Labuan In The Age of BEPS
By Lowtax Editorial
14 December, 2017
Labuan, situated a few miles off the northern coast of Borneo in Malaysia and just 60-odd square miles in size, is one of the newer additions to the list of the world's offshore jurisdictions. But while the jurisdiction has quickly risen to prominence as one of the favored platforms for investment into the region's emerging economies, the fast-changing international tax landscape, which is being driven largely by the OECD's base erosion and profit shifting (BEPS) project, has made the environment more challenging for the Labuan financial center.
Situated in the heart of the fast-growing South Eastern Asian region, and close to a number of major cities and economic hubs such as Singapore, Hong Kong, Kuala Lumpur and Jakarta, Labuan is currently home to a population of close to 100,000, benefits from a benign income tax regime, a well-regulated financial regime, a deep-water port and a well-developed supporting infrastructure, including internet communications.
Used by the British as a coaling station in the days of empire, Labuan's economic existence has traditionally depended on its port and position at the confluence of Eastern Asians trade routes. Latterly, oil and gas exploration and their supporting industries were the main contributors to the island's economy. However, these are fast being superseded by financial services, and tourism is also a growing industry as the island's year-round tropical climate, coral reefs and sandy beaches become more well-known.
The Labuan International Business and Finance Centre (IBFC)
The financial services industry in Labuan has taken root thanks to the creation of the Labuan International Offshore Financial Centre in 1990, along with the passing of a batch of offshore laws and the creation of LOFSA (Labuan Offshore Financial Services Authority). With the passage of new laws to govern its business environment in 2010, LOFSA has since re-branded itself as Labuan FSA (Labuan Financial Services Authority), and the center itself as the IBFC (Labuan International Business and Finance Centre).
The Labuan IBFC has recorded healthy growth over the past few years, and the island has quickly grown as a major conduit for Foreign Direct Investment into a number of local countries, particularly South Korea and Malaysia itself.
At the end of the second quarter of 2017, the Labuan IBFC was home to 54 international banks, 203 insurance and insurance-related companies, 391 leasing companies, and 74 private funds.
The number of companies registered in Labuan has grown steadily each year, and by the end fo 2016 had reached 13,260, of which 5,761 were active. About 70 percent of the Labuan companies originated from the Asian region. This reflects Labuan IBFC's aim to foster regional financial integration in facilitating cross-border trade and investment in the regional emerging market.
Nonetheless, the jurisdiction has also witnessed sustainable interest from investors in Europe and America, as well as the Middle Eastern region. According to the Labuan IBFC's annual report for 2016, 12.4 percent of companies registered in Labuan originated in the Americas, particularly the British Virgin Islands, the Cayman Islands, and the United States. Representation from Europe stood at 12 percent, and the Middle East at 5.6 percent.
Significantly, the Stock Exchange of Hong Kong has awarded Labuan with recognized jurisdiction status, allowing Labuan-incorporated companies to obtain listing in Hong Kong.
The Offshore Companies Act 1990 provides for the establishment of offshore companies and the registration of foreign offshore companies in Labuan. In addition, a foreign company incorporated under the laws of another country may apply to be registered as being continued in Labuan. Every offshore company may be a company limited by shares or by guarantee. The aforementioned companies may participate in offshore activities and enjoy the attractive tax treatment provided under the Labuan Offshore Business Activity Tax Act 1990 (see below).
Residents and non-residents of Malaysia are permitted to establish offshore companies in Labuan. An offshore company may carry out any business that is lawful in Malaysia in, from or through Labuan, but banking, insurance and insurance-related businesses, fund management, leasing, factoring and company management would require the offshore company to be licensed. Shipping operations in Malaysia are prohibited.
The Offshore Companies Act was amended recently to allow Malaysians to own offshore companies, as well as to permit foreign-owned offshore companies to invest in Malaysia subject to certain conditions.
Laws came into effect in February 2010 allowing for the creation of Labuan foundations, limited liability partnerships, protected cell companies (insurance and mutual funds), shipping operations, Labuan special trusts and financial planning activities. These complement the existing available range of products and services and aim to provide investors with a wider choice of financial products to maximize investment opportunities.
