Journal of Applied Accounting Research

Tax non-compliance among SMCs in Malaysia: Tax audit evidence:

Nor Azrina Mohd Yusof Lai Ming Ling Yap Bee Wah

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To cite this document:
Nor Azrina Mohd Yusof Lai Ming Ling Yap Bee Wah , (2014),"Tax non-compliance among SMCs in Malaysia: Tax audit
evidence", Journal of Applied Accounting Research, Vol. 15 Iss 2 pp. Permanent link to this document:
http://dx.doi.org/10.1108/JAAR-02-2013-0016
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TAX NON-COMPLIANCE AMONG SMCs IN MALAYSIA: TAX AUDIT

EVIDENCE

1. INTRODUCTION

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This study examines the determinants of tax non-compliance among Malaysian small-andmedium-sized corporations (SMCs). A number of theories attempt to explain the reasons for tax
non-compliance; including the economic deterrence theory which suggests that taxpayers make
decision to comply depending on attributes relating to the costs and benefits associated with tax
compliance (Allingham & Sandmo, 1972). This theory, however, mainly applies to individual
taxpayers. It is not clear whether the findings are valid for corporate taxpayers, especially SMCs.
SMCs have made major contributions to the economic and social development of developing
countries, including Malaysia. SMCs are critical in all countries. In Malaysia, SMCs are a source
of tax/fiscal revenue to the federal government and create jobs, especially for those with low
skills. In 2011, SMCs contributed 32 percent to the countrys gross domestic product (Wong,
2012) and comprised 97.3 percent of the total 662,939 business establishments in Malaysia,
employing 56 percent of the workforce and accounting for 90 percent of the retail market
(NSDC, 2011).
Most studies on tax compliance focus on the behavior of individuals, with very few studies
focusing on corporate taxpayers. The few empirical studies on corporate tax non-compliance
tend to concentrate on developed economies with varied and inconclusive results (e.g., Rice,
1992; Kamdar, 1997; Hanlon et al., 2007; Joulfaian, 2000; Tedds, 2010; Giles, 1998; Chan and
Mo, 2000; Nur-Tegin, 2008; Atawodi and Ojeka, 2012). These studies have established that
certain factors (i.e., penalty rate, marginal tax rate, foreign ownership, financial liquidity,
company size and types of industry) are significantly linked to corporate tax non-compliance.
Prior studies on corporate tax non-compliance in Malaysia (e.g., Isa and Pope, 2010; Md Noor et
al., 2009; Mohd Nor et al., 2010; Md Yassin et al., 2010) only examine tax audit cases resolved
up to the year 2005. The corporate tax rate was 28 percent in 2005 and 2006, 27 percent in 2007,
26 percent in 2008 and 25 percent in 2009. The tax rate of 25 percent was imposed until 2013
when the Malaysian government made an announcement to further reduce by one percent the
corporate tax rate in 2014. However, the effects of lowering corporate tax rate on SMCs tax
compliance behavior after year 2009 is not examined.
This study assumes that SMCs will become more compliant when the corporate tax rate is low.
Nevertheless, a review of literature found that there are some indicators of the continuous
existence of tax non-compliance among corporation after 2009. For instance, in 2010, it was
reported that there were 78,220 corporate tax audited cases conducted and resolved, resulting in
an additional tax and penalty collection of RM1,013.63 million the (IRBM, 2010). Recently, the
Global Financial Integritys report estimated that 60% to 65% of illegal fund flows from
developing economies (like Malaysia) could be due to commercial non-compliance (Kar and
Freitas, 2012). The Malaysian government has acknowledged that tax non-compliance is one of
the reasons for illegal capital flows (Bernama, 2011). Hence, it is reasonable to argue that tax
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non-compliance is somewhat prevalent in Malaysia. Nonetheless, what influence SMCs tax

non-compliance decision still remains unexplored in the Malaysian literature and the issue
remains unresolved. Hence, this is the focus of this study.
Furthermore, the differences in the tax system structure between developed and developing
countries actually merit the need to examine the issue of tax non-compliance from the
perspective of developing economies, especially within the context of Malaysia. In Malaysia, the
government has restructured its tax system to make it more competitive and attractive to both
local and foreign investors. One of the reforms is the gradual reduction of the corporate statutory
tax rates from 40% in 1988 to 25% in 2009. The decrease to 25% is considered to be in line with
the reduction of the income tax rates in other countries belonging to the Association of South
East Asian Nations, except Singapore, whereby, the tax rate is only 17% (KPMG, 2011).
Without a doubt, reducing corporate tax rate is advantageous for SMCs. The Inland Revenue
Board of Malaysia (IRBM) defines an SMC as a company in Malaysia with a paid-up capital of
ordinary shares of not more than RM2.5 million at the beginning of the basis period of a year of
assessment. The company does not control and is not controlled by another company which has a
paid up ordinary share capital of more than RM2.5 million. With regard to corporate tax rate,
SMCs with chargeable income of not more than RM500,000 are eligible for a preferential rate of
20%, whilst the remaining chargeable income was maintained at 25% since 2009.
This study has several merits. First, it uses actual tax audit cases where the non-compliance with
tax laws, rules and regulations are used as the measurement of the tax non-compliance among
SMCs in Malaysia. As highlighted by Hanlon and Heitzman (2010), most tax research that
attempted to measure tax non-compliance were based on annual reports, hence, they are not
reflective of the actual situation. Second, this study complements the scant existing literature by
empirically evaluating the factors that influenced corporate tax non-compliance in a developing
country like Malaysia. Last, but not least, the study tested the applicability of the economic
deterrence theory in the Malaysian tax setting. In view that our understanding about corporate
tax non-compliance is still incomplete, the findings provide important insights not only to the
Malaysian tax authority, but also to tax authorities and tax researchers in other parts of the world
given that tax non-compliance of SMCs is a prevalent and universal problem. For example, with
regard to the finding that marginal tax rate and company size are linked to noncompliance, when
conducting audits, tax authorities might divert resources to firms with such characteristics.
The paper is organized as follows. Section 2 reviews the relevant literature on corporate tax noncompliance. Section 3 describes the research method. Section 4 presents the results, and Section
5 concludes.

