Updated
This article serves as reference material for candidates preparing for the ATX (MYS), Advanced Taxation Malaysian variant exam from the December 2019 session onwards. The laws referred to are those in force at 31 March 2020. This article updates the previous version published in 2019 by pulling together various laws and successive development in the relevant laws relating to Labuan entities. It incorporates the changes brought about by the 2020 Budget and subsequent legislations to provide an up-to-date picture.
Labuan is an island in the South China Sea off the coast of Sabah in East Malaysia. In 1990, Labuan was established as an international offshore financial centre (IOFC) in a bid to attract international financial activities.
Right from the start, the Malaysian Government had taken pains to avoid the label 'tax haven' for Labuan, and had been vigilant against being used for international money laundering. However, its fixed tax rate of 3% capped at RM20,000 per year clearly calls to mind 'low-tax regime' and inevitably, Labuan was viewed as a tax haven. Some among the double tax treaty partners of Malaysia formally, through protocols or re-negotiated treaties, introduced limitation of benefits (LoB) with regard to Labuan structures.
In response to this development, in the 2009 Budget, the Malaysian Government put in laws to facilitate a Labuan entity to irrevocably elect to come under the purview of the mainstream Malaysian tax system rather than benefit from the favourable tax treatment available under the Labuan tax regime. The objective was to enable such a Labuan entity to avail itself of treaty benefits.
Consequently, the Labuan IOFC was rebranded as IBFC (international business financial centre) – ie the Labuan legislation, terms and nomenclatures were renamed to omit the word 'offshore' which arguably carried the pejorative 'tax haven' connotations and associations.
In the wake of the introduction of the Base Erosion and Profit Shifting (BEPS) Action Plan in 2013 by the OECD and G20 countries, leading to the development of minimum standards and best practice in tax, Malaysia has committed to implementing and adhering to these minimum standards.
Pursuant to this, Malaysia introduced a suite of changes to the Labuan tax regime, which will be discussed in this article. These changes generally took effect from 1 January 2019 or year of assessment 2020.
As well as the Labuan Business Activity Tax Act 1990 (LBATA), there is parallel Labuan legislation for companies and trusts. In 2010, a slew of legislation governing foundations, limited liability partnerships, financial services and securities and Islamic financial services and securities were put in place.
Additionally, in compliance with international taxation standards, in 2018/2019, another round of amendments came about. Consequently, two other legislations of importance were introduced:
Together they introduced some significant changes to the taxation of Labuan companies.
This article is based on the provisions of LBATA 1990, as amended as at 31 March 2020.
Labuan means the Federal Territory of Labuan.
'Labuan company' means a Labuan company incorporated under the Labuan Companies Act 1990 and includes a foreign Labuan company registered under the said Act.
'Labuan entity'
This term includes:
The Labuan business activity comprises trading and non-trading trading activities. With effect from 1 January 2019, a Labuan entity carrying on a Labuan business activity must fulfil the substantial activity requirements as below:
(i) It must employ an adequate number (ranging from two to four, depending on the type of activity) of full-time employees in Labuan; and
(ii) It must incur an adequate amount of annual operating expenditure (ranging from RM50,000 to RM3 million depending on the type of activity) in Labuan.
The above features were introduced [PU(A)2018-392 LBAT (Requirements for Labuan Business Activity) Regulations 2018] to comply with the substantial activities requirements of the BEPS minimum standards.
It has been clarified:
Regarding full time employee:
Regarding annual operating expenditure:
Preceding year basis of assessment
Tax under LBATA continues to be levied on the preceding year basis – e.g. the year of assessment 2020 has its basis period ending in 2019 – for example:
This is in contrast to the current year basis adopted, since the year 2000, in the mainstream tax system under the Income Tax Act 1967.
'Labuan business activity'
With effect from 1 January 2019, ‘Labuan business activity’ means a Labuan trading or a Labuan non-trading activity carried on, in, from or through Labuan, excluding any activity which is an offence under any written law.
This revised definition means that a Labuan entity may:
This is in contrast to the previous rules (omitted in the new definition) where a Labuan entity was required to trade in a foreign currency with non-residents or with another Labuan entity. This change is to render the Labuan tax regime compliant with the BEPS minimum standards.
Do bear in mind that the 'business' in the term 'Labuan business activity' is as defined above: it does not have the same meaning as that in the Income Tax Act 1967.
Trading activity includes:
Labuan non-trading activity
This means an activity relating to the holding of investments in securities, stocks, shares, loans, deposits or any other properties situated in Labuan by a Labuan entity on its own behalf.
