Offshore Trusts for UK Expats:
Why Labuan, Malaysia?

Presented at the Equatorial Hotel, Kuala Lumpur
On 5 May, 2005

by Robert Gordon & Peter K Searle - Barristers at law

The primary purpose of this paper is to deal with the usefulness of offshore trusts for UK expats while they are not resident in the UK, to provide flexibility for the future.

For UK expats living in South East Asia, the Federal Territory of Labuan, Malaysia may be of particular interest as it has a special regime for offshore trusts, providing significant asset protection, with little or no tax. The regime in Labuan for offshore trusts is dealt with in Appendix One hereto.

To understand the usefulness of an offshore trust for a UK expat, it is first necessary to understand the basis of the relevant UK taxation laws. As we are not UK tax practitioners¹ , necessarily what we have to say should be checked with UK professionals before being relied upon.

The UK income tax is levied under the Income and Corporation Taxes Act 1988 (“ICTA”), the capital gain tax is levied under the Taxation of Chargeable Gains Act 1992 (“TCGA”), and the inheritance tax (“IHT”) is levied under the Inheritance Tax Act 1984 (“IHTA”).

These heads of taxation have evolved over many years, not necessarily with reference to each other, so the logic of how they work is not necessarily consistent. The overwhelming conclusion that is quickly reached is that the provisions are enormously complex, which produces both opportunities and creates traps.

As the UK expat will invariably be a tax resident of the country in South East Asia where he is residing e.g. Malaysia, and as the tax system in that country will invariably be less stringent as that in the UK, the immediate income and capital gains tax issues on investment income is not usually pressing, as foreign sourced income of the individual will not be taxed in Malaysia unless remitted into Malaysia² , and there is no general capital gains tax³ . However, if and when the expat returns to the UK or goes to live in another high tax country, there will before leaving Malaysia, be a need to consider how that income and those assets should be held with the move in mind.

However, there are two good reasons why this should not be left until then, but should be looked at as soon as the former UK tax resident takes up residence in Malaysia. As will be seen, the UK inheritance tax can be avoided by forming a non resident “interest in possession” trust and living for seven years after it is settled. Alternatively, or in addition, the expat might form a non resident trust in which he and his wife are excluded from benefiting, say, for asset protection reasons, in which case the earlier it is formed, the less likely the anti avoidance provisions⁴ of the income tax law could apply.

We deal with inheritance tax first, as this will be more relevant where large sums are settled by UK domiciles.

Inheritance Tax Slide 6

Broadly, the UK levies on the estates (where ever situate) of persons domiciled in the UK at the time of death at the rate of 40%, subject to a threshold of GBP275,000 (as per the 2005 Budget, the “nil rate band”), plus an allowance of GBP55,000 for a non domiciled spouse⁵ . Non domiciles are only subject to IHT on death on their UK situs estates, subject to the same threshold. Chargeable life time transfers⁶ exceeding GBP275,000 within any seven year period, are taxed under the IHT at the rate of 20%. Once the gift is more than seven years old, it can generally be ignored.

This paper is directed at typical UK domiciled clients i.e. born in the UK and intending to "end their days there"⁷ . This is a different concept to tax residence (which may change from year to year), which is relevant to income tax and capital gains tax. These clients having been residing and working in South East Asia for a number of years, some more, some less than, 5 years. Therefore they are invariably not tax residents of the UK. What they might most likely want to settle on an offshore trust is cash. There may also be some shares⁸ .

For a significant settlement, unless the settlor (a person who directly or indirectly provides funds or property⁹ ) retains an "interest in possession" in the trust, there will be an immediate charge to inheritance tax, as a chargeable lifetime transfer. "Interest in possession" in this context means a vested interest in the income of the settlement. If the settlor lives for at least 7 years after the date of the settling of the property¹⁰ , there is no charge to IHT. A settlement where the settlor retains an "interest in possession" is called a "potentially exempt transfer" ("PET")¹¹ .

Lifetime transfers between UK domiciled spouses are not subject to inheritance tax, as the transferee’s estate will remain subject to inheritance tax.

A UK domicile with a non UK domicile spouse can make lifetime transfers totalling GBP275,000 plus GBP55,000 worth of assets to the non UK domiciled spouse without paying inheritance tax on such lifetime transfers, but this may not go far.

Whereas persons domiciled in the UK do not have a liability to UK CGT on settlement of CGT subject property into a foreign settlement if they are not resident or ordinarily resident, the IHT works on a basis of domicile or situs of assets (including cash). It has nothing to do with residence. A person not domiciled in the UK can have an IHT liability (on death) on UK situs assets¹² , excluding some bank deposits and government securities.

The "gift with reservation" (GWR) rules¹³ disregard certain transfers of assets where the settlor retains the use of the asset although it is now held by the donee¹⁴ .

If the settlement is of cash or shares, the GWR rules aren't relevant, as the only use of the property as far as the settlor is concerned, will be to be entitled to the income from the property of the trust. The GWR rules could only apply to property which the settlor can use e.g. realty¹⁵ .

