Labuan Tax Changes in Substance Requirements
Labuan tax rules have seen substantial changes since the coming into force of the amendments to the Labuan Business Activity Tax Act 1990 (LBATA) via the Finance Act 2018. Since then, there have been further amendment acts and order, as well as pronouncements, clarification and directive made by the Labuan Investment Committee (LIC) (comprising the Ministry of Finance (Tax Division), Labuan Financial Services Authority (LFSA) and Inland Revenue Board (IRB)), and by LFSA, to address areas of concern from the industry players. This alert sets out a chronology and summary of the key changes relating to substance requirements since 1 January 2019.
Changes to the Labuan Business Activity Tax 1990
Finance Act 2018 amendments to LBATA
The Finance Act 2018 amendments to LBATA came into force on 1 January 2019. Key changes are:
- The definition of “Labuan business activity” is amended to no longer contain any Malaysian ringgit restrictions or restrictions on dealing with Malaysian residents.
- The introduction of new economic substance requirements for Labuan entities. Section 2B(1)(b) requires Labuan entities, for the purpose of the Labuan business activity, to have (i) an adequate number of full time employees (FTE) in Labuan, and (ii) an adequate amount of annual operating expenditure (OPEX) in Labuan.
- Income derived from royalty or other income derived from an intellectual property right shall not enjoy LBATA tax and is now subject to tax under the Malaysian Income Tax Act 1967 (ITA).
- Labuan entities carrying on a Labuan trading activity no longer have the option to elect to pay tax of RM20,000, meaning that all Labuan entities which carry on a Labuan trading activity and which comply with the relevant economic substance requirements shall be subject to tax at the rate of 3% on its chargeable profits.
Labuan Business Activity Tax (Amendment) Act 2020
The Labuan Business Activity Tax (Amendment) Act 2020 (Amendment Act 2020) came into force on 10 February 2020.
A key change under the Amendment Act 2020 is to put into effect a pronouncement made by LIC on 11 December 2019 (LIC Pronouncement 2-2019) that any Labuan entity carrying on a Labuan business activity but fails to comply with the relevant substance requirements for a basis period for a year of assessment is subject to tax under the LBATA at the rate of 24% of its chargeable profits for that year of assessment (new subsection 2B(1A) of LBATA).
The other amendments under the Amendment Act 2020 relate to detailed and increased powers of the Director General of Inland Revenue (DG) in dealing with tax matters under the LBATA, including:
- where the DG believes that any transaction has the direct or indirect effect of altering the incidence of tax payable, relieving any person from liability or evading or avoiding liability, the DG may disregard or vary the transaction and make adjustments as he thinks fit, including the computation or re-computation of the chargeable profit, or the imposition of liability to tax;
- the DG may, in the determination of the chargeable profit of a person, substitute the price for the acquisition or supply of property or services in respect of transactions that the person has entered into, to reflect an arm’s length price for the transaction;
- the DG has the power to call for all books, accounts and returns for the purpose of obtaining full information for ascertaining whether or not a person is chargeable to tax;
- for the purposes of the LBATA, the DG has full and free access to all lands, buildings and places and to all books, documents, objects, articles, materials and things and may search such lands etc. and inspect, copy or make extracts from such books etc.
- every person who is required to furnish a return of his profits for a year of assessment shall keep and retain in safe custody sufficient documents for a period of seven years from the end of that year of assessment.
Labuan Business Activity Tax (Exemption) Order 2020
The Labuan Business Activity Tax (Exemption) Order 2020 (Exemption Order 2020) was gazetted on 2 June 2020 to give effect to an earlier pronouncement on 11 December 2019 by LIC (LIC Pronouncement 2-2019 with clarification dated 20 December 2019) that exempts a Labuan entity carrying on a Labuan business activity related to pure equity holding from the application of the substance requirement on having a FTE in the LBATA. This Exemption Order 2020 comes into effect on 1 January 2019, which means that all Labuan pure equity holding entities will not be liable to any FTE requirements since the Finance Act 2018 amendments to the LBATA read with the 2018 Regulations first came into effect and operation on 1 January 2019. A Labuan pure equity holding entity is not required to have any FTE but has to comply with “management and control” requirements and a minimum OPEX of RM20,000.
