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CHAPTER TWO

AN OVERVIEW OF TAX INCENTIVES AND SMEs IN MALAYSIA

2.0Chapter Description

This chapter provides an overview of the tax incentives policy in Malaysia, including the evolution in the promotion of tax incentives in Malaysia and types of tax incentives granted and the relevant authoritys guidelines in the application and approval of tax incentives. The chapter also presents basic demographic information on SMEs establishment, reviews of SMEs policies and programmes, explanation on the most prominent tax incentives granted to SMEs and finally reviews the implications of these tax incentives on SMEs performance. As a background chapter, the detailed narration of Malaysian tax incentives policy provides an insight to what extent the current tax incentives are significant to SMEs, especially to the home-nurtured companies operating in the manufacturing sector in Malaysia. 2.1 Malaysian Industrial Policy

Since its independence in 1957, Malaysia has experimented with a series of industrial policies. In Malaysia, industrial policy refers to selective government efforts in promoting new economic investments via various channels such as trade, credit, human resource and technology policies (Lall, 1995). From 1970s, the overriding strategy was the implementation of New Economic Policy (NEP) which intended to fairly distribute the nations wealth amongst different races in this country. In response to the racial riots in 1969, the introduction of NEP primarily sought to readdress inter-ethnic socioeconomic disparities and indirectly aimed at the promotion of a wealthy Malay business community, rather than more effective industrial policies (Jomo, 2007). Other than wealth distribution industrial policy, there are two major types of industrial policies in Malaysia where each type of industrial policy is characterized by different objectives.

2.1.1 Import-Substituting Industrialization

Government policies from the late 1950s favored import-substitution industrialization, with government intervention largely limited to the provision of tariff protection, infrastructure facilities, tax exemptions and other incentives. Malaysia has executed at least two types of import substitution policies. The first type of import substitution policy was targeted at promoting the development of light industries such as food, paint, and clothing. The second type had focused on the development of heavy industries like steel and car industries. The purpose of the policy was to promote the development of manufacturing industries serving the domestic markets (Cassey, 2005). Most of these import substituting industries were set up as subsidiaries of foreign companies to finish goods produced with imported materials for more profitable sales within the protected domestic market.

However, there were major drawbacks related to import-substituting industrialization especially related to rent-seeking when the expenditure of resources in acquiring such government-endowed rents grew in Malaysia (Edwards, 1975). In terms of location, most industries were concentrated on the west coast of the peninsular and often small-scale manufacturing businesses were pushed out while regional dispersion was considered less likely to be profitable. Finally, in 1968, Raja Mohar Committee proposed the Investment Incentive Act to encourage investments in manufacturing export goods and this new legislation reflected a strategic switch in emphasis from import-substitution to export-oriented industrialization (Jomo, 2007).

2.1.2Export Promotion Industrial Policy

Malaysia has implemented export promotion industrial policy for more than 40 years, where the effort to promote export-oriented industries had been launched since the late 1960s. The introduction of Investment Incentives Act of 1968, Free Trade Zone Act 1971 and the Promotion of Incentives Act of 1986 have actively promoted Foreign Direct Investment (FDI) in export oriented companies. These policies initially were aimed at endorsing the development of manufacturing industries serving foreign markets. Many efforts had been undertaken by the government to entice export-oriented manufacturing companies to set up their businesses in areas such as the free trade zones (FTZs). FTZs offer financial benefits in the form of pioneer status, which allows tariff exemption on imports and exports and tax holidays over a period of 5 10 years (companies were exempted from corporate income tax of 35 % and development tax of 5 %).

Upon expiration of the pioneer status, companies are often granted with investment tax credits with further tax exemptions for another 5 to 10 years. In some cases where FTZs could not be established, the companies are allowed licensed manufacturing warehouses (LMWs) which share similar privileges as companies located in FTZs (Rasiah, 2002). All the subsidies and incentives offered in the form of tax exemptions thus served not only to attract investments, but may also induce actual value added to goods produced by the Malaysian manufacturing sector.

The first IMP (1986 1995) recommended the continuation of the export-led industrialization strategy but emphasized the promotion of resource-based industries where Malaysia had already developed a strong foundation with higher local content and the diversification of the non-resource based industries. This strategy was pursued through further liberalization of trade and investment, and substantial incentives were granted to encourage investment and exports. The incentive system under the IMP was tied to industries in which Malaysia had a comparative advantage and those products that were of strategic importance to the country and termed as priority products (IMP, 1994).