The IHT liability on a settlement during life, will depend on whether the settlor lives for at least 7 years after settling the property. There is no liability if he lives for 7 or more years. If he dies between 3-7 years from settling property, the IHT will be triggered retrospectively, but fades out the longer he lived after settling the property. It is the value of the amount settled at the time of settlement that becomes liable, not what it has grown into. However, the liability to IHT if the settlor lives for less than 7 years is (subject to taper relief for death between 3-7 years of the transfer), calculated at the death rate (40%), not the life time transfer rate (half that on death): 20%.

To be a PET the settlor must retain a life interest in the income of the trust, not just have an income interest for at least seven years¹⁶ . Once the assets are settled, the settlor and his spouse cannot demand them back.

A PET must give the settlor a vested interest in the income of the settlement in order to be a PET, and therefore not subject to IHT provided the settlor lives for at least 7 years. There is no IHT problem with the settlor also being a discretionary object of the trust capital¹⁷ . However, for there to be a valid trust, it is the trustee who must control the trust, but of course the trustee would take into account the wishes of the relevant person. The commercial reality of the trust business, is that if a professional trust company does not carry out its duties professionally, it is likely to be subject to supervision of the regulatory authority, and is unlikely to be in business very long if it ignores (for no good reason) the wishes of the relevant person. This would be true of onshore and offshore professional trustees. For a case where the trustee ignored its duties so the trust was held to be a sham, so that the property was held for the estate of the settlor, which would bring it back into the IHT net, see the Abdel Raham case¹⁸ at: http://www.jerseylegalinfo.je/Judgments/JerseyLawReports/Cases/JLR1991/default.asp?JLR910103.asp

Even if a person changes their domicile to outside the UK, if they die within 3 years of changing their domicile they are still liable to IHT or if he was a resident for income tax purposes in the UK and in not less than 17 of 20 income tax years ending with the income tax year in which he made the relevant transfer. This catches the person who lived in the UK for a long time even though he never became domiciled in the UK under the general law, i.e. a deemed domicile¹⁹ .

UK Tax Residence Slide 7

The tests of residence and ordinary residence for UK domestic purposes are a mixture of statute and case law²⁰ . One statutory test, is that an individual is resident in the UK if he spends more than 6 months there in any one tax year: s336 ICTA.

A person who has left the UK for permanent residence abroad is regarded as continuing to be resident in the UK if his visits to the UK average 91 days or more per tax year. In addition, a regulator visitor to the UK becomes resident after 4 years if his visits during those years average at least 91 days per year. In cases where it is clear that the taxpayer intends to make such visits he is treated as a resident either from the date of his first visit or from the date where he forms that intention (if later).

A person is ordinarily resident in the UK if they reside in the UK habitually (Lysaght’s case²¹ ), so whilst a person who has lived in the UK for many years and is therefore ordinarily resident, goes to live outside the UK, the Inland Revenue will only treat them as losing their ordinary resident status if they have not resided in the UK in the last three income years²² . The 2005 Budget contained as measure to counter the use of convenient double tax treaties e.g. the UK/Belgium treaty, which had allowed ordinary residence to be shed immediately that the former UK taxpayer had become a Belgium tax resident, with a rule that ordinary residence can’t be lost under such a treaty unless the former UK resident has been out of the UK for 18 months.

Malaysian Tax Residence Slide 8 | Slide 9

The question of Malaysian residence for an individual is dealt with by Peter K Searle in a paper entitled “Malaysian Tax Residence for Individuals” which is available at http://www.ectrustco.com/documents/contents/whitepapers/MalaysianTaxResidence.htm

For present purposes it should be noted that s7 of the Income Tax Act 1967 (Malaysia) provides:

Article 4 Malaysia/United Kingdom DTA Slide 10

The Malaysia/UK DTA contains “tie breaker” provisions in Article 4 where a person (including a company) would otherwise be a dual resident:

Income Tax Slide 11 | Slide 12

For all trusts, resident and non resident, the settlement code in Part XV can tax settlors on the trust income, where they retain an interest in the trust (s660A).

A person who is neither resident nor ordinarily resident in the UK cannot be assessed to UK income tax on income which arises from a source outside the UK. Accordingly, an individual resident of the UK could have sought to avoid UK income tax by transferring income producing assets to a non UK resident who is not subject to UK income tax.

To prevent such arrangements, s739 of the ICTA provides that if an individual transfers assets so that as a result of that transfer, or of associated operations, income becomes payable to any person resident or domiciled outside the UK and the transferor has either power to enjoy that income²⁴ , or receives a capital sum²⁵ , the income of the non UK resident is taxed as that of the transferor. Since 1996, s739 applies irrespective of the residence of the transferor at the time of the transfer.

An individual will avoid liability under these sections if he can prove either that the transfer or associated operation was not made for the purpose of avoiding any tax²⁶ or that it was a bona fide arrangement the purpose of which was not to avoid tax²⁷ . Whitehouse comments, there is no clear procedure and the onus of proof is on the taxpayer. In IRC v. Willoughby (1997) 70 TC 57 the court accepted that if the overall objective was not tax avoidance the motive defence could apply even if the object was achieved in a tax efficient manner.

Whilst s739 can apply to transfers to a non resident individual, company or trust, the overlapping provisions of the settlement code in Part XV, in the foreign context, only apply to foreign settlements where the settlor retains an interest in the trust.

