What is Economic Substance?

Economic substance explains the economic (functional) reality of a corporate framework that has been put in place owing to international tax optimisation intents. A substantial number of international tax planning structures (finance organisations, holding and sub-holding organisations, intellectual property (IP) structures and trading organisations) have been or are being determined to aid from tax laws of other foreign jurisdictions or in order to take advantage from the favourable conditions of double taxation treaties signed between two countries.

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Functions of Economic Substance

Foreign entities are frequently put in position for financial and/or fiscal intents, however not so much as they are really ‘economically’ mandatory in the global functional operations of the organisation. The term economic substance or tax substance denotes the actual proceedings and the impactful role an organisation plays in the wider setting of an internationally functioning organisation.

The new substance requirements enable only organisations (and other corporate bodies with separate legal personality) implementing necessary activities in the following sectors:

• Banking
• Insurance
• Shipping
• Fund Management
• Financing and Leasing
• Headquarters
• Distribution and Service Centres
• Holding Company
• Intellectual Property

A legal entity that carries out more than one necessary activity will be needed to adhere with the economic substance requirements accordingly.

Significance of Economic Substance

The absence of economic substance can pose concerns for an organisation’s tax residency and elevate the risk that their tax planning solutions can be seen as tax abuse or evasion. This can potentially lead to tax implications in other jurisdictions, and denial of double tax treaties and other tax advantages too.

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Ideal Customs

Generally, substance in most jurisdictions are pretty standard whereby offshore entities are required to proof the existence of their business operations and undeniably this new requirement has now become the new norm for global enterprises.

There are several risks and complexities in keeping up a tax residency and enjoying the necessary tax treaties. In case there is no substantial economic activity executed in the foreign jurisdiction, one or both of the jurisdictions will –

• not grant the advantages of the applicable double taxation treaty. This is (or will be) conducted by adapting to existing double taxation treaty provisions, or
• carry out and apply domestic anti-abuse legislation, like the introduction of CFC rules or the requirement to reveal aggressive (cross border) tax planning structures

Impact and Implications

Failure to adhere with the new regulations will impact in the company not being able to reap preferential tax treatment under Labuan Business Activity Tax Act 1990. Rather the company will be subject to prevailing income tax rate under the Malaysian Income Tax Act 1967, that is 24%.

Economic Substance in Labuan

Labuan has undergone some legislative alterations to demonstrate its commitment to implement Base erosion and profit shifting (BEPS) action plan which is to combat tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. Working together within OECD/G20 Inclusive Framework on BEPS, Labuan together with over 135 countries and jurisdictions are collaborating on the implementation of 15 measures to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment. Labuan Business Activity Tax Act (LBATA) has been amended and since then, Labuan organisations can no longer elect to pay the MYR 20,000 flat tax rate, rather they will be subjected to 3% tax on net audited profits should it fall within the identified Labuan business activities.

The central definition of ‘Labuan business activities’ has now been reinterpreted as Labuan trading or non-trading activity which is performed in, from or through Labuan. Labuan organisations no longer require any approval from the Ministry to perform Labuan business activities with Malaysian currency or with Malaysian residents. In particular, royalties or income acquired from excessive utilisation of an intellectual property right will be issued to tax under the Malaysian Income Tax Act, instead under the Labuan tax.

Labuan companies operating regulated activities will need to meet specific substance requirements as they will be required to have a sufficient number of full-time employees and a suitable amount of annual functioning expenditure in Malaysia based on their business. For example, Labuan holding entities are required to have a minimum of 2 full-time employees in Labuan and a minimum annual expenditure in Labuan of MYR 50,000.

Labuan IBFC

Labuan International Business and Financial Centre (Labuan IBFC) boasts a broad spectrum of business and investment structures assisting in cross-border transactions, business relations and wealth management requirements. These distinctive characteristics provide stable choices for regional businesses going international or international businesses seeking at penetrating Asia’s thriving markets.

Strategically situated in the heart of Asia Pacific, Labuan IBFC is well placed to tap into one of the swiftest developing regions in the world, introducing the ideal opportunity for businesses looking to associate with Asia’s economies and beyond. For more information about the latest economic substance, get in touch with QX Trust team of consultants at CONTACT US or consultant@qx-trust.com.

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