2. LITERATURE REVIEW
2.1

Prior Studies on Corporate Tax Non-compliance

There is no standard definition of tax non-compliance. However, several researchers such as

Long and Swingen (1991), Hasseldine and Li (1999) and Devos (2009) used the definition as
provided by Roth et al. (1989). Roth et al. (1989) defined tax compliance as filing all required
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tax returns at the proper time and that the returns accurately report tax liability in accordance
with the tax code, regulations and court decisions applicable at the time the return is filed. In
Malaysia, Kasipillai and Abdul Jaabar (2006) opined that non-compliance may take several
forms, which include failure to submit a tax return within the stipulated period or nonsubmission; understatement of income; overstatement of deductions; and failure to pay assessed
taxes by the due date. Section 113 (1) of the Income Tax Act (1967) outlined that making
incorrect returns or giving incorrect information is deemed as a tax offence or tax noncompliance.
A review of the literature shows that in 1972, Allingham and Sandmo (1972) adapted Beckers
(1968) model of economic analysis of crime to formulate a theory of tax evasion in a tax
compliance setting. This theoretical model is known as an economic deterrence model and it is
one of the oldest and the best known models of tax compliance (Andreoni et al., 1998).
Allingham and Sandmo (1972) modeled individual taxpayers choice of whether and how much
to evade taxes depends on the trade-off between tax savings and the risks of audit and penalties.
Taxpayers made tax saving if they can successfully evade taxes. However, if detected, they will
be charged with higher penalties. The model leads to four propositions about the incidences of
tax evasion: (1) higher tax rate will positively lead to the incidence of tax evasion; (2) individuals
with higher risk aversion tend to evade less tax; (3) individuals with higher personal income tend
to evade more tax; and (4) compliance is positively related to the probability of being audited
and the size of the penalty if being caught.
Since Allingham and Sandmos (1972) pioneering work, there were a lot of empirical studies
(e.g., Alm, 1999; Andreoni et al., 1998; Fischer et al., 1992) conducted to examine the
determinants of tax compliance. Overall, their reviews provide similar variables in relation to tax
compliance. Unfortunately, empirical studies on corporate tax non-compliance are limited. The
earliest attempt to examine corporate tax non-compliance was conducted in the United States
(U.S). Rice (1992) utilized data from corporate tax compliance micro data obtained from the Tax
Compliance Measurement Program (TCMP). Rice was the only study that focused on mediumsized corporations. He found that firm profitability, firm size and firms belonging to a highly
regulated industry exerted a positive effect on tax compliance, followed by the marginal tax rate
which exerted a negative effect on tax compliance. Nevertheless, Kamdar (1997) found no
statistical evidence that an increase in penalties and lower tax rates would help to reduce tax noncompliance.
Another study that employed the corporate TCMP was conducted by Joulfaian (2000). He found
that corporations are more likely to evade taxes if their managers also evade personal income
taxes. His study also showed that lower marginal tax rates, higher audit rates, larger firm size and
income level had a significant impact on tax non-compliance in the U.S. In another study done in
the U.S, Hanlon et al. (2007) analyzed operational data from the Voluntary Compliance
Baseline Measurement which were more up to-date, containing data up to 2002, as compared to
the TCMP, which ended in 1988. Hanlon et al. found that corporate tax non-compliance amount
was 13% of actual tax liability. Besides, they found that larger firms and domestic companies
were more compliant, and firms in the manufacturing industry, trade, transportation,
warehousing, education and healthcare were found to be less compliant.

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On the other hand, five studies were conducted in countries other than the U.S. Of these, two
studies utilized tax audit data. The first one, Giles (1998) conducted a study to develop riskprofiling models of taxation compliance and non-compliance on the part of New Zealand firms.
He found that with an effective tax rate, larger firms, firms which are efficient, and those firms
which used tax-minimization instruments tend to be significantly more compliant. In China,
Chan and Mo (2000) analyzed 583 tax audit cases to investigate the effects of tax holidays on
foreign investors non-compliance behavior. Their results show that companies are less
compliant during the pre-holiday position and most compliant in the tax-exemption period. Chan
and Mo also found that domestic market-oriented companies, joint-venture companies and
service-oriented companies appear to be less compliant. The third study was conducted by NurTegin (2008). She analyzed firm-level survey data of 4,538 firms in 23 transition economies. She
found that the degree of business tax non-compliance is not likely to be lessened by lower tax
rates. In essence, the findings on the effect of tax rate on tax compliance are still not conclusive.
The fourth study was conducted in Canada. By using a questionnaire survey from the World
Business Environment Survey, Tedds (2010) found that firms around the world engaged in
under-reporting. He found that taxes are the second single largest causal effect on underreporting. He also found that there was a significant correlation between under-reporting and the
legal organization of the business, size, industry, age, ownership, competition and audit controls.
Lastly, the most recent study was conducted in Nigeria by Atawodi and Ojeka (2012). After
surveying 150 small and medium-enterprises, they found that higher tax rates and complexity of
filing procedures were the most crucial factors of causing non-compliance.
In Malaysia, at the time of study, there were only three empirical studies which examined
corporate tax non-compliance behavior. The first study was conducted by Md Noor et al. (2009).
They investigated the possible indicators of fraudulent financial reporting for tax noncompliance. The study found that the ratio of sales and working capital and debts over total
assets were significantly associated with companies tax non-compliance. However, their study
did not focus on other factors such as economic variables (e.g., tax rate) and corporate
characteristics.
Meanwhile, by analyzing 396 resolved corporate tax audited cases in 2004, Mohd Nor et al.
(2010) found that larger firms are more compliant than smaller firms. Their findings revealed
that firms using services from the Big 4 audit firms are less likely to commit fraud as compared
to those using smaller audit firms. The third study was conducted by Md Yassin et al. (2010)
who examined factors that influence tax non-compliance behavior among SMCs in Malaysia. By
using 1,365 observations from 1,075 corporations, which had been audited and investigated by
the IRBM, they found that marginal tax rates have a greater impact on non-compliance behavior.
They found that the level of directors ownership, the level of efficiency, size and book-tax
differences were the key factors that influence corporate tax non-compliance behavior. Md
Yassin et al. (2010) made comprehensive attempts to examine compliance behavior among
SMCs in Malaysia.
There are two key reasons to be concerned about these past studies. First, studies conducted
among corporate taxpayer are scarce either in developed or developing countries. Most of them
focused on individual taxpayers. Several tax researchers such as Joulfaian (2000) and Rice (1992)
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argued that literature on individual tax compliance has provided a formal framework for the
analysis of corporate tax non-compliance. Nevertheless, studies on individual tax compliance are
of limited use in the analysis of corporate tax non-compliance. Chan and Mo (2000) claimed that
evidence on the individual tax compliance behavior cannot be directly generalized to explain
corporate tax non-compliance because compliance behavior of corporate taxpayers may or may
not resemble individual taxpayers. Second, most of these past studies utilized TCMP data or
annual reports, as well as survey to measure tax non-compliance. Hanlon and Heitzman (2010)
argued that such measurement cannot reflect the actual situation of tax non-compliance. Thus,
this study addresses these shortcomings by utilizing actual tax findings to examine tax noncompliance among SMCs in Malaysia. Past studies on corporate tax non-compliance suggested
that marginal tax rate (Kamdar, 1997, Joulfaian, 2000) and corporate characteristics such as
foreign ownership, company size and types of industry (Chan and Mo, 2000, Rice, 1992, Hanlon
et al., 2007) did affect corporate tax non-compliance; however, the findings are not conclusive.
2.2

