It is evident that globally there is considerable interest in tapping into the growing consumer spending in Asian economies. The expanding middle class in Asia, with rising salaries, is expected to drive demand for consumer products ever higher. Thus having a trading presence in the region makes good economic sense. For instance, setting up in Malaysia, a member state of the ASEAN free trade area, can provide a company with access to 600 million potential customers, whilst at the same time enjoying a relaxation of both tariff and non-tariff barriers.
However, on the other hand, no business relishes the disruption caused by a tax audit. And yet, with the new mechanisms in place to exchange tax information and with tax collectors now working together to aggressively challenge international tax structures, the risk of an audit is increasing.
Trading companies located in offshore financial centres attract interest, firstly, because they may enjoy low taxed profits. Secondly, they attract interest because of the multiple activities they undertake. Tax collectors seek to identify the cause and effect that such activities have on the trading profits and if it is established that critical activities are conducted in their jurisdiction, they would not be slow to tax.
Businesses therefore have to be mindful that as tax information begins to flow freely and efficiently between tax collectors, trading companies located in ‘offshore financial centres’ may be considered problematic in the current tax environment.
Firstly, whilst there might be little or no tax in the financial centre it is also highly probable that there are no tax treaties, or if there are, these might be limited treaties solely for the exchange of tax information and thus offer no protection from taxation outside of the trading company’s location. And further, if there is no business purpose or operational substance in place, sooner or later the tax collector will catch up with the trading company.
These matters almost certainly require a ‘makeover’ of traditional thinking on the approach to the structuring of trading companies. To provide an idea as to how the structure might look going forward the following diagram and commentary may be illustrative.
Business Purpose – Proximity
A trading company located a long distance from its market will attract scrutiny, while a trading company located in the same region as its market makes practical sense and acts as an indicator to support business purpose.
Business Purpose - Local Infrastructure
It is helpful if the infrastructure and services required to support the activities of a trading company can be obtained in the location that the trading company is domiciled.
In Labuan the infrastructure to support a trading company is extremely well developed and available at competitive rates. Thus Labuan represents a sensible choice because it is a credible location for a trading company.
The availability of local infrastructure and support facilities is also important from the viewpoint of determining the source of profits. The source of trading profits is generally made by reference to a ‘weighting’ given to each and every activity producing the profits in combination with the place where such activities are performed.
It follows that the more activities that are performed in the trading company’s location, which outweigh activities performed elsewhere, the stronger the argument that the source of profits are in the same location.
For instance, the raising of finance, the payment of suppliers and the receipt of payments may be given a significant weighting for ‘re-invoicing’ type trading companies and it becomes important that the trading company, as is possible in Labuan, has access to local banks providing full trade related banking services.
Source of Profits
As inferred above, the conventional rules to determine the ‘source’ of trading profits can often catch out a trading company.
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 profits are ‘onshore’ and taxable or ‘offshore’ and non-taxable.
Labuan employs a modern solution to this vexed question that is simple to understand and straightforward in application. Trading activities conducted with non-Malaysians in a non-Malaysian currency would be regarded as offshore income, taxed at three per cent on the audited trading profits or by election at a fixed amount of approximately US$6,500.
It is imperative for tax purposes that the trading activities are conducted by the trading company itself and not via some other entity, for instance by the trading company’s head office located in another jurisdiction.
The fact that the trading company has to be seen to conduct the trading activities means that it must have operational substance. However, the need for operational substance creates an enormous challenge in relation to the taxation of a trading company, that is, where to locate the operational substance tax and cost efficiently.
Fortunately, Labuan is tax neutral on this issue. Regardless of whether the trading company has a ‘light’ or a ‘substantial’ presence, the same low tax outcome is achieved.
This would mean that the trading company has the flexibility of ‘housing’ in Labuan those activities that may create a tax exposure in the head office’s home location or alternatively in the targeted market.
By placing the contentious activities in Labuan creates no additional Malaysian tax and by corollary will help to minimise foreign tax risks.
Where substantial operational substance is needed, Labuan by virtue of being a substance ‘enabling’ location can help to enhance the operational substance of a trading company by making available local employees, office space, and access to local support services at a relatively low cost by reference to Asian standards.
Malaysian Tax Residency
Malaysia has territorial based taxation under which tax residency plays an important part. The Malaysian test for tax residency is the factual one of central management and control that is generally satisfied by the holding of director’s board meetings in Malaysia. Having established Malaysian tax residency the likelihood that a Labuan trading company will be taxed in the head office’s location, which may employ a residence or source based system of taxation, is minimised.
Tax Treaty Benefits –Malaysian Residency
A Malaysian tax resident Labuan trading company enjoys access to the extensive Malaysian tax treaty network.This is hugely beneficial since Malaysia’s tax treaties are in the nature 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 international trade flows. As indicated earlier it is a straightforward matter to establish tax residency in Malaysia and consequently a Labuan trading company may avoid the ‘pitfall’ of being a dual resident and potentially taxable in two jurisdictions.
If the ‘tie-breaker’ clauses in the Malaysian tax treaties are adhered to a dispute with the treaty partner on tax residency may be resolved favourably as being in Malaysia.
Tax Treaty Benefits - Permanent Establishment
While on the one hand, a trading company that trades with a country is not generally subject to tax in the country traded with, on the other, a trading company that trades within a country may find themselves taxed there.
Typically Malaysian tax treaties have rules in place concerning ‘safe harbour’ activities in the treaty party location - for instance, in relation to activities considered preparatory to the generation of profits, these may include sales solicitation, marketing, obtaining customer feedback, sourcing of materials, holding of stock for delivery as conducted either by employees or independent agents.
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.
By being tax resident in Malaysia, an established trading nation with a treaty network currently in excess of 60 countries and growing, a high degree of tax protection is provided to a Labuan trading company.
Such protection would not be available to trading companies located in countries that limit themselves to exchange of information type tax treaties, which by their nature do not provide tax benefits nor ‘safe harbour’ provisions.
Extending to a Representative Office
An extremely popular way to conduct preparatory trading activities of an essentially non-revenue generating nature within Asia is to open a lightly regulated ‘representative office. The representative office is not a separate legal entity but an extension of its foreign parent company.
A representative office is advantageous because it may allow employees to be ‘on the ground’ to explore and protect business interests before making any long term or large scale business commitment.
A representative office should be regarded as a non-taxable ‘cost centre’ but it is also a vehicle to facilitate work visa applications of non-citizen employees manning the representative office.
A representative office of a Labuan trading company is extremely tax efficient. The Labuan trading company’s profits will be lowly taxed whilst the representative office in accordance with local guidelines is regarded as non-taxable cost centre.
Further, provided the duties of the employees located in the representative office come within the ambit of the tax treaty ‘safe harbour’ rules there is added protection from local corporate taxation and yet their presence contributes towards the operational substance of the Labuan trading company.
Labuan Trading Company – best of class In Asia!
Businesses are taking on board that the Labuan trading company is a sensible choice for trading within Asia.
The Labuan trading company is also able to enjoy a high degree of tax certainty with the comfort of knowing that even the most stringent substance requirements can be met cost effectively via Labuan.
Arguably, the Labuan trading company may be considered ‘best of class’.
Corporate Tax – 3% of audited profits or on election US$ 6500 (approx. USD1=RM3.08)
Branch Tax – as above
Capital Gains Tax – 0%
Withholding tax – 0%
Indirect Tax - 0%
Double Tax Agreements (as at July 2011) - 69
Mike Grover, Tax Specialist, Labuan IBFC Inc. Sdn Bhd, Labuan