2.2History Development of Tax Incentives in Malaysia

After independence in 1957, the government realized that the Malaysian Industrialization required a conducive environment, thus, during the launching of the first economic plan, the government allocated RM 115.8 million or 2.5 percent of the total public development expenditure for industrial and mining development (Said, 2000). This allocation had been increased steadily over the subsequent five year plans and under the Fifth Malaysia Plan (1986 1990), the amount rose to RM 3,149.65 million or 4.56% of the total public development expenditure during the planned period. A positive step towards accelerating industrial development then was the establishment of industrial estates which were located at Petaling Jaya. Parallel with the industrial development, the government started to upgrade the infrastructure facilities and, apart from the physical incentives, fiscal incentives were given an emphasis as part and parcel of the overall effort to create a conducive investment climate to attract specific industries. To further demonstrate the governments concern in stimulating the investment climate for the investors, the Pioneer Industries Ordinance was introduced in 1958 where the focus was based on the promotion of import-substitution industries, such as consumer goods and intermediate goods (Said, 2000). Although, the Pioneer Industries Ordinance of 1958 was successful in attracting industries, it was inadequate in accommodating the governments wider objectives, particularly employment creation and income distribution which were necessary if the country was to industrialize rapidly. Due to the limitations of the domestic market, especially in the processing of raw materials and scarcity of domestic capital, thus, greater emphasis was placed on foreign capital, management expertise, technical know-how and marketing outlets. A shift in policy to attract foreign investments and export-oriented industries resulted in the Pioneer Industries Ordinance 1958 being replaced with the Investment Incentives Act, 1968 (IMP, 1994).

According to Said (2000), the introduction of the Investment Incentives Act, 1968 had increased emphasis on labor-intensive industries, export-oriented industries, industries utilizing domestic raw materials and the establishment of industries in the less developed areas of the country. Other than Pioneer Status, new incentives were offered such as Investment Tax Credit, Export Allowance, Double Deduction of Expenses Incurred on Promotion of Exports Overseas, Accelerated Depreciation Allowance, the Increased Capital Allowance and also Hotel Incentives. Over the years, these incentives were reviewed and improvements were made in line with the governments development objectives, for example, in 1971, the Labor Utilization Relief Act was introduced to promote labor-intensive industries. Thus, this led to the promulgation of the Promotion of Investments Act of 1986 which is currently the main legislation for fiscal incentives for manufacturing, agriculture and tourism in Malaysia.2.3Tax Incentives and SMEs in the Manufacturing Sectors

In Malaysia, various types of tax incentives are targeted at export expansion and towards the development of SMEs which are deemed as critical in developing inter-industry linkages (Kanapathy 2000). For the manufacturing sector, the two most important incentive schemes, both under PIA 1986; are the Pioneer Status (PS) and the Investment Tax Allowance (ITA). The following subsection discusses PS and ITA in greater detail.

2.3.1Pioneer Status and Investment Tax Allowance

Under the Promotion of Investment Act (PIA) 1986, the two most prominent tax incentives for SMEs are Pioneer Status (PS) and Investment Tax Allowance (ITA). These two tax incentives can be applied to SMEs which are manufacturing promoted products or are undertaking promoted activities. Generally, a company which has been granted with Pioneer Status enjoys a five years partial exemption from the payment of income tax. It only pays tax on the remaining 30 per cent of its statutory income[footnoteRef:2] (SI), with the exemption period commencing from its Production Day, which is defined as the day when its production level reaches 30 per cent of its capacity. To further encourage investments, the government gazetted the states of Perlis, Sabah, Sarawak and designated the Eastern Corridor[footnoteRef:3] of Peninsular Malaysia as the promoted areas, which entails all successful applications received from companies located in these areas to enjoy a 100 per cent tax exemption against their statutory income during their five years exemption period (PIA 1986). [2: Statutory Income is derived after deducting revenue expenditure and capital allowances from the gross income. ] [3: The Eastern Corridor of Peninsular Malaysia covers the States of Kelantan, Terengganu and Pahang, and the district of Mersing in the State of Johor.]