Hypothesis Development

This section develops a hypothesis about the impact of the penalty rate, marginal tax rate and
financial liquidity on tax non-compliance by SMCs. This study also identifies corporate
characteristics that may influence SMCs compliance behavior.
2.2.1

Penalty Rate

The relationship between tax non-compliance and the penalty rate varies among the studies.
Allingham and Sandmo (1972) found a positive relationship between the penalty rate and
reported income. In contrast, Kamdar (1997) did not find any evidence to support the notion that
increased penalty rates would help reduce tax non-compliance. In Malaysia, the IBRM took a
different strategy to motivate taxpayer to comply with tax laws, instead of imposing higher
penalty rates on understatement or omission of income. Effective January 2009, the IRBM has
reduced the penalty rate from 300% to 100% on any understatement or omission of income
during tax audits. For first time offenders, the penalty rate imposed is lower, at 45% rather than
100%. Based on unpublished data gathered from the IRBM, the majority of companies were
fined at a lower rate of 45% on understatement or omission of income. The question here is
whether the action taken by the IRBM is an effective way of improving the rate of tax
compliance.
Whilst, the OECD (2010) stated that the question is not whether or not revenue bodies should
use deterrence, but how it can be used most effectively. This is because it is not possible that
taxpayers are more willing to pay a penalty rather than disclose their actual income. In addition,
high risk evaders who have already benefited from evasion for a long period of time might
regard tax audit penalty as a financial loss due to unlucky investment (OECD, 2010). Perhaps,
paying additional taxes after a tax audit would be a common practice among hard-core and
repeated evaders in the future. Thus, this study hypothesized that a lower penalty rate imposed
could potentially reduce reported income, thus leading to an increase in tax non-compliance.
Grounded on the economic deterrence theory, the first hypothesis is developed:

H: There is a negative significant relationship between penalty rate and tax non-compliance for
SMCs.

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2.2.2

Marginal Tax Rate

The economic deterrence theory suggests that marginal tax rate does influence taxpayers
compliance behavior. Past studies show that evidence on the relationship between tax rates and
compliance behavior is mixed. Rice (1992), Joulfaian (2000) and Md Yassin et al. (2010) found
that the marginal tax rate is negatively associated with compliance behavior. Nevertheless,
Kamdar (1997) claimed that lowering marginal tax rate would not necessarily enhance corporate
tax compliance. In Malaysia, to increase the rate of tax compliance, the IRBM has reduced the
tax rate from 40% in 1988 to 25% in 2009. Whilst, for SMCs, tax is charged based on a two-tier
structure, i.e., 20% for the first chargeable income of RM500,000 and the remaining would be
taxed at 25% in year of assessment 2009 and onwards.
Some corporations view that the amount of tax paid on chargeable income above RM500,000 at
25% is relatively high. As a result, to avoid from paying extra tax on additional chargeable
income, taxpayers tend to manipulate their reported income. Based on the economic deterrence
theory that assumes rational economic behavior among taxpayers; for instance, in 2008, when
corporate tax rate was reduced from 26% to 25% in 2009, corporations saw the incentive of
transferring or deferring income from 2008 to 2009 to reduce tax. The announcement for the
change in tax rate was made early in August 2008. Therefore, corporate taxpayers had the amble
time and opportunity to defer the recording of income before the account closing date. Thus, the
second hypothesis is:
H: There is a positive significant relationship between marginal tax rate and tax noncompliance for SMCs.
2.2.3

Financial Liquidity

Generally, a firm with low financial liquidity will try to manipulate financial statement either by
increasing revenue or reducing expenditures to improve profit. Spathis (2002) found that
companies with low value of working capital to total assets are more likely to falsify their
financial statement to improve the financial position. He asserted that companies are more
motivated to engage in fraudulent financial statement when they are doing poorly. In Malaysia,
Md Noor et al. (2009) argued that financial distress may motivate management to engage in tax
fraud. Nevertheless, Md Noor et al. found a positive and significant relationship between
liquidity and tax evasion. Their findings suggested that tax evasion occurs when the companies
have the financial resources to engage it. Similarly, Md Yassin et al. (2010) also found a similar
finding. They argued that a positive relationship between cash flow and tax non-compliance
might be due to the fact with better liquidity; the management has a greater capability to hire tax
advisor or expert to do tax planning.
On the other hand, OECD (2010) stated that taxpayers are willing to evade tax in order to avoid
the loss of cash flow. For taxpayers, paying taxes will reduce their cash flow. Hence, it is
6

assumed that a corporate taxpayer who did not plan to avoid tax at an early stage of operation
may become tax non-compliant when experiencing a financial crisis in order to save the business
cash flow position. Therefore, it is reasonable to assume that a firm with inconsistent and
continuously low financial liquidity would manipulate their financial statement in order to evade
taxes. Thus, this study expects that SMCs with financial liquidity problem to be more noncompliant. The third hypothesis is:
H: There is a negative relationship between financial liquidity of SMCs and tax non-compliance.