It is worthy of note that the UK CFC provisions only apply to attribution of controlled entities income back to UK corporate entities²⁸ . This is unusual in the sphere of CFCs, and has been criticized by Prof. Brian Arnold²⁹ . In the Tax Bulletin for April 1999 the Inland Revenue Dept³⁰ made it clear that a taxpayer needed to disclose reliance on the section 741 defence in their self assessment return, in order that the exemption not be reconsidered in later years.

It is most important to note that s739 (and s660A) only have practical application where the person who made the transfer is in the UK year of income ordinarily resident in the UK. Accordingly, if the transfer takes place at the time the individual is not ordinarily resident in the UK, s739 (& s660A) can only have application for a year of income in which the individual resumes ordinary residence in the UK³¹ .

It would seem that where a trust is formed and property settled on the trust by a transferor who is at that time not ordinarily resident in the UK, the taxpayer’s motive may well not be to avoid UK taxes on his return to the UK if it can be established that the purpose for the creation of the fund was for some other purpose eg asset protection or a fund set up for a particular purpose, such as succession planning or to avoid foreign taxation³² . The trouble is of course that in order to avoid a lifetime transfer charge under IHT, it is necessary that the settlor retain a life interest in the income of the settlement, which will mean that if and when the settlor becomes resident and ordinarily resident in the UK again, they would be subject to tax on the income of the foreign settlement.

By virtue of the 1999 Tax Bulletin issued by the IRD, Whitehouse concludes that the UK domiciliary may employ an offshore trust to obtain income tax advantages for his family³³ . He says the following factors should be borne in mind:

1. The trust must be in discretionary or A&M [Accumulation and Maintenance] form; all trustees must be non resident and the income must be foreign source;
2. the settlor and his spouse must be excluded from all benefit and must not receive any actual benefit;
3. UK tax is avoided provided that the income is accumulated; any distribution should be to a non resident.

The accumulation of income in a discretionary trust in which the settlor and his spouse³⁴ are excluded as beneficiaries means that the transferor does not have “power to enjoy that income” if it is the trustee who decides to whom the income goes³⁵ . The income tax deferral would however come at the expense of the trust not being capable of being a PET for IHT purposes³⁶ .

In such a trust to avoid the income tax, the settlor should only have power to change the trustee, and perhaps have a veto over changes to the trust deed, with the exception that the settlor and his spouse should not be able to be added as beneficiaries.

If and when a UK resident beneficiary has a vested interest in the income, if that is not the year in which the income was earned by the trust, there is an additional tax of the nature of interest on the tax which would have been paid had it been vested in the year the trust earned it.

Capital Gains Tax Slide 13

A resident individual is subject to capital gains tax on his world-wide assets.

A non resident individual (excluding the “temporary non resident”) escapes capital gains tax even on disposals of assets situated in the UK except where he carries on a trade or professional vocation in the UK through a branch or agency³⁷ .

A “temporary non resident” is in the current context, a former long term resident of the UK who has been a non resident for less than five years³⁸ . An individual who is “temporarily non resident” is taxed on certain gains realized while non resident, on his return to the UK.

As a general rule, a non resident company is excluded from liability to CGT (except where it trades in the UK through a branch or agency), this could have given risen to avoidance which is dealt with in s13 (TCGA). Where the non resident company would be a “close company” if it was resident in the UK, the gain of the company is attributed to the “participator’s interest in the company” on a “just and reasonable basis”. In any event, s13 would only have any impact on participators³⁹ who are themselves UK resident⁴⁰ .

Section 13 is only presently relevant if the non resident trust in consideration owns the shares in a company which makes the capital gain, either in the UK or outside the UK.

A trust is not UK resident if a majority of the trustees are non resident and the trust is administered outside the UK.

Gains can be taxed to the settlor of a foreign settlement if the settlement is a “qualifying settlement”, but the taxation of the settlor on gains made by the foreign settlement can only apply in years where the settlor is both domiciled and either resident or ordinarily resident in the UK. Gains realized in other years are not taxed as the settlor’s, nor are gains realized in the year when the settlor dies.

A qualifying settlement is one in which “defined persons” are identified. “Defined Persons” are the settlor, the settlor’s spouse, children of the settlor or of the settlor’s spouse (with no age limit), the spouse of any such children, company controlled by a person or persons referred to above, a company associated with a company falling within the definition, any grandchild of the settlor or of his spouse the spouse of any such grandchild, and companies controlled by such persons and companies associated with such persons. In order for the settlor charge to apply, it is necessary that the “defined persons” benefits or will or may become entitled to benefit in either the income or the capital of the settlement.

It should be noted that the settlor charge under s86 (TCGA) can apply regardless of the motive of the settlor⁴¹ .

It would seem therefore that the UK expat settles the foreign trust while non resident then any capital gains made by the trust which are accumulated will not be subject to UK tax (whether the situs of the assets is UK or foreign), while the settlor remains a non resident of the UK. Clearly such a trust should realize all capital gains immediately before the settlor resumes residence in the UK.

In relation to capital gains tax, the fact that the settlor and his spouse might be excluded (so as to avoid an income tax liability) will not prevent the trust from being a qualifying settlement for CGT purposes as invariably lineal descendants of the settlor and/or spouse will be named beneficiaries⁴² .