It has been clarified by the Labuan authorities that a Labuan entity must carry out a business activity that is listed in the Substance Requirements order [PU(A) 392 of 2018] (see list below) for it to come under the purview of LBATA.
It is important to note that a Labuan entity that carries out a business activity that is NOT included in the list above will be subject to tax under the Income Tax Act, not LBATA.
A Labuan entity that carries on a Labuan business activity that is included in the list above but fails to fulfil the substance requirements for a year of assessment will be subject to tax under LBATA but at 24%.
It should be noted that for item 22 above, i.e. a pure equity holding company, the substance requirements are the prescribed minimum operating expenditure and having management and control in Malaysia. It is not required to have any full time employees.
Scope of charge [section 3]
A Labuan entity is subject to tax under LBATA in respect of its Labuan business activity, as defined above.
Tax rate
The tax rate applicable to a Labuan entity is 3% on the chargeable income from Labuan trading activities only.
This means the income from the Labuan non-trading activities (ie the holding of investments in securities, stocks, shares, loans, deposits or other properties) of a Labuan entity is not subject to tax at all.
For ease of reference, let us refer to this preferential tax treatment as the 3%+0% tax treatment.
Net profit per audited accounts for Labuan trading activities
Tax is chargeable only on the net profits as reflected in the audited accounts in respect of Labuan trading activities – ie banking, insurance, trading, management, licensing, shipping operations and any other activity (other than the holding of investments in securities, stocks, shares, loans, deposits or other properties).
Intellectual property income
With effect from 1 January 2019, any income from royalty or other income derived from an 'intellectual property right’ by a Labuan entity shall be subject to tax under the Income Tax Act 1967, not LBATA.
An 'intellectual property right’, whether or not registered or registrable, is defined as a right arising from any:
This means that royalty income or other income derived by a Labuan entity from any intellectual property right will not be able to enjoy the preferential 3% tax rate or tax exemption, but will instead be subject to tax at the rates prevailing under the mainstream Income Tax Act.
As stated earlier, with effect from the year of assessment (YA) 2020, a Labuan entity carrying on a Labuan business activity but which fails to comply with the substance requirements, (ie the prescribed minimum number of full-time employees in Labuan, the prescribed minimum amount of annual operating expenditure in Labuan, or the residence requirement) for a basis period for a year of assessment shall be charged to tax at 24% upon its chargeable profits for that YA under the Labuan tax legislation.
This is a significant new development. It means that a Labuan entity will only enjoy the preferential 3%+0% treatment for a year of assessment if it fulfils the substance requirements during said year of assessment.
Another implication is that a Labuan entity may enjoy the 3%+0% treatment for a year of assessment, but it may have to bear the 24% tax for another year of assessment, depending on its fulfilment of the substance requirements.
Tax return and statutory declaration
A Labuan entity carrying on Labuan business activities which are Labuan trading activities must file an annual statutory declaration and tax return within three months from the commencement of the year of assessment – ie by 31 March of the following calendar year.
This filing deadline of 31 March applies regardless of the financial year end. For instance, a Labuan company with a financial year end on 31 January must file its tax return for YA 2020 (basis period: 1 February 2018 to 31 January 2019) by 31 March 2020. Similarly, another Labuan company with year end on 30 September must also submit its YA 2020 (basis period: 1 October 2018 to 30 September 2019) tax return by the deadline of 31 March 2020.
No more election for tax of RM20,000
With effect from 1 January 2019, the election by a Labuan entity to be charged to tax of RM20,000 instead of 3% of net profits has been removed.
This means that the capping of the annual tax liability to RM20,000 and the dispensation from the submission of the annual tax return, no longer apply.
Tax rebate
Zakat paid to a Labuan Islamic religious authority (and evidenced by a receipt) up to the amount of tax charged may be given as a rebate. No refund is available if the Zakat paid exceeds the tax charged.
Non-trading activities not chargeable to tax
A Labuan entity carrying on a Labuan business activity which is a Labuan non-trading activity is not chargeable to tax, provided it has fulfilled the substance requirements.
A statutory declaration in a prescribed form, instead of an annual tax return, is all that is required compliance-wise for a Labuan entity which carries out only non-trading activities.
For a Labuan entity chargeable to tax under LBATA, the full payment of the tax charged for a year of assessment must be made at the time of filing the tax return [section 11].