Regular Malaysian companies can be used in Labuan, but will not receive the tax and other privileges accorded to Offshore Companies (see below).
Generally, companies incorporated in Malaysia are regulated by the Malaysian Companies Act, 1965. The types of companies are:
- a company limited by shares, which can be private or public;
- branch of a foreign company;
- partnership or sole proprietorship.
Foreign investors normally conduct their businesses in Malaysia in the form of a private company limited by shares.
In line with the Malaysian government's move to liberalize the financial sector, Labuan Holding companies have been permitted to set up an operational and management office in the capital city of Kuala Lumpur since 2009.
Finance Center Sectors
Labuan banks are in the business of providing credit facilities, receiving deposits, investment banking services, building credit and credit token business, development finance business, leasing business, factoring, money broking, Islamic banking business, or such other activities as are approved by the Minister of Finance, Malaysia. All Labuan banks are governed and regulated under the Labuan Financial Services and Securities Act 2010.
According to the 2016 Labuan IBFC annual the jurisdiction's banking sector remained "strong and stable" in 2016, with total deposits increasing by 17.9 percent compared to a negative growth in the preceding year. Total assets increased by 7 percent to USD47.4bn and the total loans outstanding grew marginally to USD32.3bn. The pretax profit of the Labuan banking sector jumped from USD461.1m to USD620.6m due to mainly improved quality of assets. Islamic financing also increased by 55.6 percent to USD1.8bn from USD1.2bn.
Labuan insurance business includes life, general, reinsurance, captive insurance, insurance management, underwriting management and insurance broking, but does not include domestic insurance business; and it is transacted in foreign currency. Labuan insurers may carry on reinsurance of domestic insurance business in Malaysian currency and such other business as may be specified by the Labuan FSA.
Labuan insurance activities are governed by the Labuan Financial Services and Securities Act 2010.
Effective March 2011, Labuan insurance and takaful entities, with the exception of insurance management and underwriting, may co-locate their offices in any parts of Malaysia.
In 2016, the majority of Labuan's 204 insurance and insurance-related licensees were reinsurers, captive insurers, and insurance brokers. In 2016, 11 insurance and insurance-related entities were approved comprising one general insurer, three general reinsurers, one life insurer, four insurance brokers, one captive insurer and one captive takaful operator.
2016 was also marked by the entrance to the Labuan market of two well-rated general reinsurance companies from the United States of America and Germany, specializing in property and casualty insurance.
According to the 2016 Labuan IBFC annual report, there was a 3.3 percent increase in total gross premiums of (re)insurers to USD1.4bn in 2016 (2015: USD1.3bn) despite a decrease in total gross premiums over the past three years. This was mainly due to the increase in gross premiums written on motor and other classes of insurance outside Malaysia by Labuan general insurers and reinsurers.
The Labuan IBFC is also positioned to capitalize on the growth of the oil and gas industry in Asia, and is fast becoming the financing hub for the region's oil and gas business.
According to the 2016 Labuan IBFC annual report, Labuan IBFC has become "the center of choice" for the aviation sector, with 24 new leasing companies (2015: 14) established to cater to demand for the leasing structure.
However, there was a 20 percent decline in the number of new leasing company approvals in 2016, from 45 in 2015 to 36. This decline was due in large part, according to the report, to the challenges faced by the oil and gas sector, particularly with regard to the volatility of oil prices, and developments in various economies which have affected the Labuan leasing industry and the center as a whole.
Trusts and Wealth Management
Labuan IBFC offers a comprehensive array of wealth management products suitable for high net-worth individuals, family offices and other wealth managers needing structures for efficient wealth transfer and inheritance management.
The relevant Acts related to wealth management include the Labuan Trusts Act 1996 and the Labuan Foundations Act 2010 that permit the establishment of a wide diversity of structures such as trusts and foundations for the management of international and approved Malaysian assets.
According to the 2016 Labuan IBFC annual report, in 2016, a total of 22 new foundations were registered in Labuan IBFC (up from 36 in 2015) bringing the total number of registered foundations to 188.
