By Nithea Nadarajah
Global tax laws are continuously evolving, impacting global financial centres as well as business activities of companies conducting cross-border businesses and presenting them with critical challenges to overcome. Therefore, an understanding of key tax considerations and their implications are essential for companies to map out effective tax strategies that will ensure tax compliance, efficiency and facilitate sound business decisions.
To educate the market, Labuan IBFC and PwC Malaysia recently held a webinar on “International Tax Developments: Impact on Global Financial Centres”, covering how recent and upcoming global tax developments such as BEPS and BEPS 2.0 – digital economy is affecting global financial centres including Labuan IBFC.
The webinar commenced with presentations on recent and upcoming global tax developments impacting global financial centres and Labuan IBFC, followed by a panel discussion moderated by Farah Jaafar-Crossby, CEO, Labuan IBFC Inc and featuring Aurobindo Ponniah, Tax Director, PwC Malaysia and Jennifer Chang, Tax Partner, PwC Malaysia.
Following are some highlights of the webinar:
BEPS Project Updates
To promote equitable tax and mitigate tax arbitrage and legal profit shifting strategies practised by MNCs, there is a dire need for a cohesive and aligned global tax environment that plugs the tax loopholes enabling MNCs to leverage on favourable tax regimes.
Towards improved equitability, the Organisation for Economic Cooperation and Development (OECD) had launched the Base Erosion and Profit Shifting (BEPS) Project in July 2013, with 137 countries currently in collaboration.
Malaysia officially became an associate member of the BEPS Project in 2017 and along with Labuan (which is a federal territory of Malaysia), has committed to the implementation of the BEPS Project requirements. Throughout 2018 to 2020, Malaysia (including Labuan), had implemented a number of rules, many tax incentives, increased substance requirements, and reviewed permanent establishments as well as tax treaties, explained Aurobindo in his presentation.
The OECD emphasises that its member countries strive to implement a minimum of four (out of fifteen) standards under its BEPS Inclusive Framework (IF), as outlined below:
Implementing Country-by-Country Reporting Rules
Country-by-Country Reporting (CbCR) Rules, being one of OECD’s main priorities, applies to MNCs with a consolidated group revenue of 750 million Euros or more (equivalent to around RM3 billion or more). MNCs that reach this threshold are expected to annually file a report with their home jurisdiction tax authorities, detailing key financial and non-financial information relating to their business undertakings which are duly segregated by jurisdictions. The information obtained will then be uploaded onto a shared system amongst tax authorities of other OECD member countries who have signed an exchange of information protocol. Access to such extensive and holistic information facilitates a better understanding of MNC structures which enable tax authorities to make informed assessments covering transfer pricing and other BEPS related risks. These action plans are also implemented in Labuan resulting in MNCs headquartered in Labuan being subject to similar requirements. In cases of non-compliance, there are financial sanctions or even imprisonment. Malaysia’s financial sanctions range between RM20,000 to RM100,000 and/or six (6) months imprisonment (upon conviction). Labuan’s financial sanctions are even higher, cautioned Aurobindo.
Countering harmful tax practices
In order to curb profit shifting activities, MNCs are required to demonstrate that profits generated are attributable to the locality of the underlying economic activity and value creation (substantial activity). Indicators of substantial activity would naturally be the existence of a physical office with employees equipped with the relevant skillsets as well as adequate level of investment outlay. In situations where tax gaps could be exploited in order to maximise revenue relating to Intellectual Properties (IPs), the ‘Nexus’ approach is applied which necessitates proof that the IP was actually developed in the jurisdiction which grants the tax incentive.
Economic substance requirements have been widely adopted by a number of financial centres (including Labuan), where the level of investment and annual business spend, as well as factors such as the number of employees, the location of the core business activity, decision making, documentation and physical office are duly considered.
Efforts are also being made to curb ‘Ring Fencing’, a form of inequality practised by a tax jurisdiction which either excludes domestic taxpayers from its regime or prevents other taxpayers from operating in domestic markets. Labuan entities were previously prohibited from transacting in Malaysian Ringgit and with Malaysian entities, a law which has now been removed in order to be in line with Malaysia’s adherence to OECD standards on BEPS.
Prevention of Treaty Abuse
In order to prevent the granting of treaty benefits under inappropriate circumstances, tax treaties should be reviewed and updated in accordance with the BEPS framework by ensuring that transparent tax requirements and anti-abuse provisions are duly inserted. The Multilateral Instrument (MLI) is a form of treaty instrument signed up by all the BEPS member countries which allows for the modification of existing bilateral treaties in a synchronised manner without the need to renegotiate each treaty separately. However, for the MLI amendments to take effect, both Contracting States party to a particular treaty arrangement should be on the same page.
Enhancing the Dispute Resolution Mechanism
The OECD Model Tax Convention provides an independent mechanism through which disputes can be resolved equitably and efficiently. The Mutual Agreement Procedure (MAP) is a provision which facilitates the process of resolving such disputes and its update is pertinent to ensure the swift resolution of tax-related disputes between countries so as to reduce any serious impact to cross border businesses.