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2.2.4

Control Variables

This study also controlled corporate characteristics which are believed to influence SMCs tax
non-compliance. Based on limited data, the control variables are foreign ownership (jointventures vs. wholly domestics-owned companies), company size and types of industry. A
dummy variable for each industry was included to control for variations across industries that
could have a significant effect of the results. The details are presented next.
2.2.4.1 Foreign Ownership
There is mixed evidence on foreign ownership and corporate tax non-compliance. In China,
Chan and Mo (2000) found that joint venture companies are less tax compliant than wholly
foreign-owned companies. They found that due to a lower basic salary, Chinese managers in
joint-venture companies tend to collaborate with foreign managers to manipulate financial
statements. Hanlon et al. (2007) found that foreign-controlled companies have more than double
the proposed deficiency rate when compared to domestic companies. Hanlon et al. defined
proposed deficiency rate as additional tax divided by reported tax plus additional tax.
In Malaysia, although Md Yassin et al. (2010) did not find any statistical evidence on the
influence of foreign ownership, they did suggest that foreign ownership may influence noncompliance behavior. Note that in Malaysia, there are four categories for foreign equity in
comparison to their paid-up capital. For the first category, the range is between 70%-100%,
second, is between 51%-69%, third, is between 21%-50% and fourth, is less than or equal to
20%. In this study, for the purpose of data analysis, foreign ownership has been categorized into
two categories that are: (1) joint-venture; and (2) wholly domestic-owned. This study assumes
that a company with foreign counterparts irrespective of the percentage is prone to tax evasion
because they can easily handle technical and complex tax issues with the presence of foreign
counterparts. Therefore, this study expects larger tax audit adjustments for SMCs with foreign
ownership. Hence, this study hypothesizes that:
H: There is a positive relationship between foreign ownership and tax non-compliance for
SMCs.

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2.2.4.2 Company Size

Past studies found mixed evidence between company size and tax non-compliance. Tedds (2010)
and Nur-Tegin (2008) found that company size was negatively associated with tax noncompliance. Smaller companies are more likely to evade tax than larger ones. Survey data from
transition and from some African economies show that smaller firms generally report a lower
fraction of their revenue to tax authorities, presumably because smaller firms transact business in
cash (Gauthier and Gersovitz, 1997, Gauthier and Reinikka, 2001). In this vein, Nur-Tegin (2008)
argued that it is easier for smaller firms to conceal income and to be invisible. Wallace (2002)
claimed that even if small start-up firms act in good faith, tax compliance is a burden to them. To
comply with tax laws and regulations, firms need to incur additional expenses (i.e., tax agents
fee) on top of tax liability. In Malaysian tax setting, Abdul Mansor and Mohd Hanefah (2008)
found tax agents fee to be an additional tax compliance cost and posed a heavy burden on SMCs.
In contrast, some prior studies (e.g., Rice, 1992, Hanlon et al., 2007, Mohd Nor et al., 2010,
Joulfaian, 2000) found a positive association between company size and tax non-compliance.
Their studies support the political cost theory of Zimmerman (1983). According to Zimmerman
(1983), as the size of the company grows, the company will become more visible and hence, it is
more exposed to government examination and wealth transfer. Whilst, Watts and Zimmerman
(1986) argued that the political cost theory introduced a political dimension that can influence
the choice of accounting policies. As a result, profitable firms would want to safeguard the cash
flow in order not to pay huge tax to the government by choosing different accounting methods in
reporting and valuing assets. Hence, firms with high level of profit would generally attract tax
authority to conduct a tax audit to verify the tax return. Wallace (2002) noted that tax
administrators tend to focus audit on large companies due to a larger potential for revenue
collection.
It is worth noting here that the prior studies that found a positive association between company
size and tax non-compliance all examined public listed companies. However, in this study, the
focus is on SMCs which are smaller size as compared to public listed company. Hence, as the
political cost theory may not be applicable, this study expects an adverse relationship between
company size and tax non-compliance. Abdul Mansor and Mohd Hanefah (2008) found that
small enterprises have a higher percentage of tax compliance costs as compared to large
enterprises. Thus, it is reasonable to argue that tax compliant costs would influence the intention
of SMCs to comply with tax laws and regulations. This study expects smaller SMCs to be more
tax non-compliant (have larger tax audit adjustments) than larger SMCs. Accordingly, the fifth
hypothesis is proposed as follow:
H: There is a negative relationship between company size and tax non-compliance for SMCs.
2.2.4.3 Types of Industry
A review of literature found the relationship between types of industry and tax non-compliance is
mixed. This is because different industries may have different characteristics and incentives to
develop various strategies to avoid and evade tax. An industry that is heavily based on cash
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transaction is more likely to have incentives to engage in tax non-compliance. Cash transactions
are hard to investigate as it has no documentary evidence. Due to the low visibility features of
cash transactions, it is difficult for the tax authority to trace the source of income. Bankman
(2007) argued that the underpayment of taxes on business income is commonly attributed to the
receipt of cash. In line with Bankman (2007), Morse et al. (2009) found that underreporting
income is common with cash transactions in business sectors. OECD (2004) reported that much
unrecorded activity in developed countries consists of labor-intensive services such as
construction and catering because these businesses have fewer visible fixed assets than capitalintensive business.
Past studies have highlighted the relationship between industry types and tax non-compliance
among corporate taxpayers. For example, in U.S, Rice (1992) found that the service-oriented
industry is more compliant than other industries. In contrast, in China, Chan and Mo (2000)
found that service-oriented industry is less compliant than the manufacturing industry. Whilst, in
Malaysia, Mohd Nor et al. (2010) found that the construction industry is positively associated
with fraudulent financial reporting. Based on these inconsistent findings, the sixth hypothesis is
proposed as follow:
H: There is a relationship between types of industry and tax non-compliance for SMCs.

3. METHODOLOGY
3.1

Samples

This study used tax audit findings obtained from the IRBM. With official approval from the
IRBM, the researchers approach the tax officer in charge of Case Management System (CMS) to
extract the data. The officer was briefed to extract data using simple random method from the
CMS and there was no indication that he/she intentionally included or excluded any cases in the
sampling process. Thus, the sample selected should be a general representative of audited and
resolved corporate cases in Malaysia. The tax officer extracted 509 corporate tax audited cases
resolved in 2011. Of the 509 cases, 117 cases were non-SMCs (paid-up ordinary share capital
exceeded RM2.5 million); hence, they were excluded from the data analysis, thus, leaving a
sample of 392 cases related to SMCs. Of the 392 cases, 17 cases were excluded. Of these 17
cases, five of them are outliers as they have extremely large financial liquidity ratio as compared
to the others, and another 12 cases did not have complete information. Hence, a total of 375
cases were usable and analyzed. Of the 375 cases, 72 cases had zero tax audit adjustment, which
indicated that they were tax compliant companies. As a result, only 303 cases had tax audit
adjustments, which indicate that intentional and/or unintentional tax non-compliance was
committed by SMCs and detected by tax auditors during tax audit.

