What Is the Status of the Malaysia US Tax Treaty?
Understand the tax implications for U.S. persons with Malaysian income, focusing on domestic relief options since no tax treaty is currently in force.
An income tax treaty between the United States and Malaysia does not currently exist. Although a treaty was negotiated and signed, it was never ratified by the U.S. Senate and is not in force. The primary purpose of such treaties is to prevent the double taxation of income and establish cooperation on tax enforcement. Without one, the tax relationship is governed by each country’s domestic laws, requiring U.S. citizens with Malaysian income to navigate both systems.
Current Tax Rules in the Absence of a Treaty
The United States taxes its citizens and residents on their worldwide income, regardless of where it is earned. This citizenship-based taxation system means Americans must file U.S. federal tax returns even if they live abroad. Consequently, any income a U.S. person receives from Malaysian sources is subject to U.S. income tax.
Malaysia taxes income sourced within its borders. For non-resident individuals, this income is taxed at a flat rate of 30%. A person is considered a non-resident for tax purposes if they are in Malaysia for less than 182 days in a calendar year, creating a direct potential for double taxation.
To address this, U.S. tax law provides the Foreign Tax Credit (FTC). The FTC allows U.S. taxpayers to reduce their U.S. income tax liability on a dollar-for-dollar basis for income taxes already paid to a foreign government. The amount of the credit is subject to limitations, generally preventing it from offsetting U.S. tax on U.S. source income.
Certain income exempt in Malaysia may still be taxable in the U.S. For example, Malaysia exempts most foreign-sourced income for residents until December 31, 2026, but this is still taxable for U.S. citizens. Also, contributions by a Malaysian employer to a pension plan like the Employees Provident Fund (EPF) are included in a U.S. citizen’s gross income in the year they are made.
The absence of a treaty also means there are no negotiated reductions in withholding tax rates. Malaysia imposes a withholding tax of 15% on interest and 10% on royalties paid to non-residents.
Analysis of the Proposed Treaty’s Key Articles
The proposed but unratified treaty would have significantly altered the tax landscape. It included a definition for “permanent establishment” (PE), such as an office or factory. Under this rule, a U.S. enterprise’s business profits would only be taxable in Malaysia if it maintained a PE there.
The proposed treaty also outlined maximum withholding tax rates on dividends, interest, and royalties to encourage cross-border investment. For individuals, it had specific rules for pensions, government wages, and exemptions for students and trainees on payments received from abroad.
A standard “Saving Clause” was included, which preserves the right of the United States to tax its own citizens as if the treaty did not exist. While some exceptions apply, this clause means a U.S. citizen in Malaysia could not use the treaty to avoid U.S. tax on their worldwide income.
How to Claim Relief from Double Taxation
U.S. taxpayers have two primary methods to claim relief from double taxation on Malaysian income: the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE). Taxpayers can often choose whichever is more beneficial for their situation.
In addition to the FTC, U.S. citizens may be able to claim the FEIE, which allows them to exclude a certain amount of their foreign-earned income from U.S. taxation. For 2024, the exclusion amount was up to $126,500. This option is available to those who meet certain residency tests in a foreign country.
The most common method for relief is claiming the Foreign Tax Credit on IRS Form 1116, “Foreign Tax Credit.” This form must be completed and attached to the taxpayer’s Form 1040.
To complete Form 1116, a taxpayer must gather documentation showing the total foreign source income received and proof of the foreign income taxes paid. The form requires the taxpayer to categorize their foreign income and calculate the credit separately for each type.
The form guides the taxpayer through a limitation calculation, which ensures the credit cannot exceed the U.S. tax that would have been due on that foreign income. The final amount is transferred from Form 1116 to the taxpayer’s Form 1040, directly reducing their total U.S. tax liability.