Mike Grover, Tax Specialist, Labuan IBFC Inc. Sdn Bhd, Labuan
Mike Grover examines in the detail the advantages presented by the Labuan Trading Company and highlights the unique features or ‘tax treasures’ that are afforded through the use of this tax planning structure.
No businessman relishes the disruption caused by a tax audit. And yet, with the new mechanisms in place to exchange tax information and tax collectors now working together to aggressively challenge international tax structures, the risk of audit is increasing.
Sophisticated tax planning works on the assumption that tax collectors can pierce the corporate veil where hitherto secrecy rules may have thwarted them. This approach to ‘tax planning’, which relies solely on secrecy, is flawed and will eventually fail. Consequently, the concept of ‘future proofing ’is fast finding favour.
In the context of international tax planning, future proofing anticipates the interest areas of tax collectors, and with this knowledge attempts to create a tax structure which is sufficiently robust and able to withstand future enquiry, for instance, a probe by tax collectors into business purpose and operational substance.
As a general rule, international tax structures lacking business purpose may be struck down. Operational substance, on the other hand, is essentially about having the personnel and infrastructure in the right place, at the right time, doing the right things. Getting this ‘mix’ wrong can have unexpected and possibly unpleasant tax consequences.
Trading companies located in low tax locations attract tax collectors interest because of the multiple activities a trading company undertakes, the cause and effect on profits such activities have and the possibility that the activities may be conducted in a number of locations gives rise to the possibility of ‘tax mischief”.
Businesses have to be mindful that as tax information begins to flow freely and efficiently between tax authorities, future proofing of trading companies in low tax locations is paramount.
In this environment the Labuan Trading Company’s ‘star’ is rising! As with many other possible locations Labuan is highly suitable as a tax efficient ‘profit centre’ for trading companies. But Labuan is distinguished by a number of interesting and possibly unique features, its eight ‘Tax Treasures’, that should help trading companies navigate the new tax landscape.
Tax Treasure 1
A trading company located a long distance from its market attracts the interest of tax collectors. If for instance, the targeted market is in the Asia-Pacific region, a Labuan Trading Company, being centrally located in the same region, makes practical sense and indicates business purpose.
Tax Treasure 2
Labuan is part of Malaysia, an established trading nation, ranked 24th worldwide and 9th within the Asia-Pacific region. As a result the infrastructure and services required to support the activities of a trading company, such as banking and insurance, are extremely well developed and available at competitive rates. Labuan is thus a credible trading company location with real functionality, both of which are indicators of business purpose.
Tax Treasure 3
Malaysia has a large network of ‘comprehensive’ tax treaties – those that create a reasonable balance between exchange of tax information and tax benefits - designed specifically to overcome tax ‘friction’ points that might impede its international trade flows.
On the one hand, trading companies that trade with another country are not generally subject to tax in the country it is trading with. On the other, trading companies that trade within a country may find themselves taxed there.
Typically a tax treaty has rules in place concerning ‘safe harbour’ activities in that other country, for instance, in relation to the holding of stock or the activities of employees or agents, without triggering a tax liability.
Without a specific tax treaty, there are no specific ‘safe harbour’ provisions and thus the final word on what constitutes trading within a country tends to lie with local tax collectors. This can result in some tough issues being faced, including the appropriate allocation of trading profits to their jurisdiction.
In contrast, a Labuan trading company may access Malaysia’s tax treaties and by doing so obtain a degree of protection not available to trading companies located in for instance, the Caribbean, where typically the exchange of information type tax treaties do not have the tax benefits and ‘safe harbour’ provisions.
Tax Treasure 4
The conventional rules to determine the ‘source’ of trading profits are generally the bane of a trading company in ‘territorial’ type taxing systems.
Such rules, developed over time according to tax case law and the capricious practices of the tax collector, create frequent disputes on whether the trading activities are ‘onshore’ and taxable or ‘offshore’ and non-taxable.
Malaysia, Singapore and Hong Kong, are all possible trading company locations in the Asia-Pacific and each employ a form of the conventional rules, but in a refreshing departure, Labuan employs a very modern solution to this thorny issue – its tax provisions are neatly inscribed in an Act.
The Labuan Business Activity Tax Act 1990 encapsulates the jurisdiction’s tax structure and provides a yearly option for all Labuan registered trading companies to either incur a flat tax rate of RM20,000 per annum, or three per cent of net profit.
To enjoy this tax structure a Labuan trading company merely has to demonstrate that it deals with non-Malaysians in a currency other than Malaysian Ringgit and does so in, from or through Labuan.
This easily understood and simple to follow rule ensures a high level of certainty concerning the ability of a Labuan Trading Company to demonstrate its trading profits are generated within Labuan and hence will be efficiently taxed.