As an alternative to Pioneer Status, eligible companies may apply for Investment Tax Allowance (ITA). Pioneer companies are only entitled to this incentive after the expiry of the pioneer period or if their pioneer status has been withdrawn. In other words the ITA is mutually exclusive with the pioneer status. This incentive is also available to companies carrying out promoted activities or producing promoted products. This type of incentive is well suited for projects or industries that are capital intensive and have a long gestation period. A company granted ITA is entitled to an allowance of 60 per cent on its qualifying capital expenditure which includes factory, plant, machinery or other equipment used for the approved project and the related expenses are incurred within five years from the date the first qualifying capital expenditure is allowed. The company can then offset this allowance against 70 per cent of its statutory income for each year of assessment. Any unutilized allowances can be carried forward to subsequent years until they are fully utilized. The remaining 30 per cent of the companys statutory income will be taxed at the prevailing company tax rate (PIA 1986).

Similar with PS, any SMEs granted with ITA located in the promoted areas are also eligible for an allowance of 100 per cent on their qualifying capital expenditure incurred within a period of five years. The allowance can be utilized to offset against 100 per cent of the statutory income for each year of assessment.

The greatest challenge for eligible SMEs prior to being awarded with either PS or ITA is on the criteria stipulated in the Act which require all companies to comply with at least one of the following criteria:

a) The value added on the product must be at least 15 per cent, orb) The project must contribute towards the socio-economic development of the rural population.

However, in a meeting with an officer from the Ministry of International Trade and Industry, (MITI), he stressed that the above criteria are not intended to burden SMEs as the 15 per cent rate for value added is reasonably low and achievable even if the SMEs are from the small category. The aim of the government in introducing such criteria is to prepare SMEs to achieve competitive advantage through the production of quality products for both domestic and global markets. Application for this tax incentive should be forwarded to Malaysia Industrial Development Authority (MIDA), an institution under MITI.

PS or ITA is also eligible for SMEs registered under the Industrial linkage Program (ILP) Incentives. The ILP incentives have been enhanced under the World Class Program with the aim to encourage SME vendors to produce intermediate goods for the international market. A PS for 10 years with full exemption on its statutory income or 100% ITA on qualifying capital expenditure incurred within a five year period with full exemption on statutory income are granted to SMEs capable of achieving World Class Standard. In addition, those SMEs under the Basic Program and are producing the intermediate goods in an approved ILP scheme, may also be granted PS with full exemption (tax rate of 100%) on statutory income for five years or 60% of ITA on qualifying capital expenditure incurred within a five year period with full exemption on statutory income. However, with effect from 13th September 2003, if companies are participating in ILP, the 60% of ITA on qualifying capital expenditure may be set-off against 100% of their statutory income.

The PIA 1986 also provides PS for small scale manufacturing companies, defined as companies incorporated in Malaysia with shareholders funds not exceeding RM500, 000 and having Malaysian equity of at least 70 percent, as well as manufacturing products or undertaking promoted activities under the Promoted List for Small Scale Companies. However, in order to qualify for PS, they need to fulfill at least one of the following criteria:

a) Products should be used as raw materials or components by manufacturing industries;b) Products substitute imports and the local material content is more than 50% in terms of value;c) Export at least 50% of their input; andd) Contribute towards socio-economic development. Table 2.1 below shows the distribution of total applications and approval of two tax incentives to SMEs; PS and ITA for the period 1995 until 2000 as reported in SMI Development Plan (2001 2005). As shown in the table, SMEs are more favorable towards PS and the contribution of SMEs approved with PS towards potential employment and capital investment are also higher as compared to ITA. On the other hand, Table 2.2 highlights the total number of SMEs projects approved with tax incentives according to their ownership status for the year of 1997 until 2007. As shown in the table, about 1,346 of the SMEs have been approved with tax incentives, with the highest being awarded to Wholly Malaysian-owned SMEs (851 companies), followed by Malaysian majority (269 companies) and Wholly Foreign SMEs (113 companies). In addition, the government also granted tax incentives to SMEs with Foreign majority (95 companies) and Joint Venture companies where the portion of shares capital are equally owned between the government and foreign investors (18 companies).