In practice, the tax authorities require the tax payment to be made a few days before the submission of the tax return to afford sufficient lead time for the clearance of the payment cheque. The filing of the tax return should be accompanied by documentary evidence of payment – eg the bank pay-in slip.
Where the Director General of Inland Revenue raises an assessment or additional assessment [under section 6], the tax becomes due and payable. A 10% penalty is leviable if the tax has not been paid within 30 days after the service of the notice of assessment.
No indirect taxes
Labuan enjoys free-port status. Hence indirect taxes are not applicable to Labuan entities located in Labuan. Labuan entities are therefore exempt from sales tax and service tax.
Stamp duty
Stamp duty is exempted on all instruments executed by a Labuan entity in connection with its Labuan business activity.
Exchange control
Labuan entities are also not subject to exchange control restrictions.
Payments by Labuan entities
The following exemptions are available to recipients of income from Labuan entities:
Withholding tax
In addition, the following payments made by Labuan entities to non-residents are exempted in the hands of non-resident recipients, and hence are not subject to withholding provisions:
To date, 11 countries have specifically excluded Labuan entities from accessing treaty benefits in their double tax agreements with Malaysia. They are Japan, Netherlands, United Kingdom, Australia, Sweden, Luxembourg, Republic of Seychelles, Chile, Indonesia, South Africa and South Korea.
In an attempt to facilitate Labuan entities accessing treaty benefits, the laws have been amended to allow a Labuan company to elect to be treated for tax purposes under the Income Tax Act 1967 rather than the Labuan Business Activities Tax Act 1990.
The election must be made within three months of the beginning of the basis period for a year of assessment. For instance, a Labuan company with a year end 30 June intends to elect to be tax treated under the Income Tax Act for YA 2022 (basis period: 1 July 2020 to 30 June 2021). The company must elect by 30 September 2020.
Once made, the election is irrevocable.
Scope of charge
All income derived from Malaysia will be taxable.
Dividend and foreign-sourced income
Expenses
Expenses and outgoings incurred in the production of gross income are tax deductible.
Exemptions
The exemption from indirect taxes, stamp duty and withholding tax under the Labuan tax regime will cease to apply to a Labuan entity once it has elected to come under the Income Tax Act.
Another significant development with effect from 1 January 2019 is the non-deduction, under the Income Tax Act [PU(A) order 375 of 2018], of payment made by a tax resident of Malaysia to a Labuan company as follows:
For instance, a Malaysian resident company which makes payment to a Labuan company for use of intellectual property, shipping charges, etc will be allowed a tax deduction of only 3% of the total payment made. This means that 97% of any such payments will be disallowed to the Malaysian resident payer. If the payment is interest or relates to a lease, the resident payer will be given a tax deduction of only 75%.
However, the above non-deduction rules do not apply to the following:
a) Transactions between Labuan International Commodity Trading Company and Malaysian residents;
b) Transactions between Labuan entities that have opted to pay tax under the Income Tax Act and Malaysian residents; and
c) Transactions between Labuan entities that have opted to pay tax under the Income Tax Act and Labuan entities that are paying taxes under the Labuan Business Activity Tax Act 1990.
The above is punitive and presumably anti-avoidance in nature.
Individuals working in Labuan for Labuan entities
| Exemption order | Effective | Exemption |
|---|---|---|
| PU(A) 418 of 2011 | YA2011 to 2020 | The Minister exempts any person from the payment of income tax on 65% of the statutory income from a source consisting of the provision of qualifying professional service rendered in Labuan by that company to a Labuan entity. 'qualifying professional service' means legal, accounting, financial or secretarial service. |
| PU(A) 419 of 2011 | YA2011 to 2020 | Exemption for non-citizens in respect of 100% of director’s fees from Labuan entities. |
| PU(A) 420 of 2011 | YA2011 to 2020 | Exemption of 50% of employment income in managerial capacity with Labuan entity in Labuan, or in a co-located office of marketing office which may be located elsewhere in Malaysia to facilitate business meetings, but cannot be for exercising trading activities on behalf of Labuan entities. |
| PU(A) 421 of 2011 | YA2011 to 2020 | Exemption for Malaysian citizens in respect of 50% of gross housing allowance and gross Labuan Territory Allowance received in respect of exercising employment in Labuan with Labuan entity. |
| PU(A) 209 of 2012 | With effect from 11 February 2010 | The Minister exempts from tax any gains or profit falling under section 4(f) of the Act received by a non-resident from a Labuan entity. |
Written by a member of the ATX (MYS) examining team