BEPS and the Labuan Taxation System
OECD’s efforts to counter harmful tax practices have pushed preferential or low-tax regimes, such as offshore financial centres into the limelight. Labuan has duly aligned its tax framework to conform to OECD’s BEPS minimum standard requirements. Amendments to the Labuan tax regulations took effect on 1 January 2019 or the year of assessment 2020 (Labuan’s tax rules are based on preceding year basis), which are elucidated as follows:
- A Labuan business activity is defined as a Labuan trading or a Labuan non-trading activity carried on, in, from or through Labuan, excluding any activity which is an offence under any written law. Previous restrictions relating to trading with Malaysia have now been removed, thereby paving the way for Labuan companies to trade in any currency (including in Malaysian Ringgit) and with Malaysian residents. [Section 2(1) of the Labuan Business Activity Tax Act 1990 (LBATA) refers].
- Labuan non-trading activities are not subject to tax in Labuan. Whereas Labuan trading activities (including a combination of non-trading activities) are subject to a preferential tax rate of 3% on the net profits per the audited accounts (capital gains inclusive). Furthermore, zakat payments can be set-off against the final tax payable, explained Jennifer Chang.
- It is pertinent to note that Labuan entities (carrying on Labuan trading activities) no longer have the privilege to make an annual election to pay tax at the fixed amount of RM20,000 as the corresponding Section 7 under the LBATA has now been removed.
- Labuan entities (carrying on Labuan business activities) qualify for preferential tax rates only if the economic substance requirements stipulated under Section 2B(1)(b) of LBATA are duly complied with on an annual basis. These substance requirements expect a Labuan entity to have an adequate number of full-time employees based in Labuan and to incur an adequate amount of annual operating expenditure in Labuan (depending on the nature of activity undertaken). Non-compliance of this requirement will effectuate the application of the prevailing domestic tax rate under the Section 2B(1)(b) of LBATA, which is currently at the rate of 24%.
- Labuan entities that do not carry on Labuan business activities will be subject to tax under MITA at the prevailing tax rate of 24%.
- Income derived from royalty and other income from an IP right shall not qualify for tax under LBATA’s preferential rates, but is subject to tax under MITA, with the prevailing tax rate of 24%.
- In light of the Covid-19 pandemic, Labuan entities were granted an extension until 28 October 2020 (under normal circumstances – 31 March annually) to submit their tax returns to the authorities. Furthermore, since physical travelling is curbed, virtual meetings held through video conferencing during this year are also acceptable in order to meet Labuan’s ‘control and management’ requirements.
With the exception of the abovementioned amendments, Labuan’s duty-free status and several exemptions covering stamp duty, withholding tax and indirect tax, as well as partial exemptions on housing allowances and managerial level employment income, remain unchanged.
BEPS 2.0 – Digital Economy
The tax system has always been built on the premise of brick-and-mortar. As such, technological changes have literally ‘up-ended’ the taxation system with immense difficulties faced in taxing an entity which earns from one jurisdiction but is based in another jurisdiction (leaving aside the concept of permanent establishment), said Aurobindo.
Difficulties faced in reaching a consensus under BEPS Action 1, relating to this matter of taxing rights along with other unresolved issues, necessitated the birth of BEPS 2.0 and its following pillars:
- Pillar One; applicable to digitalised and consumer-facing businesses, which looks at the allocation of new taxing rights for cross border activities based on the Nexus approach by using indicators such as the quantum of sales and the locality of customer base, amongst others.
- Pillar Two; applicable to a wider range of business activities, looks at introducing a new global anti-base erosion tax rules which seeks to impose a minimum rate of tax on all businesses operating internationally. Naturally, this is somewhat contentious as it may be attractive to developing countries but will create adverse reactions to most developed countries.
Two extensive reports (Pillar One and Pillar Two Blueprints) seeking public comments on all aspects of the tax challenges arising from digitisation were published by the OECD on 12 October 2020. This public consultation process (submitted via the public consultation document) will remain open until 14 December 2020, and thereafter, virtual consultation meetings (through prior registration) will be scheduled around mid-January 2021. It is imperative for MNCs to evaluate the potential implications of the BEPS 2.0 recommendations and participate in this ongoing consultative process as its implementation will be the mainspring of a paradigm shift in the global tax landscape, clearly moving well beyond the substance of digitalised businesses.
“We are grappling with the changes, knowing full well, that there will be more changes coming with the pandemic (COVID-19) a lot of things are going digital anyway. Presumably, there will be a stronger push by governments who want to adopt some kind of system that is a little bit more all-encompassing,” summed up Farah.
As the voice of the Malaysian accountancy profession, MIA is pleased to feature this important discussion on International Tax Developments: Global Financial Centres that will support sustainable taxation in a digital world.