It is of interest that a transfer by a settlor to an accumulation and maintenance (A & M) trust⁴³ is within the definition of a PET for IHT purposes. However for income tax purposes, the effect of s660B (ICTA) is that the income of an A & M trust for the benefit of the settlor’s own infant unmarried children which is distributed for the benefit of those children, will result in the income which is distributed being taxed as the settlor’s⁴⁴ . There may be some scope for the use of such a A & M trust if it is to accumulate its income until the children reach the stipulated age, or if the children are themselves non residents, but otherwise, it might be more flexible to have a simple discretionary trust if no payments are going to be made to beneficiaries.

A UK domiciled and resident beneficiary may be taxed in the UK on a capital gain made by a foreign trust if it isn’t taxed to the settlor. However, this will only be if that person benefits from the capital gain.

If a UK domiciled and resident beneficiary of a foreign trust receives a capital payment made out of capital gains, there is an interest charge in addition to the tax liability to reflect the delayed payment of the capital gains tax, although it is limited to a 6 year period⁴⁵ .

Proposal One Slide 14

Bringing together the inheritance tax, income tax and capital gains tax regimes into something that produces a result which makes some sense, might involve the following:

To potentially reduce the onerous inheritance tax consequences of a UK domicile leaving a significant estate, subject as it is to a 40% charge over the threshold of GBP275,000 (plus GBP55,000 for a non domiciled spouse), and assuming the client expects to live for seven more years, the client while non resident, could settle a large amount of cash⁴⁶ into a non resident settlement in which he would retain a life interest. The non resident settlement could then form a non resident company which would then subscribe the cash for shares in the company. The company would then invest the cash so as to produce foreign source income and gains⁴⁷ , which it would accumulate. Appendix Two deals with why Labuan, Malaysia is often a suitable jurisdiction in which to form such a company.

If the settlor lives for seven years after settling the cash, what it has grown into will not from part of his estate for UK inheritance tax purposes, whether he dies in the UK or elsewhere.

Whilst the settlor is not resident in the UK, he will not be liable to UK income tax or capital gains tax on the income of the company.

In preparation to return to the UK, the company should realise all its non cash assets, to avoid an attribution of capital gains to the settlor on his return. The company would then only earn income and not make capital gains e.g. place the cash on deposit at interest.

As the non resident trust itself makes no income, on his resuming residence in the UK, there is no trust income in which he has an “interest in possession”, as for income tax purposes, the income of the company is not deemed to be that of the trust⁴⁸ .

If he lives more than seven years after he settles the cash, it is no longer part of his estate for inheritance tax purposes.

If the beneficiaries who ultimately take on a winding up of the trust (e.g. the settlor’s children or grandchildren) reside outside the UK at the time they take, no UK tax should be payable.

If the client waited until immediately before his return to the UK to create the non resident trust, then he will have potentially wasted years of the seven year period to avoid the inheritance tax net.

The income tax anti avoidance provisions shouldn’t apply if his main purpose was to come within as a suitable asset protection regime e.g. Labuan, Malaysia, to provide for succession, and/or to avoid foreign taxes.

Proposal Two Slide 15

If the settlor and his wife have opportunities to make large capital gains from relatively small investments outside the UK e.g. “serious” growth stocks, so that the lifetime transfer provisions of the inheritance tax shouldn’t be a big issue⁴⁹ , they might set up a non resident discretionary trust (with that small investment) in which they would thereafter be completely excluded from benefiting, but in which their family would be named as beneficiaries. The trust could, but need not invest in an interposed non resident company⁵⁰ (as the settlor isn’t going to retain an “interest in possession”).

While they reside outside the UK the income and capital gains tax provisions will not apply to the trust’s (or company’s) accumulated income and gains.

Before they return to the UK to reside, the growth assets should be cashed in, so that when they return to the UK there is only income from money on deposit offshore.

If the client had made those growth investments in his own name for say, four years, while he was residing in Malaysia, the settling of the proceeds into a trust immediately before returning to the UK would, if it was an “interest in possession” trust, have resulted in him losing four years of the seven years to get the wealth out of the inheritance tax net.

If alternatively, he waited until immediately before returning to the UK to set up a non resident trust in which he and his wife had no interest, it is much more likely that the income tax anti avoidance provision might be triggered, unless he could make out the asset protection purpose, and of course, the then much larger settlement will be subject to the lifetime transfer provisions of the inheritance tax.

In the End Slide 16

Once the settlor is dead, the income tax and capital gains provisions obviously can have no implications for the settlor (or his estate), so the utility of non resident trusts is actually even greater after that time⁵¹ while income and gains are accumulated, which is of some consolation to the settlor?

Disclaimer

This paper does not constitute advice. It should not be relied on as such. Persons wishing to explore the opportunities to use offshore trusts should seek professional advice.

APPENDIX ONE

Labuan Trusts

The following are extracts from a paper “Offshore Trusts in Labuan IOFC” by Peter K Searle which focuses on the regulation and taxation of offshore trusts in Labuan. It is available on the internet and includes links to relevant cases and legislation at http://www.ectrustco.com/documents/contents/whitepapers/offshoretrusts.htm

The Labuan Offshore Trusts Act, 1996 (“LOTA”) defines “offshore trust” as follows - Slide 18

For ease of reference, this paper calls trusts which satisfy the LOTA definition of “offshore trusts”, “Labuan offshore trusts”.

By virtue of the definition in section 7 of LOTA, some trusts which may be considered “offshore trusts” in general terms, are not so defined under LOTA. For example, where the Trustee is not a Trust company registered under section 4 of the Labuan Trust Companies Act 1990.