Finance Act 2020 amendments to LBATA
The Finance Act 2020 amendments to LBATA came into force on 31 December 2020. Key changes are:
- following earlier pronouncements and clarifications by LIC and LFSA, subsection 2B(1)(b) is amended to state the substance requirements of (i) a Labuan trading activity to (A) have an adequate number of FTE in Labuan; and (B) have an adequate amount of OPEX in Labuan, as prescribed by the Minister by regulations; and (ii) a Labuan non-trading activity to (A) have an adequate number of FTE in Labuan; (B) have an adequate amount of OPEX in Labuan; and (C) comply with any condition in relation to control and management in Labuan, as prescribed by the Minister by regulations.
- a new subsection 2B(1B) is included to provide that, where the Labuan entity fails to comply with substance requirements and is charged to tax at the rate of 24% upon its chargeable profits for that year of assessment, such chargeable profits shall be the net profits as reflected in the audited accounts in respect of such Labuan business activity of the Labuan entity for the basis period for that year of assessment.
- where a Labuan entity makes an irrevocable election for any profit for any basis period for a year of assessment and subsequent basis period to be charged to tax under ITA in respect of that Labuan business activity, the Labuan entity shall furnish such election to the DG within 3 months after the beginning of the basis period for a year of assessment. This period of 3 months can now, under the amended subsection 3A(2), be extended by the DG as the DG may allow.
- Section 6D(1) now allows for appeals against additional assessments made under LBATA from year of assessment 2020 onwards.
Labuan Business Activity Tax (Requirements for Labuan Business Activity) Regulations 2018
The Labuan Business Activity Tax (Requirements for Labuan Business Activity) Regulations 2018 (2018 Regulations) came into operation on 1 January 2019. These regulations specify in a schedule the (i) the minimum number of FTE required in Labuan and (ii) the minimum amount of OPEX required in Labuan for each type of Labuan entity carrying on a Labuan business activity. There are 21 types listed, most of which are licensed entities and would already have to comply with some form of substance requirements under their respective industry guidelines. What is of note are the substance requirements now imposed on insurance and insurance-related licensees (which previously could rely on appointing a Labuan insurance manager or Labuan underwriting manager to comply with substance requirements), and holding companies.
LFSA expanded and updated (in terms of FTE and OPEX for certain types of Labuan entities) on 20 December 2019 and on 21 January 2020 via pronouncements, to include Labuan entities that carry on pure equity holding activities, and Labuan “other trading” entities that carry out administrative, accounting and legal services including backroom processing, payroll services, talent management, agency services, insolvency related services and management services.
Labuan Business Activity Tax (Requirements for Labuan Business Activity) 2018 (Amendment) Regulations 2020
The Labuan Business Activity Tax (Requirements for Labuan Business Activity) 2018 (Amendment) Regulations 2020 (2020 Amendment Regulations) was gazetted to give effect to LFSA’s earlier pronouncements on the revision of substance requirements for certain Labuan entities as well as to incorporate the exemption provided for under the Exemption Order 2020.
This 2020 Amendment Regulations is stated to have come into effect on 1 January 2019, which is when the 2018 Regulations first came into operation.
The key amendments to the 2018 Regulations are as follows:
- revised list of substance requirements for certain Labuan entities including Labuan banks, investment banks, insurers, insurance brokers, leasing companies and holding companies. The substance requirements for Labuan holding companies are as follows:
- for Labuan entities that undertake investment holding activities other than pure equity holding activities, they require a minimum of 1 FTE and minimum OPEX of RM20,000 in Labuan.
- for Labuan entities that undertake pure equity holding activities, they do not need to have any FTE in Labuan, but they require a minimum OPEX of RM20,000 in Labuan.
- removal of Labuan International Commodity Trading Company (LITC) from the list of Labuan entities that are subject to substance requirements. Based on a pronouncement by LIC on 9 February 2021 (LIC Pronouncement 4-2021), substance requirements for LITC will be regulated under a separate gazette order that will be gazetted in due course.
