The OECD Inclusive Framework, in follow-up work related to BEPS Action 5, has released new global standards that apply to "no or only nominal tax" jurisdictions and that require "substantial activities" in order for the tax regime not to be considered a "harmful tax practice." The objective is to prevent such low-tax jurisdictions from attracting profits from certain mobile activities without corresponding economic activity.
Overview
The types of mobile activities covered include headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping, holding companies, and the provision of intangibles.
Taxpayers should monitor how each relevant jurisdiction implements the new substance requirements (both law changes and future regulations) and be prepared to demonstrate that certain "core income generating activities" are occurring within low-tax jurisdictions commensurate with the profits being reported in those jurisdictions.
Failure to satisfy the substantial activities requirements may result in other countries taking certain "defensive measures" in response, which could include denying deductions, imposing withholding taxes on payments to companies in such jurisdictions, or applying controlled foreign corporation rules to subsidiaries in such jurisdictions.
New Development: Tax Framework in Labuan
Recent developments to tax laws for Labuan entities have seen the introduction of new regulations to enhance the reputation and credibility of the tax regime in Labuan. The changes are welcomed as Malaysia seeks to implement the minimum standards under the Base Erosion and Profit Shifting (BEPS) Action Plan.
Key Changes to the LBATA
Labuan Business Activity: The definition of "Labuan business activity" was amended to remove Malaysian ringgit restrictions or restrictions on dealing with Malaysian residents.
Economic Substance Requirements (ESR): Section 2B(1)(b)(i) of the LBATA requires Labuan entities, for trading activities, to have an adequate number of full-time employees in Labuan and an adequate amount of annual operating expenditure in Labuan. For non-trading activities, additional control and management requirements in Labuan apply.
Exclusion of IP Rights Income: Any income derived from royalty and other income derived from intellectual property rights is subjected to tax at 17% or 24% under Income Tax Act 1967.
Removal of RM20,000 Option: Labuan entities carrying on a trading activity no longer have the option to elect to pay tax of RM20,000. All Labuan entities that comply with the relevant economic substance requirements shall be subject to tax at 3% on chargeable profits.
Non-Complying ESR: A Labuan Entity carrying on a Labuan business activity but failing to comply with the relevant substance requirements is subject to tax at 24% of its chargeable profits.
Non-Deductibility
With effect from 1 January 2019, certain payments made to a Labuan Entity by a Malaysian resident company are not entitled to a full tax deduction:
| No. | Type of Payment | Amount Not Allowed for Deduction |
|---|---|---|
| 1 | Interest payment | 25% |
| 2 | Lease rental | 25% |
| 3 | Other payments | 97% |
Substance Requirements Schedule
A Labuan entity carrying on a Labuan business activity is only subject to tax at the rate of 3% or 0% of the net profit provided that it has fulfilled the requirement of the number of full-time employees and an amount of annual operating expenditure as specified below:
| Labuan Entity Type | Min. FTE in Labuan | Min. Annual OPEX (RM) |
|---|---|---|
| Labuan insurer, reinsurer, takaful operator or retakaful operator | 3 | 200,000 |
| Labuan underwriting manager or underwriting takaful manager | 4 | 100,000 |
| Labuan insurance manager or takaful manager | 4 | 100,000 |
| Labuan insurance broker or takaful broker | 2 | 100,000 |
| Labuan first party captive insurer or captive takaful | 2 | 100,000 |
| Labuan third party captive insurer or captive takaful | 2 | 100,000 |
| Labuan International Commodity Trading Company | 3 | 3,000,000 |
| Labuan bank, investment bank, Islamic bank or Islamic investment bank | 3 | 200,000 |
| Labuan trust company | 3 | 120,000 |
| Labuan leasing company (10 or less related companies) | 2 per group | 100,000 each |
| Labuan leasing company (11 to 20 related companies) | 3 per group | 100,000 each |
| Labuan leasing company (21 to 30 related companies) | 4 per group | 100,000 each |
| Labuan leasing company (more than 30 related companies) | +1 per 10 additional | 100,000 each |
| Labuan credit token company | 2 | 100,000 |
| Labuan development finance company | 2 | 100,000 |
| Labuan building credit company | 2 | 100,000 |
| Labuan factoring company | 2 | 100,000 |
| Labuan money broker | 2 | 100,000 |
| Labuan fund manager | 2 | 100,000 |
| Labuan securities licensee | 2 | 100,000 |
| Labuan fund administrator | 2 | 100,000 |
| Labuan company management (Section 129 LFSSA) | 2 | 100,000 |
| Labuan International Financial Exchange | 2 | 120,000 |
| Self-regulatory organisation | 2 | 120,000 |
| Investment holding (other than pure equity) | 1 | 20,000 |
| Pure equity holding activities | Exempted* | 20,000 |
| Administrative, accounting, legal, backroom, payroll, talent management, agency, insolvency and management services | 2 | 50,000 |
FTE = Full Time Employees | OPEX = Operating Expenditures
* Pure equity holding entities must: convene a board meeting in Labuan at least once a year, have a registered office in Labuan, appoint a secretary resident in Labuan, and keep accounting and business records in Labuan.
Summary of Tax Treatment
| Entity | Business Activity | Substance Compliance | Tax Rate |
|---|---|---|---|
| Entity A | Trading + Non-Trading* | Trading: Not Comply / Non-Trading: Comply | 24% |
| Entity B | Trading + Non-Trading* | Trading: Comply / Non-Trading: Not Comply | 3% |
| Entity C | Trading | Comply | 3% |
| Entity D | Trading | Not Comply | 24% |
| Entity E | Non-Trading | Comply | 0% |
| Entity F | Non-Trading | Not Comply | 24% |
* Subsection 2(2) of the LBATA provides that where a Labuan Entity carries on both a Labuan trading activity and a Labuan non-trading activity, such entity shall be deemed to be carrying on a Labuan trading activity.
Conclusion: Labuan IBFC continues to introduce necessary changes to its laws and regulations to remain both reputable and competitive. Businesses would do well to look at whether their existing structures are in compliance with the new requirements.
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