The distinction is important as Labuan offshore trusts are taxed in the same way as offshore companies in Labuan, whereas other offshore trusts may be the subject of different taxation regimes, dependent upon the residence of the trustee and/or the settlor.

The regulation and benefits of Labuan offshore trusts

The Offshore Financial Centre Island of Labuan, a Federal Territory of Malaysia, is strategically located in the South China Sea close to the Kingdom of Brunei. It was proclaimed a Federal Territory of Malaysia in 1984. The domestic law of Labuan remains the law of Sabah, the State of Malaysia situated in Borneo of which it formed part. Sabah was, until 1963, a British colony named “British North Borneo”. The law of Sabah is based on common law and equitable principles, save for express Constitutional and statutory provisions.

The Federal Territory of Labuan was established as an International Offshore Financial Centre (IOFC) and Freeport by six Acts passed by the Malaysian Parliament in 1990 and as such, offers unparalleled advantages as an investment, asset protection and/or e-commerce centre. A key component of this system is the offshore trust industry.

The LOTA provides for the regulation of Labuan offshore trusts and confers statutory benefits on Labuan offshore trusts.

For present purposes, the relevant definitions under section 2 of the LOTA are as follows; Slide 23

1. who is a citizen or permanent resident of Malaysia; or
2. who has established a place of business and is operating in Malaysia, other than an offshore company or a foreign offshore company incorporated or registered under the Offshore Companies Act 1990,
   and includes a person who is declared to be a resident pursuant to section 43 of the Exchange Control Act 1953;” (emphasis added)

Thus, paragraphs 7(1) (a) and (c) of the definition of Labuan offshore trusts require that the settlor and beneficiaries respectively, be non-residents of Malaysia.

However, by virtue of the exclusion of offshore companies from the definition of “resident”, Labuan offshore companies may be both settlors and/or beneficiaries of a trust and still fall within the definition of a Labuan offshore trust. Such trusts would therefore be entitled to the protection and benefits of LOTA.

Section 3 of LOTA defines a trust as follows –

This definition of a trust is unexceptional. Basically, it codifies in the statutory context of LOTA, the definition of trusts adopted over centuries by numerous Courts of Equity, bearing in mind that such Courts have not been able to comprehensively define a “trust” (per Mayo J. in Re Scott [1948] S.A.S.R. 193, at 196).

The definition of “trust” in section 3 of LOTA includes testamentary trusts, inter vivos trusts, discretionary trusts, fixed trusts, unit trusts, purpose trusts, charitable trusts, constructive trusts, implied trusts, secret trusts and no doubt, other trusts which are, from time to time, to be found to exist by Courts of Equity, however described or characterized.

However, such trusts will only be Labuan offshore trusts if they satisfy the definition contained in section 7 of LOTA.

Section 8 of LOTA provides that a Labuan offshore trust shall not be valid unless it is created by will or other instrument in writing. This provision could not be intended to invalidate, say, constructive trusts or implied trusts, which are clearly “trusts” within the definition contained in section 3. It is intended to confer the benefits of LOTA only on those Labuan offshore trusts which have been reduced to writing, even if only in the form of a unilateral declaration by a trust company (as prescribed by sub-section 8(2)).

Section 9 of LOTA expressly provides for the recognition and enforceability of Labuan offshore trusts;

” 9.(1) An offshore trust, validly created in accordance with or as provided by this Act, whether in Labuan or abroad, shall be recognised and be enforceable in accordance with its terms, by the courts in Malaysia situated at Labuan or at such other place as may be designated by the Chief Justice of the Federal Court notwithstanding the provisions of any other law.”

Section 9 does not prevent the recognition or enforceability of trusts which fall outside the definition of Labuan offshore trusts. However, it expressly overrides the provisions of any other law, for example other laws which may otherwise impede the express benefits provided to Labuan offshore trusts by LOTA.

Section 10 of LOTA contains some of the most important benefits provided to Labuan offshore trusts, particularly in cases where asset protection is one of the main objects behind the creation of the trust –

Thus, orders made by Bankruptcy Courts or Family Courts of other jurisdictions will not be enforceable against Labuan offshore trusts unless the claim satisfies the strict legislative regime proscribed by LOTA.

Fraudulent dispositions to a Labuan offshore trust can only be attacked on a very limited basis under of LOTA, and only on the basis of proof beyond reasonable doubt; Slide 24

Thus, aside from being required to discharge a heavy criminal burden of proof, the creditor’s claim will not put the other assets of the Labuan offshore trust at risk and no such claim could void the creation or resettlement of the Labuan offshore trust. This stands in stark contrast to the usual range of equitable remedies in such cases, which would, save for sub-section 11(1), include a declaration that the trust is void, orders to the trustee to account, and equitable damages.

Subsections 11(3) to (5) place further statutory barriers in the way of creditors who may seek to attack a Labuan offshore trust - Slide 25

3. An offshore trust created or registered in Labuan and a disposition of property to such trust shall not be fraudulent as against a creditor of a settlor -
1. if its creation or registration, or the disposition, takes place after the expiration of two years from the date that creditor's cause of action accrued; or
2. if its creation or registration, or the disposition, takes place before the expiration of two years from the date that creditor's cause of action accrued and that creditor fails to commence such action before the expiration of one year from the date of such creation or registration, or disposition.