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TABLE 2.1Tax Incentives for SMEs for the Period 1995 Until 2000Pioneer StatusInvestment Tax Allowance

YearApplicationsApprovedPotential EmploymentCapital Investment (RM000)ApplicationsApprovedPotential EmploymentCapital Investment (RM000)

19952561454,409242,9781931036,200

19962251233,434268,74116620213,800

19971791042,904274,57120918324,888

19981401213,103236,60713919534,770

199981611,448113,90042274,263

2000123612,028228,88361342,074

Total1,00461517,3261,365,680783074485,995

Source: MIDA (2005)

TABLE 2.2SMEs Project Approved with Tax Incentives According to their OwnershipOwnershipNumberEmploymentTotal Capital Investment (RM)

Wholly Malaysian85123,5563,003,940,225.00

Wholly Foreign1133,168664,657,189.00

Malaysian Majority2697,9411,071,675,454.00

Foreign Majority952,605324,728,611.00

Joint Venture 50/501857591,157,231.00

Total1,34637,8455,156,158,710.00

Source: Unpublished data from MIDA (2008) Furthermore, other than these two mutually exclusive tax incentives, SMEs are also entitled to apply for Reinvestment Allowance (RA) and enjoy the preferential tax rate of 20 per cent on their chargeable income. The following subsection explains RA and preferential tax rate applicable to SMEs.

2.3.2Reinvestment Allowance and Preferential Tax Rate

RA is more commonly known as a second round incentive to companies which have already enjoyed the tax holiday from either pioneer status or ITA. RA is provided under Schedule 7A of the Income Tax Act 1967 which states that any resident company in Malaysia that has complied with the following conditions is eligible for RA:

a) has been in manufacturing operation for not less than twelve months; andb) has incurred qualifying expenditures for either expansion, modernization or automation or diversification of its existing manufacturing business within the same industry

RA requires no prior approval from MIDA and those companies utilizing the RA will enjoy a flat rate of 60 per cent exemption on the qualifying capital expenditure incurred. This 60 per cent RA will be set off against 70 per cent of statutory income (SI), and if RA exceeds 70 per cent of SI, the unabsorbed RA can be carried forward indefinitely. On the other hand, if the amount of RA is below 70 per cent of SI, the amount of RA is credited to an exempt income account (Kwai Fatt 2007). Finally, to encourage the setting up of a resident company, the government has increased the chargeable income from RM 100, 000 (until YA 2003) to RM 500, 000 with effect from Year Assessment 2004 (wef YA 2004) at a preferential tax rate of 20 per cent on the chargeable income. With effect from YA 2004, a resident company which has a paid up ordinary shares capital of not more than RM 2.5million (categorized as a small scale company) is given the preferential tax rate of 20 per cent on the chargeable income of not exceeding RM500,000.

2.3.3The Process of Application, Approval and Granting the Tax Incentives

Other than the qualification criteria which require eligible SMEs to comply as stipulated in the Act, the whole process of application, approval and granting the tax incentives is another barrier which delays the eligible SMEs in their utilization of tax incentives. Figure 2.1 and 2.2 visualizes the whole process of granting tax incentives to companies including SMEs. As depicted in Figure 2.1 and 2.2, the application process of tax incentives is divided into two main stages; the first stage is the process of application and approval of tax incentives, and the second stage is the process of awarding the certificate of PS or determining the effective date of ITA. Firstly, both PS and ITA forms are submitted to MIDA, the principal government agency which is actively involved in promoting the manufacturing sector. Being the main authority that leads and monitors the manufacturing sector, MIDA is responsible in assisting the interested companies to invest in the manufacturing sector, facilitate the implementation of their projects and evaluate the application of tax incentives for the investment projects.

MIDA takes an active role in providing advisory services during the companies initial stage of seeking information on tax incentives and going through the process of applying for tax incentives. Such services provided by MIDA include giving information on tax incentives and assisting the business owners or applicants to fill up the tax incentives application form accurately. While incomplete forms will be returned and asked to be resubmitted, the completed application will be processed by MIDA within 60 days from the date received. The decision either to accept or reject the application is at the discretion of the Industries Action Committee where a decision is made according to SMEs eligibility and compliance. Eligible SMEs will receive the approval letters from Ministry of Finance (MOF) and Ministry of International Trade and Industry (MITI).