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3.2

Measurement of Corporate Tax Non-compliance

This study measured corporate tax non-compliance by using tax audit adjustments deflated by
total assets. Tax audit adjustments are additional taxes imposed due to SMCs fraudulent
activities either by under-reporting income or over deducting expenses after a tax audit has been
resolved. This study used total assets as a deflator because a companys assets can be accounted
for the companys ability to engage in the manipulation of taxable income. Hanlon et al. (2007)
suggested that by using total assets or total sales as deflator, companies with zero reported and
zero unreported income can be retained in data analysis. Besides, Hanlon et al. also claimed that
by using total assets or total sales as a deflator, researchers could distinguish those companies
that underreport by USD10 of tax and those that underreport by USD1 million of tax. This is
because when the reported income is zero but with some amount of unreported income, the
proposed deficiency rate will become 100%. In line with Chan and Mo (2000), in this study, the
dependent variable was subjected to a log transform to control for heteroskedasticity problem.
Besides this, for those companies with zero tax audit adjustment, the zero tax audit
adjustment figure has been changed to one Ringgit Malaysia (RM, the Malaysian currency) to
avoid taking the log of zero. Next section presents the research model and variables.
3.3

The Research Model and Variable Definitions

The research model is presented as follows:

Log (ADJ/ASSETS) = + PENALTY RATE+ MARGINAL TAX RATE +
FINANCIAL LIQUIDITY + DFOREIGN OWNERSHIP +
COMPANY SIZE+ DMANUFACTURING +
DCONSTRUCTION + DWHOLESALE & RETAIL TRADE +
DSERVICES +
whereby:
Dependent Variable:
Log (ADJ/ASSETS)

= natural logarithm of tax audit adjustment deflated by total

assets.

Independent Variables of Interest:

PENALTY RATE
MARGINAL TAX RATE
FINANCIAL LIQUIDITY

= ratio of penalty amount divided by additional taxes;

= marginal tax rates according to the basis year;
= ratio of current assets divided by current liabilities;

Control Variables:
DFOREIGN OWNERSHIP
LOG_COMPANY SIZE
DMANUFACTURING
DCONSTRUCTION
DWHOLESALE &RETAIL
TRADE
DSERVICES

= 1 if company has a foreign ownership, 0 otherwise;

= natural logarithm of total assets;
= 1 if company is a manufacturing industry, 0 otherwise;
= 1 if company is a construction industry, 0 otherwise;
= 1 if company is a wholesale & retail trade industry, 0
otherwise;
= 1 if company is a service industry, 0 otherwise.
10

The regression coefficient, is estimated using ordinary least square method. A significant tvalue for will indicate a significant prediction.

4. THE FINDINGS

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4.1

The Profiles of SMCs

Table 1 presents the demographic profiles of SMCs. Of the 375 corporate cases audited and
resolved in 2011, 28.3% were from the service industry and followed by the construction
industry (25.3%). Note that the most predominant industry engaged in tax non-compliance is the
construction industry (29%). Meanwhile, 27.8% of compliant firms were from the real estate
industry. Most companies (89.8%) which were engaged in tax non-compliance were from wholly
domestic-owned companies. Just 5.3% of SMCs had high foreign equity between 70-100%.
More than 80% of the SMCs were profit making companies. In respect of company size,
measured based on total assets, 28.5% of SMCs had a total asset between RM10 million to
RM50 million. This indicates that the IRBM focused tax audit on companies with larger total
assets. Meanwhile, as for penalty rate, majority (78.5%) of non-compliant companies were
imposed a penalty of 45%.
<Insert Table 1>
4.2

Descriptive Statistics

Table 2 provides descriptive statistics for the independent and dependent variables. Panel A
shows the mean for penalty was 33.86%. The mean for penalty rate which is below 45%
indicates that the IRBM imposed low penalty when tax auditors discover tax non-compliance
during tax audit. The mean for marginal tax rate was 20.72%. The mean for financial liquidity is
1.3264 (which is based on SMCs current ratio); the findings show that SMCs did not have
strong financial liquidity, hence might encounter problems in paying off debts and tax
obligations. Further analysis found current ratio of most SMCs was below the acceptable current
ratio value of 2:1. In turn, Panel B presents the corporate characteristic of SMCs, whilst, Panel C
reports the tax audit adjustments. Note that, the mean for tax audit adjustment as a percentage of
total assets (ADJ/ASSETS) was 1.16% for the 375 resolved cases and 1.43% for the noncompliant cases. Meanwhile, the mean for total assets average is RM16.6 million. It is worth
noting that the percentage of non-compliant firm (the rate of non-compliance) within the
industries is highest in construction industry (92.63%) and lowest in real estate (52.38%);
consistently, the mean tax audit adjustments deflated by total assets for the construction industry
is also greater than the other industries.
<Insert Table 2>
Whilst, in respect of tax audit adjustment and penalty, a total of RM54, 880,068.13 additional
taxes and penalties were collected (see Table 3). Note that more than RM25 million were
11

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collected from the services industry followed by the construction industry. The plausible
explanation for the highest number of non-compliant cases coming from the services industry
was that the bulk of tax audit was conducted on firms in this sector. The service industry
comprises of utilities, transport, storage and communication, financial intermediation, hotels and
restaurants, business services and government services. It is worth noting here that in terms of
the distribution of SMCs, the services industry dominates the proportion of SMCs in Malaysia. It
was reported that about 90% of the 645,136 SMCs in Malaysia are from the services industry;
and about 3% (19,354) of SMCs from the construction industry (SME, 2012). Therefore, due to
the high proportion of SMCs from the service industry, it is reasonable that the service industry
has the highest number of tax non-compliance cases. On the other hand, the construction industry
is operated on a project basis, where income is based on work in progress. The daily dealing is
voluminous with many invoices and transactions which provide the opportunity for construction
firms to manipulate or falsify the invoices. As argued by OECD (2004), construction which is
classified as labor-intensive business have fewer visible fixed assets, as a results, it becomes
advantageous for this industry to engage in tax non-compliance. Overall, the amount of
additional taxes and penalty collected from these industries somewhat reflect the magnitude of
tax non-compliance among SMCs in Malaysia.
<Insert Table 3>
4.3