4. An offshore trust created or registered in Labuan and a disposition of property to such trust shall not be fraudulent as against a creditor of a settlor if the creation or registration, or the disposition of property, took place before that creditor's cause of action against the settlor accrued or had arisen. Slide 26


5. A settlor shall not have imputed to him an intent to defraud a creditor solely by reason that the settlor -
1. has created or registered an offshore trust or has disposed of property to such trust within two years from the date of that creditor's cause of action accruing; or
2. is a beneficiary. “ (emphasis added).

Section 12 of LOTA provides for Labuan offshore trusts to be registered with the Labuan Offshore Services Authority (“LOFSA”). In such instances, the prescribed fee for registration is RM750 and the annual renewal fee of the certificate of registration isRM50. This may be a very cheap price to pay for the security and benefit of the asset protection provisions of LOTA, including third party government verification of the existence and creation of the Labuan offshore trust. The annual fee of RM 50 also compares very favourably with the annual fee of RM2,600 payable to LOFSA in respect an offshore company.

Subject to the terms of the trust or to any order of the High Court of Malaysia to the contrary, section 15(3) prohibits LOFSA from disclosing any such documents or information.

Section 41 of LOTA provides for a strict confidentiality regime in relation to Labuan offshore trusts – Slide 27

It should be noted in passing that the confidentiality regime that exists in Labuan has satisfied the OECD that there is sufficiency transparency and exchange of information provisions for Labuan in particular and Malaysia in general to be considered a complying jurisdiction. Thus, no international regulatory bodies consider Labuan or Malaysia to be a non-cooperative tax haven.

This express statutory confidentiality regime may be contrasted with the confusing situation which has arisen in Courts of Equity, for example in Hartigan Nominees Pty Ltd v Rydge (1992) 29 NSWLR 405, a case concerned with disclosure of a memorandum of wishes addressed to the trustees by Sir Norman Rydge (who was in substance, but not nominally, the settlor). President Kirby (now a Justice of the High Court of Australia observed at pp 421-2:

On this point, see generally, texts on trusts, such as Chapter 9 of Ford & Lee “Principles of the Law of Trusts” Thomson (looseleaf).

LOTA contains a number of other provisions which are beneficial to Labuan offshore trusts and the beneficiaries thereof. The full text of LOTA is available at -http://www.ectrustco.com/documents/legislation/LabuanOffshoreTrustAct1990.htm

The Taxation of Offshore Trusts in Labuan

The Labuan Offshore Business Activity Tax Act, 1990 (“LOBATA”), provides for the by defining offshore companies to include Labuan offshore trusts (sub-section 2(1)) Slide 30.

LOBATA taxes offshore trading activities (excluding shipping and petroleum activities) carried on by a Labuan offshore trust at the rate of 3% on its audited offshore trading profits or, upon election, at a fixed rate of MR20,000. (The MR is fixed at the rate of 3.8 to the US$). Slide 31

Offshore non-trading activities relating to investments in securities, stock, shares, deposits and immovable properties derived by Labuan offshore trusts are not chargeable to tax in Malaysia.

Interest, royalties and management fees paid by a Labuan offshore trust to a non-resident or another offshore company are not subject to withholding tax. A Labuan offshore trust is not subject to stamp duty under the Stamp Duty Act, 1949. There is no Malaysian tax on dividends paid by a Labuan offshore trust in respect of dividends distributed out of income derived from offshore business activities or income exempt from income tax.

The Director General of Inland Revenue may require a person to furnish information for the purposes of LOBATA but such information shall be regarded as confidential and shall not be communicated or disclosed to any person except for the purpose of LOBATA only.

APPENDIX TWO

Non resident company owned by Labuan Trust

There are many advantages in having the company owned by the Labuan Offshore Trust to be a tax resident of a double tax treaty country such as Malaysia, compared with a non-double tax treaty country e.g. Hong Kong.

Malaysia has an extensive double tax treaty network with 60 countries including the United Kingdom, Canada, Australia, New Zealand, other Commonwealth countries, ASEAN countries and many EU and Arab countries.

Double tax treaty countries have enormous advantages including the following -

(1) a residence tie breaking Article which deems dual resident companies to be a resident solely of one of the Contracting States. Without treaty protection, the company is at risk of being a tax resident, and therefore taxable in both, or numerous, States, whereas dual residence companies are protected from taxation in the other Contracting State.

(2) Provided the non-resident does not have a “permanent establishment” in the other Contracting State:

1. “business profits” sourced in the other Contracting State are protected from source country tax;
2. Interest, unfranked dividends and royalties are subject to a reduced rate of withholding tax.
3. Dividends distributed from a double tax treaty country and capital gains from disposal of shares are commonly exempt from tax in the hands of non portfolio corporate shareholders in the Other Contracting State (the “participation exemption”).

By way of contrast, income which is properly subject to tax in non-double tax treaty countries may also be taxable in high tax countries. The absence of a double tax treaty has the consequence that numerous tax laws are capable of applying potentially without the benefit of any double tax treaty relief.

