contract must also include clauses for liability, confidentiality, non-disclosure, and intellectual property ownership to protect both parties.
The contract should exclude clauses on employee benefits and freelancers should not been provided with any traditional employee benefits like EPF contributions, SOCSO coverage (beyond voluntary schemes), or medical leave.
Author: Yusrizal bin Zainol Abidin