Correlation among Study Variables

Table 4 presents the result from the correlation among the studied variables. This study
investigates the relationship between the dependent variable, natural logarithm of tax audit
adjustment deflated by total assets (log ADJ/ASSET) and independent variables which are
penalty rate, marginal tax rate, financial liquidity and company size by using the Pearson
product-moment correlation coefficient. There was a strong, positive correlation between penalty
rate and tax non-compliance, r = .785, p < .01, with high penalty rate linked to high tax noncompliance. Whilst, for marginal tax rate, there was a moderate, positive relationship between
these two variables, r = .397, p < .01. Higher tax non-compliance was associated with higher
marginal tax rate. In turn, there was no significant association between log ADJ/ASSET and
financial liquidity, with r = -.011, p > .05. Meanwhile, for company size, there was a low,
negative correlation between company size and tax non-compliance, r = -.195, p < .01. As firm
size grew larger, the company became more compliant.
<Insert Table 4>
4.4

The Multiple Regression Result

This study used multiple regression to test the hypotheses. The result is shown in Table 5. The
regression model is statistically significant at the 5% level (F-value = 86.288, p < .00). This
study predicted that the penalty rate would have a negative relationship with tax non-compliance.
However, H is not supported. In contrast, this study found that there is a positive significant
relationship (beta coefficient of 0.0695, t = 21.569, p< 0.001) between these two variables.
Nevertheless, the findings contradict with the economic deterrence theory which suggests a
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negative relationship between the penalty rate and tax non-compliance. The findings are
inconsistent with both Allingham and Sandmo (1972) and Kamdar (1997). The plausible
explanation is that SMCs tend to be risk-takers when the penalties and fines imposed by the tax
authorities are not too high.
Marginal tax rate was hypothesized to have a positive relationship with tax non-compliance. This
H is supported with a beta coefficient of 0.199 (t = 6.145, p< 0.01). The result implies that
SMCs with higher marginal tax rates experience a greater level of tax non-compliance. The
findings are consistent with the Rice (1992), Joulfaian (2000) and Md Yassin et al. (2010) who
found that tax rate did influence corporate tax compliance behavior. Note that Atawodi and
Ojeka (2012) found most of the Nigerian SMCs did not mind paying taxes provided that the tax
rates are lower. This shows that when marginal tax rate is higher, the motivation to engage in tax
non-compliance is also high. This finding supports the economic deterrence theory developed by
Allingham and Sandmo (1972). According to Allingham and Sandmo (1972), tax rate did affect
tax compliance when the taxpayers assumed rational behavior. The result suggests that higher tax
rate would cause taxpayers to be more engaged in tax non-compliance activities. This is because
taxpayers would make decision to evade or not to evade taxes when the benefits of evading taxes
outweigh the costs of evades tax.
Hypothesis H predicts that there is a negative relationship between financial liquidity of SMCs
and tax non-compliance. Results from the data analysis show a positive effect (beta coefficient of
0.002, t = 0.07, p>.05) but this relationship is not statistically significant, thus H is not
supported. This indicates that financial liquidity does not affect tax non-compliance. Malaysian
tax practitioners for example, Thanneermalai and Rosley (2010) had the opinion that a lossmaking company is more likely to be selected for a tax audit, however, the finding does not
support this claim, and is inconsistent with Spathis (2002) and Md Noor et al. (2009), as well as
the conventional belief that a loss-making company is more likely to be non-compliant.
In addition, this study predicts that foreign ownership would have a positive relationship with tax
non-compliance. Although a positive association between these variables (beta coefficient 0.015,
t = 0.484, p> 0.05) is detected, but this relationship is statistically insignificant, therefore, H is
not supported. There is no difference in tax non-compliance behavior between companies with
and without foreign ownership. This finding does not support Hanlon et al. (2007) who found
that the foreign-controlled companies tend to engage in tax non-compliance. This result
somewhat signals that nowadays, SMCs are becoming smarter in planning their tax liability.
Without the presence of foreign partners, SMCs engage in-house tax accountant or hire tax
advisor to avoid or evade tax.
As for company size, this study found that there is an adverse relationship between company size
and tax non-compliance of SMCs, the regression coefficient is -0.165 (t = -5.408, p< 0.001),
suggesting that as the size of SMCs become larger, the SMCs become more compliant. Hence,
H5 is supported. Larger SMCs are more compliant possibly because they have better internal
control, proper accounting system and better corporate governance as compared to smaller SMCs.
The finding supports Tedds (2010) and Nur-Tegin (2008). Nonetheless, the finding contradicts
the political cost theory which suggests that larger public listed companies tend to engage in tax
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non-compliance due to their capability in earning management and choice of accounting method
as compared to smaller firms.
Lastly, this study found there is a positive relationship between types of industry and tax noncompliance of SMCs, significant at 90% confidence level. This suggests that H6 is supported. To
probe the issue further, this study found that the service industry is less compliant than the real
estate industry at the 5% significant level, The results are consistent with the study conducted by
Chan and Mo (2000) who also found that service-oriented industry to be less compliant. Whilst,
at the 10% significant level, this study also found that the construction industry is less compliant
than the real estate industry. This finding supports Mohd Nor et al. (2010) who found that the
construction industry is highly associated with tax non-compliance. Overall, the findings support
prior studies of Rice (1992), Hanlon et al. (2007) and Mohd Nor et al. (2010) who found that
certain types of industry are more inclined to be tax non-compliant.
<Insert Table 5 >