Framework of International Taxation Slide 33

Double Tax Agreements

Whilst each country has its own rulings concerning the taxation of international business, there are a number of “norms”. These “norms” are also reflected in the various model double tax agreements. Those are the OECD model conventions (1963, 1977, 1997, and 2003), the UN model, the US model, the Andean model, and the ASEAN model.

The UK, Canada and Australia are members of the OECD so invariably, they will look to the OECD model in their conventions with other OECD members. Malaysia is not a member of the OECD, and has its own model treaty.

Taxation treaties seek to achieve their purpose of avoiding double taxation by allocating the right to tax various types of income (and in some cases capital gain) to the country of residence only, or partly to the country of source with residual taxation to the country of residence. A country by its taxation treaties, limits its right to tax certain sources of income in the hands of the resident of the other country with which it has entered into the taxation treaty.

Most high tax countries (e.g. UK, Canada and Australia) tax their residents on their world-wide income (with credits for foreign tax paid), but only tax non residents on income sourced within the high tax jurisdiction.

Elimination of Double Tax

Where both countries’ domestic law subjects the income to tax it is necessary to prescribe a method for relieving double taxation in the taxation treaty.

The “method for elimination of double taxation” article of Malaysia’s treaties generally provides that a Malaysian resident shall be entitled to a credit for treaty country tax paid in accordance with the treaty, whether directly or by deduction, in respect of income derived by that person from sources in the treaty country.

“Tie Breaker” Provisions

Income Tax Act 1967 (Malaysia)

Section 2 defines “offshore company” to have the meaning assigned by LOBATA.

Section 3B provides “Notwithstanding section 3, tax shall not be charged under this Act on income in respect of an offshore business activity carried on by an offshore company.” Slide 34

So even though a Labuan company will not pay tax under the Income Tax Act 1967 (although its offshore trading income may be subject to 3% tax, or by election, to a flat 20,000 ringgit tax under LOBATA⁵² ), as it should be managed and controlled in Malaysia, it will prima facie be a resident of Malaysia for the purposes of the UK/ Malaysia DTA⁵³ .

Malaysia/United Kingdom DTA

Article 4 Malaysia/United Kingdom DTA Slide 35

Unlike many treaties, the Malaysia/Canada DTA at para 1 of the Protocol expressly recognises trusts as a “person” entitled to the benefit of the DTA. However, as most of Malaysia’s DTAs don’t expressly recognise a trust as a “person” for the purpose of the DTA, it makes sense to use a Labuan company to potentially attract the benefit of the relevant DTA.

Limitation of Benefits

Generally Malaysia’s double tax treaties do not exclude Labuan offshore companies from obtaining the benefits of those agreements. At present, of 60 Malaysian double tax treaties (of which about 50 have come into force), only six exclude Labuan companies carrying on offshore trading business subject to s2(1) of the LOBATA. They are the 1997 United Kingdom treaty⁵⁴ , the 1998 Netherlands treaty, the 1999 Protocol to the 1999 Japanese treaty, the 2002 Protocol to the Australian treaty, and the 2004 treaty with Luxembourg. This was achieved in all but the Japanese treaty, by an exchange of notes contemplated by the treaty, concerning tax privileged persons. The Japanese treaty refers explicitly to such Labuan companies carrying on offshore trading business subject to s2 (1) of LOBATA. Norway, Sweden and Switzerland have also recently also excluded Labuan offshore companies. If anything, these exclusions support the view that Labuan is part of Malaysia for the purposes of most treaties, as the Netherlands, Japan, the UK, Australia, Norway, Luxembourg, Sweden and Switzerland have decided it was necessary to expressly exclude in their treaty or by an exchange of notes contemplated by the treaty, Labuan companies carrying on offshore business activities subject to s2(1) of LOBATA from benefit of their treaties, to achieve that result. Accordingly, Labuan companies are extremely useful for doing treaty protected business with 52 countries (once all treaties have come into force).

Where Labuan companies are excluded from a relevant treaty, consideration could be given to the Labuan company owning a Malaysian domestic company i.e. a “Malay Satay”.

Para 28(1) of Schedule 6 to the Income Tax Act 1967 exempts the foreign source income of a Malaysian domestic company even if remitted into Malaysia⁵⁵ .

Para 28(2) of Schedule 6 has the effect of exempting from Malaysian domestic tax, a dividend paid by a Malaysian domestic company to its Labuan parent company.

As the dividend income of the Labuan parent from the Malaysian subsidiary will not be trading income, it should not be subject to tax under LOBATA.

CFC Legislation Slide 36

A number of countries have a “territorial” system of taxation such that it is only income sourced in that country which is subject to tax there. A good example in the Asia Pacific region is Hong Kong. Such countries are not concerned from a tax perspective about residents setting up offshore companies to derive foreign source income, as they don’t tax such income anyway.

However, most countries tax residents on domestic and foreign source income, but non residents only on domestic source income, and so several high tax countries have complex rules designed to attribute to resident taxpayers, income derived by entities resident outside that country, but controlled by a resident. The rules are designed to prevent the deferral that would otherwise apply until the controlled entity paid a dividend to the resident. The control foreign corporation (CFC) and their related foreign investment fund (FIF) and transferor trust rules, are usually designed to attribute passive income, or income from transactions with associates (“tainted income”). Countries with CFC rules include USA, Canada, United Kingdom, Germany, France, Sweden, Norway, Japan, Australia and New Zealand.