The Labuan IBFC is being positioned as the leading center for Islamic finance and wealth management in the Asia Pacific region.
Labuan's situation is helped a great deal by the fact that it is part of one of the most populous Islamic countries in the world, Malaysia, which is itself attempting to become a hub for Islamic Finance.
The wide range of Islamic financial products and services available in Labuan IBFC includes Islamic banking, Islamic capital markets, takaful, retakaful, Islamic funds, waqf and Islamic trust administration. These products and services are offered under various Shariah-compliant schemes by the Islamic financial institutions in Labuan.
The Labuan Islamic Financial Services and Securities Act 2010 streamline procedures and requirements for all Shariah-related activities in the Labuan IBFC.
The Government of Malaysia provides a number of tax breaks in the area of Islamic Finance, including tax exemptions for foreign Islamic fund managers. In addition, as a result of the Government's 2010 Budget, expenses for the issuance of Islamic securities are also tax deductible.
According to the Labuan IBFC's most recent annual report, in 2016, Labuan's Islamic banking sector was represented by three banks, two investment banks and 11 Islamic windows of conventional banks. Total Islamic deposits with Labuan Islamic banks, including conventional banks with Islamic windows, accounted for 1.8 percent or USD200.8m of total deposits banking deposits, an increase of 29.4 percent from the previous year. Most of the depositors were non-residents, who accounted for 98.3 percent or USD197.3m of the total Islamic deposits.
The Malaysian Government hopes that the existence of the Labuan IBFC will act as a catalyst for the growth of Islamic Finance. Indeed, Labuan is already well on the way to becoming an Islamic Finance hub in its own right.
The Labuan Offshore Business Activity Tax Act 1990 (as amended in 2004) provides for the reduction or complete exemption of income tax in respect of certain business activities carried on by offshore companies in Labuan.
Chargeable profits derived by an offshore company from an offshore trading activity are subject to tax at a rate of 3 percent.
Alternatively, an offshore company which carries on an offshore trading activity may, within three months from the commencement of any calendar year, elect to be charged to tax of MYR20,000 for that year of assessment.
An offshore company which carries on an offshore non-trading activity is exempt from income tax altogether.
The Malaysian Income Tax Act 1967 applies to any activity other than offshore business activity carried on by an offshore company, i.e. it pays normal taxes.
However, a company registered under the Labuan Companies Act 1990 (and exempt from Malaysian income tax) can make an irrevocable election to be taxed under the Malaysian Income Tax Act. Under this Act, corporations are taxed at the Malaysian corporate tax rate of 24 percent (2017). However all foreign-sourced income is exempted from tax and there is no capital gains tax, except for transactions involving certain landed properties in Malaysia.
This addition to the tax regime, announced in the 2008 Budget, is designed to ensure that Labuan's tax regime remains as flexible as possible, given that investors in Labuan undertake a wide range of financial activities.
A significant advantage of electing to be taxed under the Income Tax Act 1967 is that it provides more certain access to Malaysia's extensive network of double tax avoidance treaties, which includes more than 80 agreements.
Global Incentives For Trading (GIFT) Scheme
Under the GIFT program, a general Labuan International Trading Company (LITC) is subject to a corporate tax rate of 3 percent, but an LITC set up purely as a liquefied natural gas (LNG) trading company is entitled to a 100 percent income tax exemption on chargeable profit for the first three years of its operation, provided the company is licensed before December 31, 2014.
The LITC is required to maintain a registered office in Labuan, which is the office of its Labuan trust company. However, the LITC is allowed to establish its operational office(s) anywhere in Malaysia, while being required to provide the details of that office to the LFSA upon commencement of business. It must also ensure that its business is conducted with a proper corporate governance and risk management framework in place.
Other tax incentives applicable for an LITC include a 100 percent exemption on fees paid to non-Malaysian directors of the LITC; a 50 percent exemption on gross employment income of non-Malaysian professional and managerial staff, including traders with the LITC; an exemption on dividends received by or from the LITC; an exemption on royalties received from the LITC; an exemption on interest received by residents or non-residents from the LITC; and a stamp duty exemption on all instruments for Labuan business activities and the transfer of shares.