After the first stage of the process is completed, the second stage is the process of awarding the PS certificate or determining the effective date of ITA. Within 24 months after the date of approval of the tax incentives, all SMEs that have been approved with tax incentives must apply for the certificate of PS or determine the effective date for ITA. At this stage, all approved SMEs must comply with the requirement that their production capacity level have attained 30 per cent. In cases where their production capacity is below the required 30 percent level, they need to request to defer the process of awarding the certificate. On the other hand, approved SMEs which have achieved the production capacity level of 30 per cent will have to submit the application form to apply for the certificate of PS or the effective date of ITA.

As shown in Figure 2.2, after the PS or ITA has been granted to SMEs, it is assumed that SMEs will be successful in their utilization of the tax incentives. Such an assumption is made as MIDA does not have any monitoring process to observe the suitability of SMEs choice of tax incentives and whether SMEs are successful in the utilization of tax incentives. The flow charts clearly show that MIDA does not require any performance reports from the SMEs that have been granted with tax incentives. Following the detailed discussion on the development of tax incentives in Malaysia, the subsequent sections provide an overview of the current profiles of the SMEs business establishments, which include definition of SMEs, challenges faced by the Malaysian SMEs and the available programs for SMEs development.

FIGURE 2.1 Flowchart of the Application And Approval Process of Tax Incentives to SMEs**

MIDA provides advisory services and assists investors in their applications for investment tax incentivesIf the applicants wish to reapply for ITI, they can do so by submitting new application formsSMEs seeking information on the investment tax incentives

Forms returned to applicants

Receive application forms and sort by type of industryRequest to submit additional informationRespective division screen and check the application forms Applicants submit application form to MIDA No respond

pletedIncomplete

The completed form will be processed within 60 days from the date received by MIDACompleted

Evaluate and tabled in the meeting Submission of additional information as

Industries Action Committee (Main Representative): MITI, MIDA, MOF, IRB and SME CorpThe decision either to accept or reject will take into consideration the criteria of eligibility complied by SMEs requested by MIDA

AcceptDecision:Accept or Reject

RejectLetter of rejection is sent to the applicant

Send approval letter to eligible SMEsMOFMITIAPPROVAL

If the eligible SMEs do not meet the production capacity level of 30%, they need to request to defer the certificateWithin 24 months after the date of ITI approval, the SMEs must apply for the certificatePioneer Status CertificateEffective Date for Investment Tax AllowanceAwarding eligible SMEs with ITI certificateEligible SMEs approved with ITI send application form to MITI

Fulfil the criteria to apply for ITI certificate

FIGURE 2.2 Application Process of the ITI Certificate**

**Note: This flowchart has been constructed based on the discussion with a MIDAs officer who is directly involved with the client charter of application and approval of tax incentives. The researcher took the initiative to draw out this flowchart since there is no simplified visual flow chart to show the process involved in the application, approval or awarding the certificate of PS or ITA.

2.4Profile of SMEs in Malaysia

SMEs in Malaysia play an important role in the countrys economic development. According to statistics provided by SMIDEC, in 2005 SMEs accounted for 99.2 per cent or 518,996 of all enterprises establishments in the manufacturing sector. In Figure 2.3, the distribution of SMEs in Malaysia by their geographical location shows that most SMEs are concentrated in Selangor, Kuala Lumpur and Johor comprising a total of 43.3 percent. Perak and Sarawak are next with 9.3percent and 6.8 percent respectively, while Sabah and Penang have 6.3percent of total SMEs. SMEs in most of the states are characterised by micro establishments. Of significance are the states of Kelantan, Terengganu and Perlis where the proportion of micro establishments are high, making up 91.9percent, 87.9percent and 87.1percent of SMEs respectively. As indicated in Figure 2.4, the comparison of business establishments between the two years of 2003 and 2010 shows that the percentage of micro businesses decrease by 1.3percent, and the increase in small and medium-sized companies are by 0.08percent and 0.06percent respectively.

In terms of distribution of SMEs in the business sectors, Figure 2.5 reveals that the service sector has recorded the highest growth of micro SMEs, while mining and quarrying sectors have the least number of micro businesses. For the manufacturing sector, the distribution of micro businesses is 57.1percent, comprising of 36.8percent of small-sized companies and 6.1% of medium-sized companies. Although there is only a small percentage of medium-sized companies in the manufacturing sector; however, they are able to generate the highest output value worth of RM130,639 million in 2010. This amount also represents the highest output value compared to other business sectors. In addition, SMEs contributed 32.5 percent to the Malaysian GDP in 2011 and 57percent of the workforce (at 3.7 million employees) (SME, 2012).