For a general overview of the operation of such regimes, see Brian J Arnold and Patrick Dibout, “Limits on the Use of Low-Tax Regimes by Multinational Businesses: Current Measures and Emerging Treads”, General Report – in 2001 IFA Cahiers vol B, pp 21-89.

Residence of Companies Slide 37

The determination of residence of taxpayers is fundamental to the concept of relief of double taxation pursuant to a treaty.

Most countries that use the place of management as a test of residence for companies consider central management to be located at the head office or corporate seat, for example, France, Germany and Japan, or in the place where the directors meet, for example, Canada and the United Kingdom.

The classic general law central management and control test, which until 1988 was the sole test of company residence in the United Kingdom, was set out in the speech of Lord Loreburn in De Beers Consolidated Mines Ltd v Howe [1906] AC 455. Also see Unit Construction Co Ltd v. Bullock [1959] 3 All ER 831. As can be seen from Swedish Central Railway Co v. Thompson [1925] AC 495, the central management and control of a company can be shared between two countries, such that the company can under the test, be a dual resident.

More recently, both Untelrab Ltd v McGregor (Inspector of Taxes) [1996] STC(SCD) 1 and R v Dimsey; R v Allen [2000] QB 744, highlight the need to be fastidious in ensuring that the majority of the board of a Malaysia company is resident in Malaysia, and do in fact meet for the purpose of considering resolutions, rather than that an individual, for example, in Canada, whether a director or not, conduct the Malaysian company’s board level decisions, on their own. On one occasion, the Canadian revenue successfully relied on the doctrine of sham, as the tax haven subsidiary in question was found to be a “mere puppet” of its Canadian parent: Dominion Bridge Co. Ltd. v The Queen 75 DTC 5150. Since then, the sham argument has not been accepted: Spur Oil Ltd v The Queen 81 DTC 5168; R v Redpath Industries Ltd 83 DTC 5117; Consolidated Bathurst Ltd v The Queen 85 DTC 5120. Also see Victoria Insurance Co. Ltd v MNR 77 DTC 320.

Malaysia determines corporate residence solely on the basis of “central management and control”. The United Kingdom, Canada and Australia are examples (there are many) of countries which now determine corporate tax residence on the alternative bases of:

1. place of incorporation; or
2. place of central management and control.

In contrast, the United States simply looks to the place of incorporation.

The High Court of Australia in Esquire Nominees Ltd v FC of T (1973) 129 CLR 177 held that a company incorporated on Norfolk Island (a territory of Australia but then only taxable on income sourced from the mainland), and all of whose board resided on Norfolk Island, indeed had its central management and control on Norfolk Island, notwithstanding the resolutions for board meetings were prepared in Melbourne by the ultimate shareholders’ accountants. This was on the basis that the board meet to consider such resolutions, and it would not have passed them, had they been illegal or not in the best interests of the company.

The relevant principles to be gleaned from the authorities are:-

(1) Effective Management should be where the board of directors meets to conduct and manage the business including ratifying any decisions made by others and

(2) A majority of the board should be residents of the jurisdiction the company is or purports to be resident of.

Source of Income Slide 42

There is a “source of income” article appearing in most of the UK’s, Canada’s and Australia’s taxation treaties. More than half of those articles provide that income derived by a resident of one country which is permitted to be taxed in the other country in accordance with the taxation treaty, is deemed for all purposes of the treaty to be income arising from sources in the other country. This empowers each country to exercise taxing rights allocated to it by the treaty. Almost all treaties specify this to be the case for the purposes of providing tax credits, which ensures double taxation relief as intended.

In Anglo-Canadian and Australian jurisprudence the source of income from the sale of trading stock by a simple merchant is the place where the contract of sale was entered into. The source of income where the taxpayer’s business involves a range of activities, such as extraction, manufacture/processing and sale, is apportioned between the places at which the various activities are carried out.

In Entores Ltd v. Miles Far Eastern Corporation [1955] 2 QB 327 at 332-4 Denning LJ stated that where the offeror and the offeree are located in different countries and communication is not by post, but telephone, telegram, telex or some instantaneous means of communication, acceptance will only be effective when it is received – not at the moment of transmission – “and the contract is made at the place where the acceptance is received”. That decision has been followed in Canada and Australia.

As the place the contract is made is where the offeror receives notice of the acceptance of the offer, a Canadian purchaser from a Labuan resident communicating electronically, is entering into the contract in Labuan if the Labuan resident’s e-commerce server is in Labuan. That is, Labuan is the place of receipt of acceptance. For a general overview of income source considerations in electronic commerce, see Gary D. Sprague and Michael P. Boyle, “Taxation of income derived from electronic commerce”, General Report – in 2001 IFA Cahiers Vol A, pp 21-63.

Permanent Establishments Slide 43

The “business profits” article of most Double Tax Treaties provide that the business profits of a resident of one treaty country are taxable only in that country unless it carries on business in the other country through a permanent establishment. Under these circumstances, the profits of the enterprise which are “attributable” or “effectively connected” to the permanent establishment may be subject to tax in the treaty country in which the permanent establishment is located. The concept was considered in Australia in Unysis Ltd v FC of T (2002) 51 ATR 386, and very recently in McDermott Industries (Aust) Pty Ltd v FC of T [2005] FCAFC 67 (29 April, 2005).