In January 2013, the Labuan FSA issued guidelines applicable to all Labuan international trading companies (LITCs) licensed to conduct international commodity trading business in the Labuan IBFC under the GIFT program.
The guidelines, which went into effect on January 1, 2013, and supersede those previously issued on October 31, 2011, cover a Labuan international commodity trading business involved in the trading of physical and related derivative instruments of petroleum and petroleum-related products including liquefied natural gas (LNG), agriculture products, refined raw materials, chemicals and base minerals. An LITC can deal only with non-residents in any currency other than Malaysian ringgit.
In addition, within five years after the date it obtained its license, an LITC must have a minimum annual turnover of USD100m; minimum annual business spending of MYR3m (USD735,000) payable to Malaysian residents; and at least three professional Malaysian-resident traders employed with a minimum salary of MYR15,000 per month each.
Labuan, Tax Transparency, And BEPS
In September 2013, the Labuan FSA confirmed that it remains committed to upholding its legal framework in line with internationally-agreed tax standards and best practices, following a meeting with the Organization for Economic Cooperation and Development (OECD) Center for Tax Policy.
"The meeting with OECD is important because it provided a stakeholder engagement platform for the Labuan Financial Services Authority (Labuan FSA) to reiterate our position with regards to the regulatory and tax transparency framework, in particular to the effective exchange of information," said Danial Mah Abdullah, Deputy Director General of Labuan FSA. "The OECD Center's continued endorsement is important for Labuan IBFC in its ambition to be the International Financial and Business Center for the Asia Pacific."
However, in October 2017, Muhammad bin Ibrahim, the Governor of the Central Bank of Malaysia, stressed the need for Labuan to review its international tax framework in light of the OECD's work on Action 5 of the base erosion and profit shifting project, on harmful tax practices.
Speaking on October 27 at the Labuan Industry Annual Dinner 2017, he said: "There have been significant advancements with respect to international taxation practices. Authorities are now more proactive in seeking to mitigate the distortionary effects of harmful tax competition on the allocation of resources and its negative implications on national tax bases."
He added: "In addition to that, work has commenced on reviewing respective jurisdictions' preferential tax regimes against the standards outlined, to combat harmful tax practices. The standard [under Action 5], which forms one of the four BEPS minimum standards, will require authorities to step up on transparency and substance rules for geographically mobile activities, such as financial services. It seeks, for one, to prohibit the shifting away of income into preferential tax regimes where businesses have little or no economic activity. Such international developments will directly influence IBFC's business model going forward."
Other initiatives undertaken to ensure that the Labuan IBFC conforms to international standards include equipping the Labuan FSA with adequate powers to ensure Labuan entities comply with statutory requirements, namely record-keeping, accounting, submission of information and powers of entry, search and seizure; and a broadening of the provisions of the Labuan Business Activity Tax Act 1990 relating to the disclosure of information to encompass tax information exchange agreements in addition to the existing double tax agreements signed by Malaysia.
Labuan FSA is a member of international organizations, including the International Association of Insurance Supervisors, Group of International Financial Supervisors, and Asia/Pacific Group on Money Laundering, while Labuan IBFC is a full signatory to the International Organization of Securities Commission's Multilateral Memorandum of Understanding Concerning Consultation, Cooperation and the Exchange of Information.
Labuan FSA has also signed the multilateral convention agreement with the European Securities and Markets Authority to strengthen investor protection and cooperation between jurisdictions.
Although still a relatively unknown financial center in global terms, Labuan is nevertheless a significant presence on the investment landscape of the Asia-Pacific region, as the aforementioned statistics attest. And the regulatory authority intends to continue enhancing Labuan's legislative framework to be on a par with international standards, as it positions the Labuan IBFC "as a mid-shore jurisdiction with a robust regulatory framework and the flexibility and competitiveness of an international financial center."
However, balancing the needs of international investors against demands for ever tighter transparency standards is going to be tricky tight rope to walk. And while the first phase of the Labuan IBFC's could be characterized by growth, the next phase might be a little more challenging.
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