However, in terms of the export market, Malaysian SMEs share of total exports is only about 20 per cent lower than many other countries such as the Philippines, Hong Kong, Taiwan and even the USA (SMIDEC, 2002). The largest concentration of SMEs in Malaysia are involved in the textile and apparel sector, food and beverages, metals and metals products as well as wood and wood products. A majority of manufacturing companies in Malaysia are located in the central part of Malaysia and around the countrys major industrial regions (IMP2, 2005).

The governments commitment and concern for the development of SMEs has been evident from the early 1970s with the introduction of the New Economic Policy in 1971, which aimed to improve the peoples welfare and restructure ethnic economic imbalances (Ariff & Abu Bakar, 2002). Furthermore, the governments commitment to the development of SMEs can also be seen in the second Industrial Master Plan (IMP2 2005), which ended in 2005, this is followed by the Third Industrial Master Plan (IMP, 2006) for the years 2006 to 2020, coinciding with the countrys vision for 2020 (Saleh & Ndubisi, 2006).

In addition, the government has implemented numerous financial and non-financial incentives with the key intention of enhancing the growth of SMEs. Some examples of the financial incentives given are grants, conventional loans, venture capital funding and tax incentives, while non-financial incentives are in the form of physical infrastructure, information and training provided by the Government or by trade associations. All these incentives are mainly provided and coordinated by Government agencies. The main agencies that offer incentives to SMEs are Malaysia Technology Development Corporation (MTDC) and Malaysian Industrial Development Authority (MIDA).

In terms of financing, as reported in Malaysia SME (2012), local financial institutions are the main source of financing for medium-sized companies (51.7percent), while financing from other sources which includes grants or financing from the government and financing from co-operatives accounts for 28.5percent. Micro and small-sized companies have depended mainly on their own internally generated funds. Only 17.4percent of micro establishments indicated that they relied on financial institutions for financing.

Source: Malaysia SME (October 2012)FIGURE 2.3Distributions of SMEs by State

Source: Malaysia SME (October 2012)

FIGURE 2.4Comparisons of Business Establishments According to their Sizes

Source: Malaysia SME (October 2012)FIGURE 2.5Distributions of SMEs According to the Business Sectors

2.4.1Definition of SMEs

This section reviews the definitions of SMEs from the various literatures. It is important to understand the definition of SMEs since the nature of SMEs can be understood from how the SMEs are being defined and their characteristics which can be considered as unique in the business sector (MacGregor & Vrazalic 2008). There are a number of definitions of what constitutes SME. Meredith (1994) suggested that any definition of SMEs should include two components; first is the quantitative approach which defined SMEs based on their quantitative characteristics such as a) number of employees, b) sales turnover and c) total assets; while second, is the qualitative approach which reflects on how the business is organized and carried out. Mc Mohan et al.(1993) further claimed that based on the qualitative approach the number of employees is also widely used around the world to define the term SMEs.

Moreover, from the literature reviews, the quantitative characteristics of SMEs vary from industry to industry and from country to country. For example, an enterprise type of business, which is considered as small in one industry such as cement manufacturing, may be regarded as large in another industry such as trading or tourism. Similarly, an enterprise, which is considered small by USA standards, may be relatively large in other countries such as Thailand, Malaysia or Vietnam (Nguyen 2001). In addition, this study supports Nguyens (2001) assertions that between qualitative and quantitative approach, the quantitative definition of SMEs is more important as it acts as the underlying base for the research undertaken and aids in gathering the statistical information. Table 2.1 below summarizes the quantitative definitions of SMEs from different countries as adopted from Nguyen (2001) with additional information drawn from the literature review:TABLE 2.3Summary of the Quantitative Definitions of SMEsCountryIndustry/StatusQuantitative Characteristics

USRetailingAnnual sales or receipts not exceeding $2 to $7.5 million, depending on the industry

ServicesAnnual receipts not exceeding $2 to $8 million depending on the industry

WholesalingYearly sales must not be over $9.5 to $22 million, depending on the industry

AgricultureAnnual receipts not exceeding $1 million

General constructionAverage annual receipts not exceeding $9.5million

Special trade constructionAverage annual receipts not exceeding $1 or $2 million

ManufacturingMaximum number of employees may range from 250 to 1,500, depending on the industry