5. CONCLUSION
This study found that the significant predictors of tax non-compliance of SMCs are marginal tax
rate, company size and types of industry. The findings support the economic deterrence theory
that corporate tax rate does affect tax non-compliance. In addition, this study found that the two
most predominant industries that engaged in tax non-compliance are services and construction
industries. Notably, the IRBM collected about RM38 million in additional taxes and penalty
from these two industries in 2011. The amount of concealed income unearthed during tax audit
indicates clearly that there is a widespread tax underreporting in Malaysia and the quantum of
tax lost through tax underreporting is quite high.
The findings provide some implications to the policy makers and tax authority. First, it is evident
that SMCs in Malaysia concealed income by exploiting the loopholes in the tax laws when
reported tax returns. This study also found most tax defaulters were fined 45% on the concealed
income; but the tax penalty imposed did not deter hard-core SMCs to under report tax as they
may regard the low penalty as an unlucky investment. It is also of the opinion that tax
defaulters are treated very leniently. Tax defaulters like other criminals should be punished
adequately according to the severity of the offence in order to deter them from repeating it and at
the same time to serve as a stern warning to others who have the intention to cheat. The famous
Greek philosopher Aristotle once asserted that punishment is a sort of medicine, hence, just a
monetary fine is not sufficient to curb tax underreporting. Punishment for tax violation is the
only remedy that would deter tax defaulters even a short tem imprisonment will suffice.
However, to date, hardly any criminal prosecution of tax underreporting has taken place since the
endorsement of tax legislations. This study suggests that the IRBM should consider penalizing
tax defaulters by imprisonment, even though it is only for one day. This is because a jail sentence
even for just a day may create a fear factor among taxpayers. Related to this, as the burden of
proof rests on the tax department, tax officers must be trained to audit, investigate and collect
supporting evidence to substantiate the charge and in court procedure.
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In addition, besides reducing the corporate tax rate from 40% in 1988 to 25% in 2009 onwards,
the policy makers should consider designing special tax incentives for SMCs to reduce their tax
burden and find ways to assist SMCs in tax compliance and grow in business. Without a doubt,
lowering tax rates alone cannot be considered as an effective way to increase tax compliance
because if SMCs fail to grow in business and to generate more profit, paying tax liability would
be a burden to them. At the time of study, the marginal tax rate for SMCs is 25%. Though this
rate of 25% is regarded as low, this corporate tax rate is still high as compared to the neighboring
country such as Singapore with corporate tax rate of 17% (KPMG, 2011). Given that SMCs are
the engine of growth, a Malaysian tax academic and consultant, Dr. Veerinderjeet Singh
recommended that corporate tax rate should be lowered further. Instead of having a two-tier
structure, he suggested a three-tier structure; the first RM500,000 of chargeable income would be
taxed at 15%, the next RM500,000 at 20% and the balance at 25% (Dheshi, 2010). We support
the above suggestion.
The findings show that smaller SMCs tend to engage in tax non-compliance than larger ones.
However, based on the profiles of SMCs as presented in Table 1; it appears that tax auditor
focused tax audit on larger SMCs. In view that the two main objectives of tax audit are to
encourage voluntary compliance and to educate taxpayers, the IRBM should allocate more
resources to audit micro and smaller firms because they dominate the business population in
Malaysia (SME, 2012). Tax auditors should use tax audit as an avenue to educate and assist
SMCs in tax compliance. But we wonder how many tax auditors do this?
This study found that the service and construction industries are more non-compliant as
compared to the real estate industry. In view of these, the IRBM needs to intensify and divert
more resources to audit firms belonging to these two industries. It is a well known fact that the
chance of being selected for tax audit is once in every five years, hence, some risk takers would
perceive that the chance to be selected for audit is relatively low. This study concurs with
OECDs (2010) suggestion that the tax authorities should administer audits on a regular basis
and over a long period of time to deter hard-core and repeat tax defaulters. This study suggests
tax audit should be once in every 3 years. In turn, those who cheat in revenue should be publicly
exposured in mass media and online. Publicity of names of tax evaders, the amount of concealed
income, penalty and punishment should be made known, as it can serve as a stern warning to
others.
To date, there is a scarcity of empirical study on corporate tax non-compliance, especially studies
that utilized actual tax non-compliance data. Hence, this study has merit as it has utilized the
actual tax audit cases where the non-compliance with tax laws, rules and regulations are used as
the measurement of the tax non-compliance among SMCs in Malaysia. This study complements
the scant existing literature by empirically evaluating the factors that influenced corporate tax
non-compliance in a developing country like Malaysia. This study contributes to the tax
compliance literature by testing the applicability of the economic deterrence theory in the
Malaysian tax setting. The findings provide important insights not only to the Malaysian tax
authorities, but also to tax authorities and tax researchers in other parts of the world given that
tax non-compliance of SMCs is a prevalent and universal problem. For example, this study found
that marginal tax rate and company size are linked to noncompliance, therefore, when
conducting audits, tax authorities might divert resources to firms with such characteristics.
15

This study only sampled SMCs audited and resolved in 2011, hence, the results cannot be
generalized to non-SMCs because non-SMCs may have different corporate characteristics and
better corporate governance. Care must be exercised in generalize the findings. Future studies
should be conducted to examine other variables such as corporate governance, institutional
factors and corporate culture.

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Acknowledgments:
An earlier version of this paper was presented at the 25th Annual Australasian Tax Teachers
Association Conference, 23-25 January 2013, the University of Auckland, New Zealand. The
funding from Accounting Research Institute, Ministry of Higher Education Malaysia [Ref: 100RMI/ARI 16/6/2 (43/2010)] is gratefully acknowledged. The authors also thank the conference
participants for their insightful comments.

18

Table 1 Profiles of SMCs

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Characteristics

Major Industries:
Manufacturing
Construction
Wholesale and Retail Trade
Real Estate
Service
Foreign Ownership:
70-100%
51-69%
20-50%
Less than 19%
None
Profitability of the firm:
With Net Profit
With Net Loss
Size based on total assets:
Less than RM500,000
Between RM500,001-RM1,000,000
Between RM1,000,001 RM1,500,000
Between RM1,500,001 RM2,000,000
Between RM2,000,001 RM2,500,000
Between RM2,500,001 RM3,000,000
Between RM3,000,001 RM5,000,000
Between RM5,000,001 RM10,000,000
Between RM10,000,001 RM50,000,000
Above RM10,000,001
Penalty Rate:
Zero penalty rate
Less than 45%
45%
Above 45%

Compliant Firms

Non-compliant
Firms
n
%

All Firms

13
7
18
20
14

(18.1)
(9.7)
(25.0)
(27.8)
(19.4)

46
88
55
22
92

(15.2)
(29.0)
(18.2)
(7.3)
(30.4)

59
95
73
42
106

(15.7)
(25.3)
(19.5)
(11.2)
(28.3)

5
0
6
1
60

(6.9)
(0.0)
(8.3)
(1.4)
(83.3)

15
(5.0)
0
(0.0)
13
(4.3)
3
(1.0)
272 (89.8)

20
0
19
4
332

(5.3)
(0.0)
(5.1)
(1.1)
(88.5)

45 (62.5)
27 (37.5)

265 (87.5)
38 (12.5)