Tax Treasure 5
A Labuan Trading Company may, if it wishes, establish tax residency in Malaysia by demonstrating that its ‘highest level of control’ is exercised in Malaysia. This is desirable since a Labuan Trading Company can then assert that it is taxable according to Malaysian tax law.
The Malaysian Income Tax Act 1967 dictates a headline rate of 25 per cent on domestically sourced income but does not tax foreign sourced income generated by a Malaysian company.
Clearly another “cheery on the pie” is the fact that a Malaysian company has undeniable access to all 75 Malaysian tax treaties. Importantly, tax treaties include ‘tie-breaker’ clauses to resolve disputes between treaty partners relating to the tax residency of a company.
A Labuan Trading Company can achieve a ‘solid’ Malaysian tax residency by satisfying the ‘tie-breaker’ conditions of Malaysian tax treaties. In doing so, a Labuan Trading Company may avoid the ‘pitfall’ of being a dual-resident company and potentially taxable in two jurisdictions.
Tax Treasure 6
The need for operational substance creates an enormous challenge on the location of a trading company’s functions. Fortunately, a Labuan Trading Company’s level of operational substance has no impact on its Labuan tax position. The same amount of tax is payable whether there is a ‘light’ presence in Labuan or a ‘substantial’ one.
Thus, businesses enjoy the flexibility of ‘housing’ in Labuan those activities causing contention in their home location and/or the targeted market.
In this regard, Labuan is clearly a sophisticated financial centre that ‘enables’ substance to be created in real terms. That is, a Labuan Trading Company has the ability to employ local staff, maintain a local office, and have access to local support services at a relatively low cost.
Placing the contentious activities in Labuan causes no adverse Labuan tax consequences and by corollary, helps to minimise international tax risks.
Tax Treasure 7
Labuan’s tax efficient framework creates a level playing field for transactions no matter their nature. Transactions with uncertain tax outcomes may have to be reported for accounting purposes and tax collectors are known to leverage off the inherent level of comfort Company Directors have with the tax positions taken to encourage disclosure.
The source of trading income, whether profit is revenue (and taxable) or capital (and non taxable), and Islamic funding arrangements are examples of tax uncertain areas. There is no downside to conducting tax uncertain transactions via a Labuan Trading Company as the low tax system results in a minimal tax exposure whatever the outcome and therefore plays a useful tax risk management role.
Tax Treasure 8
Labuan Trusts and Foundations have an unlimited ‘life’ and when employed as the shareholder of a Labuan Trading Company may navigate a way through transfer taxes and or capital gains tax on the disposal and acquisition of shares between family members and additionally, avoid inheritance and wealth taxes.
One further interesting quality worth exploring is whether the holding of shares in the Labuan Trading Company by a Labuan Foundation or Trust might legitimately ‘side-step’ rules which seek to tax residents on the profits of foreign companies in which they hold controlling interests.
All for one and one for all
Labuan’s unique position in international tax planning is even more entrenched as every single ‘treasure’ described above applies, with appropriate modifications; to ALL Labuan ‘business wrappers’, including the Labuan Chargeable Company, Investment Holding Companies, banks, insurance entities, Protected Cell Companies, Limited Partnerships, trusts and foundations.
Across the board, these Labuan ‘wrappers’ are able to enjoy certainty in its tax liability, with the comfort of knowing that even the most stringent substance requirements can be met cost effectively in Labuan.
Over the last couple of years, the Labuan Financial Services Authority has embraced the idea that the Labuan framework; specifically its legal and tax structure, should not be limited to the confines of the island.
Indeed, the thinking is that so long as the Labuan framework is utilized there should be no limitation on the actual physical location of the entity. Welcome to Abstract Labuan!
The ‘birth’ of abstract Labuan is personified with co-location, which provides for Labuan entities to have a presence onshore in Kuala Lumpur or any other location within Malaysia. Clearly, Labuan is undergoing a paradigm shift.
A co-located Labuan Holding Company in Kuala Lumpur brings with it an array of practical benefits, for example Kuala Lumpur’s location within six hours flight time of all the largest markets in Asia is ideal for directors of a European headquartered multinational company seeking a holding company location in Asia.
In addition, consider Malaysia’s superb quality of life, its range of service providers, and its ever growing human resource pool, all of which are also big pull factors for holding companies to establish a co-located Labuan company. The icing on the cake though, has to be Malaysia’s cost efficiency, at every turn and in every aspect, Malaysia provides better value for money than any other Asian jurisdiction instinctively considered.
Clearly, with the enhancements Labuan IBFC is undergoing there is no doubt its fast becoming Asia’s jurisdiction of choice; in the challenging world of cross border taxation.
Mike Grover, Tax Specialist, Labuan IBFC Inc. Sdn Bhd, Labuan