UKManufacturing200 employees or less

RetailingTurnover 50,000 pa or less

Wholesale200,000 pa or less

Construction200,000 pa or less

Mining25 employees or less

Motor traderTurnover 100,000 pa or less

Miscellaneous servicesTurnover 50,000 pa or less

Road transportation5 vehicles or less

AustraliaManufacturing50 employees or less

GeneralTurnover not exceeding $500,000

JapanManufacturingLess than 300 employees

WholesalesLess than 100 employees

Retail and serviceLess than 50 employees

South African SME Act(Gordon 2003)SME100 200 employees

OR

Turnover of five million Rand (US$833,000)

MicroMaximum five employees

EgyptSME1) The number of workers2) Fixed assets; and3) Annual turnover (Rizk 2004)

Thailand(Norlaphoompipat 2008)Production sectorMedium size: not exceeding 200 million bath Small size: not exceeding 50 million bath

OR

Medium size: not exceeding 200 employees and small size not exceeding 50 employees

Trading sectorMedium size wholesale not exceeding 100 million bath and small size not exceeding 50 million bathMedium size retail not exceeding 60 million and small size not exceeding 30 million bathORWholesale medium size not exceeding 50 employees, retail medium size not exceeding 30 employees and small size not exceeding 15 employees

Service sectorMedium size: not exceeding 200 million bath Small size: not exceeding 50 million bathORMedium size not exceeding 200 employees and small sizes not exceeding 50 employees

Adopted from Nguyen (2001)

Since there is no universal definition of SMEs (Meredith, 1994), three commonly used criteria in defining small and medium businesses are; number of employees, annual sales and fixed assets (Ibrahim A.B. & Goodwin 1986). In Malaysia, SMEs can be defined according to their size, number of employees and activity (Sin 2010). According to Saleh and Ndubisi (2006), definition of SMEs in Malaysia fall into 2 broad categories:1. Manufacturing, manufacturing-related services and agro-based industries Full-time employees not exceeding 150; or Annual sales turnover not exceeding RM25 million2. Services, primary agriculture and Information and Communications Technology (ICT) Full-time employees not exceeding 50; or Annual sales turnover not exceeding RM5 millionHowever, for the purpose of this study, the criteria for defining SMEs have been adopted from the Small and Medium Industrial Development Plan in manufacturing and manufacturing-related services in Malaysia. TABLE 2.4Definition of SMEs in MalaysiaSmall EnterpriseMedium Enterprise

Manufacturing, Manufacturing - Related Services and Agro-based industries Sales turnover between RM250,000 and less than RM10 million OR full time employees between 5 and 50Sales turnover between RM10 million and RM25 million OR full time employees between 51 and 150

Source: SMIDEC 2005

2.4.2Challenges Faced by Malaysian SMEsAccording to SMIDPs 2001 to 2005 reports (SMIDEC, 2002), a majority of SMEs comprising 76 percent of all establishments in the manufacturing sector are small companies. At present, these companies are still confronted with a number of basic issues related to market access, low technological capability, shortage of labor and skills, reluctance to relocate to designated industrial sites, shortage of financing as well as lack of general awareness of the incentives. In a study by Saleh and Ndubisi (2006), they observed that Malaysian SMEs are still facing challenges either at domestic level or in the global market which could hinder their resilience and competitiveness. Their study also listed all the challenges faced by SMEs. They are as follows: a) Ongoing difficulties in obtaining funds from financial institutions and the government. Usually the interest charged by financial institutions on loans borrowed by SMEs is high, and this is compounded by a lack of financial transparency by SMEs.b) A lack of human capital is the most significant challenge facing Malaysian SMEs. It is often too expensive for SMEs to employ a professional and competent workforce.c) SMEs face a high level of international competition; this includes from AFTA member countries and competition from MNCs or new competitors (for example from China and India).d) A lack of access to better technology and ICT which hinders more efficient and productive business operations.e) A high level of bureaucracy in government agencies inhibits efficient SME business development operations.f) A low level of research and development expenditure.g) A substantial orientation towards the domestic rather than international market place.