310
65

(82.7)
(17.3)

8
16
17
22
18
10
60
54
87
11

(2.5)
(5.3)
(5.6)
(7.0)
(5.9)
(3.3)
(19.8)
(17.8)
(28.7)
(3.6)

11
18
27
24
21
13
71
68
107
15

(2.9)
(4.8)
(7.2)
(6.4)
(5.6)
(3.5)
(18.9)
(17.8)
(28.5)
(4.0)

5
48
238
12

(1.7)
(15.8)
(78.5)
(4.0)

77
48
238
12

(20.5)
(12.8)
(63.5)
(3.2)

3
2
10
2
3
3
11
14
20
4

(4.2)
(2.8)
(13.9)
(2.8)
(4.2)
(4.2)
(15.3)
(19.4)
(27.8)
(5.6)

72 (100.0)
0 (0.0)
0 (0.0)
0 (0.00)

n
375
375
375

Manufacturing
Construction
Wholesale
Real Estate
Service
Total

13
7
18
20
14
72

n
0
0
0
0
0
0

0
0
0
0
0
0

Mean Std. deviation

Compliant Firms

46
88
55
22
92
303

Max
8.87

n
375

Min
5.13

Value
1
0

Category
Joint-Venture
Wholly domestic-owned

Min
0.00
0.00
0.11

Mean
6.7354

No. of Firms
43
332

Mean
0.3386
0.2072
1.3264

0.0071
0.0199
0.0169
0.0108
0.1179
0.0143

Mean

0.0089
0.4599
0.0298
0.0304
0.0204
0.0315

Std. deviation

Non-compliant Firms

Max
1.02
0.28
9.88

59
95
73
42
106
375

0.0055
0.0185
0.0128
0.0056
0.0102
0.0116

n Mean

Standard deviation
0.56753

0.0085
0.0446
0.0269
0.0224
0.0194
0.0289

Std. deviation

All Firms

Percentage of the Sample

11.5
88.5

Standard deviation
0.18905
0.06673
1.03708

DFOREIGN OWNERSHIP = 1 if company has a joint venture, 0 otherwise;

ADJ/ASSETS
= tax audit adjustment deflated by total assets
Non-compliant Firms denotes firms with tax audit adjustments. The percentage of non-compliant firms (the rate of non-compliance) within industry:
manufacturing (77.97%), construction (92.63%), wholesale and retail-trade (75.34%), real estate (52.38%) and service (86.79%).
The total number of sample firms (375) is distributed across five major industry.

Variable definition:

_________________________

Variable
ADJ/ASSETS

Industry

Panel C: Tax Audit Adjustments

COMPANY SIZE

Variable
DFOREIGN OWNERSHIP

Panel B: Independent Variable-Control Variable

Variables
PENALTY RATE
MARGINAL TAX RATE
FINANCIAL LIQUIDITY

Panel A: Independent Variables

Table 2 Descriptive Statistics for Independent and Dependent Variables Used in Statistical Analysis

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Table 3 Tax Audit Adjustment and Penalty

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Industry

Tax Audit
Adjustment
(RM)

Percentage
(%)

Penalty
(RM)

Percentage
(%)

Total Tax Audit

Adjustment &
Penalty (RM)

Services

92

18,077,780.23

46.9

7,655,214.56

46.8

25,732,994.79

Construction

88

9,592,784.40

24.9

4,026,225.57

24.6

13,619,009.97

Wholesale &
Retail Trade

55

6,658,948.16

17.3

2,957,283.55

18.1

9,616,231.71

Manufacturing

46

3,046,557.48

7.9

1,200,165.86

7.3

4,246,723.34

Real Estate

22

1,150,906.91

3.0

514,201.59

3.1

1,665,108.50

Total

303

38,526,977.18

100.0

16,353,091.13

100.0

54,880,068.13

Table 4 Correlations among Study Variables

Scale
Log (ADJ/ASSETS)

Log
(ADJ/ASSETS)
-

Penalty Rate
Marginal Tax Rate
Financial Liquidity
Company Size
** Correlation is significant at the 0.01 level (2-tailed).

Penalty
Rate
.785**

Marginal
Tax Rate
.397**

Financial
Liquidity
-.011

Company
Size
-.195**

.295**

-.038

-.082

.024

.134**

-.065
-

Table 5 Regression Results (DV=Log ADJ/ASSET)

Model: Log (ADJ/ASSETS) = + PENALTY RATE+ MARGINAL TAX RATE +

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FINANCIAL LIQUIDITY + DFOREIGN

OWNERSHIP + COMPANY SIZE+
DMANUFACTURING + DCONSTRUCTION
+ DWHOLESALE & RETAIL TRADE +
DSERVICES +
Regression
Coefficient

t-values

p-value

Intercept

-6.263

-17.598

.000

Independent variables of
Interest:
PENALTY RATE
MARGINAL TAX RATE
FINANCIAL LIQUIDITY

0.695
0.199
0.002

21.569
6.145
0.070

.000
.000*
.944

Control variables:
DFOREIGN OWNERSHIP
COMPANY SIZE
DMANUFACTURING
DCONSTRUCTION
DWHOLESALE& RETAIL TRADE
DSERVICE

0.015
-0.165
0.051
0.090
0.002
0.098

0.484
-5.408
1.180
1.856
0.054
1.976

.629
.000*
.239
.064***
.957
.049**

Sample size
F-value

375
86.288 (p-value = .00)

R
Adjusted R

68.0%
67.2%

________________________
Variable definitions:

Log (ADJ/ASSETS)
= tax audit adjustment deflated by total assets
PENALTY RATE
= ratio of penalty amount divided by additional taxes
MARGINAL TAX RATE = marginal tax rates according to the basis year;
FINANCIAL LIQUIDITY = ratio of current assets divided by current liabilities;
LOG_COMPANY SIZE = natural logarithm of total assets;
DFOREIGN OWNERSHIP= 1 if company has a joint venture, 0 otherwise;
DMANUFACTURING = 1 if company is a manufacturing industry, 0 otherwise;
DCONSTRUCTION
= 1 if company is a construction industry, 0 otherwise;
DWHOLESALE &
= 1 if company is a wholesale and retail trade industry, 0 otherwise;
RETAIL TRADE
DSERVICE
= 1 if company is a service industry, 0 otherwise
*Significant at the 0.01 level, ** significant at the 0.05 level,*** significant at the 0.10 level