The Income Tax (Deductions Not Allowed for Payment Made to Labuan Company by Resident) Rules 2018 (Non-Deductible Rules 2018) came into effect on 1 January 2019, which provide for certain amounts of interest payments, lease rentals and other payments to not be allowed for deductions where such payments are made by a resident to a Labuan company. On 19 June 2019, the LIC issued their first pronouncement (LIC Pronouncement 1-2019), which clarified that payments made by a resident general insurer to a Labuan reinsurer and payments made by a resident to a Labuan entity which has made an election to be taxed under ITA are not subject to the Non-Deductible Rules 2018. Further, on 23 December 2019, LFSA clarified that the Non-Deductible Rules 2018 do not apply to transactions between a LITC and Malaysian residents, transactions between Labuan entities that have opted to pay tax under ITA and Malaysian residents, and transactions between Labuan entities that are paying taxes under ITA and Labuan entities that are paying taxes under LBATA.
LIC Pronouncements and LFSA Directive on Management and Control
For completeness, the key points affecting substance requirements in the four LIC pronouncements are set out below, some of which have been incorporated into the LBATA and the Regulations, and the LFSA directive on management and control:
- LIC Pronouncement 1-2019 (19 June 2019): Labuan entities which are dormant or struck off, including those under winding up proceedings or liquidation, which do not derive any source of income need not comply with substance requirements.
A FTE includes at least an officer of a managerial capacity, and other employees who are employed either on permanent or contract basis by Labuan entities, including non-managerial and clerical staff.
- LIC Pronouncement 2-2019 (11 December 2019) with Clarification dated 20 December 2019: Substance requirements are extended to Labuan entities that undertake pure equity holding activities are required to comply with management and control requirements as well as a minimum OPEX of RM20,000. For Labuan holding entities that undertake other than pure equity holding activities, they are required to employ 1 FTE and comply with a minimum OPEX of RM20,000.
Labuan entities which are dormant, struck off, in the process of winding up or liquidation and which are not deriving any source of income, need not comply with substance requirements and are also exempted from audit requirements. Run-off entities are required to comply with substance requirements. Labuan entities that do not meet substance requirements are subject to a higher tax rate of 24% of net profit under LBATA.
- LIC Pronouncement 3-2020 (11 March 2020): Labuan entities which meet the criteria to be regarded as pure equity holding entities, will still be regarded as such if they receive interest from the placing of dividend monies or proceeds from disposal of shares, in financial institutions. Further, the holding company is broadly divided into two categories – (a) companies that hold a variety of assets and earn different types of income (for example interest, rent, royalty) – for such companies that receive only non-dividend income from the holding of investments such as bonds, sukuk, debt instruments, properties, securities, the Labuan entity is deemed to be undertaking non-pure equity holding activities and have to comply with 1 FTE and RM20,000 OPEX; and (b) companies that hold equity participation and earn only dividends and capital gains.
The FTE of a non-pure equity holding entity can be at any level, so long as the functions or job scopes are dedicated to serve the business operations of the entity.
- Directive on Management and Control Requirements for Labuan Entities that Undertake Pure Equity Holding Activities (10 August 2020) with Clarification dated 10 September 2020: Labuan pure equity holding entities must observe the following requirements: hold board meetings in Labuan at least once a year; have a registered office in Labuan; appoint a Labuan trust company as resident secretary in Labuan; and keep accounting and business records including minutes of meeting in Labuan. Given the current travel restrictions due to the COVID-19 pandemic, the board meeting can be conducted virtually, provided that the hosting of the board meeting is arranged by the resident secretary in Labuan. This Directive is effective from year of assessment 2021 onwards.
- LIC Pronouncement 4-2021 (9 February 2021): Substance requirements for LITC are no longer regulated under the 2018 Regulations. They will be regulated under a separate gazette order that will be gazetted in due course.
The clarity and certainty to the tax substance requirements in Labuan provided through the Finance Act 2020 and the 2020 Amendment Regulations is welcome and certainly aids the Labuan industry players and potential users and clients in positioning their business through Labuan accordingly.
Chua Wei Min is a director of ZICO Insights Law LLC.
This alert is for general information only and is not a substitute for legal advice.