Recently, as reported in SME Annual Report 2008, due to world predicaments such as the global economic and financial crisis, to a larger extent this phenomenon adversely impacted Malaysian SMEs, especially those in the manufacturing sector. SMEs were negatively impacted in terms of their production, profit margins and new orders due to reductions in demand for their products and services, delays in payment collection, funding issues and high cost of raw materials (Council, 2008). In order to mitigate the problems, the government has initiated many policy measures for the benefit of SMEs. These policy measures addressed several key areas of concerns which include easing the financial burden and assisting companies to restructure loans, reducing the cost of doing business, enhancing capacity building and assisting specific vulnerable groups to increase resilience and to better weather the current economic challenges (Council, 2008).2.4.3 Enhancing the SMEs DevelopmentThe governments policy aspirations for SME development are embodied in the IMP3 and the Ninth Malaysia Plan (9MP). The National SME Development Council (NSDC) is an important platform established in 2004 to chart the overall policy direction and strategy for SME development. One of the key outcomes of this Council is the Annual SME Integrated Plan of Action (formerly known as the National SME Development Blueprint), to enhance tracking and alignment in the implementation of the programs undertaken by the various Ministries and Agencies involved in SME development (Council, 2008). The NSDC is chaired by the Prime Minister, and comprised of members who are Ministers and Heads of key Government Agencies involved in SME development. Specifically, the Council is entrusted with the following responsibilities: Formulating overall broad policies and strategies to facilitate the development of SMEs across all economic sectors; Reviewing the roles and responsibilities of Government Ministries and Agencies responsible for SME development; Enhancing cooperation and coordination, as well as guiding stakeholders to ensure the effective implementation of SME development policies and action plans; Encouraging and strengthening the role of the private sector in supporting the overall development of SMEs; and Emphasizing the development of Bumiputera SMEs across all sectors of the economy.

Other than NSDC, Malaysias New Economic Model (NEM) unveiled on 30 March 2010 is another economic plan geared to generate the per capita income in Malaysia to more than double by 2020. In summary, this program aims to shift affirmative action from being ethnically-based to being need-based hence becoming a more competitive, market and investor friendly economy. Moreover, for the private sector, NEM is empowered to reduce fiscal disparity between the wealthiest and poorest of Malaysians. NEM also provides capability and capacity building programs for SMEs in the Bumiputera Commercial and Industrial Community (BCIC). Moreover, it offers ongoing support to successful Bumiputera companies to expand through partnerships with the business community, including the GLCs, with a view to raise the performance of the entire BCIC. These capability and capacity building programs focus on building talent, identify new technologies and enhance collaboration between bumiputera and non-bumiputera companies as well as with MNCs (NEAC 2009).

2.5 Summary

To summarize, this chapter is divided into two parts; the first part presents the overall views related to the promoted tax incentives for SMEs in the manufacturing sector which include types of tax incentives available and the process of application and granting of the tax incentives. The second part provides the profile of SMEs in Malaysia and covers issues with regards to SMEs business establishments, challenges faced by the SMEs in order to survive and a brief explanation on the SMEs development programs. It also details the governments aims of assisting SMEs to gain a more competitive advantage in response to globalization as well as to help SMEs to be more successful in the future.

From the reviews of the SMEs business establishments, it is important to note that SMEs account for more than 90percent of the total business establishments in Malaysia, which suggests their vital role in the nations economic development and can be seen from their ability to establish critical linkages in the global supply chain, strengthen industry cluster formation and increase domestic value added.

The government has already initiated various programs in the form of fiscal and non-fiscal assistance to SMEs since these companies are constantly confronted with various challenges to develop or penetrate the global markets. One of the essential fiscal policies which continue to provide support to SMEs is the granting of various types of tax incentives to eligible SMEs, especially in the manufacturing sector. To qualify for tax incentives, SMEs need to fulfil many eligibility criteria prior to application of tax incentives. However, the current profit-tax based tax incentives are seen to have a negative impact on the SMEs with losses incurred during the global economic crisis severely impacting their ability to utilize the tax incentives granted.

Hence, this study will investigate the impact of the current tax incentives on the performance of SMEs in Malaysia focusing particularly on the manufacturing sector. The utilization of tax incentives is likely to depend on the strength of the companies financial characteristics in utilizing these tax incentives. Therefore, this involves the examination of the financial characteristics difference between successful and unsuccessful SMEs in the utilization of tax incentives.