"Labuan Trusts Law Updates"
www.ectrustco.com ASIA PACIFIC TRUSTS & OFFSHORE SEMINAR THE LANGAHM PALACE HOTEL, HONG KONG, SAR MARCH 23, 2006 LABUAN TRUSTS LAW UPDATE Peter K Searle (EC Trust (Labuan) Bhd), who acknowledges the assistance of Robert Gordon in the preparation of this article. http://www.ectrustco.com/ 1. Introduction 2. Regulation and benefits of Labuan Offshore Trusts 3. Taxation of Labuan Trusts 4. The taxation of Labuan Trusts by High Tax Jurisdictions 1. Introduction This paper focuses on the regulation and taxation of Labuan Trusts. 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 expression “Labuan Trusts” covers trusts which are specifically defined as an “offshore trust” as defined in the Labuan Offshore Trusts Act, 1996 (“LOTA”), and those Trusts which are also “Labuan Trusts”, but which fall outside that definition. The LOTA defines “offshore trust” as follows - ”7.(1) A trust is an offshore trust where – (a) the settlor is a qualified person [non-resident of Malaysia] at the time the trust is created; (b) the trust property does not include any immovable property situated in Malaysia, unless otherwise allowed by the relevant authorities and laws for the time being in force; (c) subject to subsections (2) and (3), all the beneficiaries under the trust are qualified persons at the time the trust is created or at the time any one or more of them otherwise become entitled to be beneficiaries under the trust; and www.ectrustco.com (d) at least one of the trustees is a trust company.” 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. Of particular interest are cases in which an offshore company incorporated under the Offshore Companies Act 1990 (‘the OCA”), rather than a trust company, is trustee of a trust. But what of an offshore company, Trust Officer or director of a Trust Company, who acts as servant or agent of, or on behalf of, a trust company? Such a company, Trust Officer or director is not a trust company personally. Would their appointment as trustee on behalf of the trust company preclude the trust from being defined as a Labuan offshore trust? The relevant definitions of the Labuan Trust Companies Act 1990 are as follows – “trust company” means any company registered to carry on business as a trust company under section 4; “trust company business” means the business of carrying on any economic activity by a company as a trustee, agent, executor or administrator pursuant to the objects of the company and, without limiting the generality of the foregoing, includes- (a) establishing or using a share transfer office or share registration office; (b) administering, managing or otherwise dealing with property as an agent, legal personal representative or trustee, whether by servant or agent or otherwise;” (emphasis added) LOTA is remedial or beneficial legislation which should, according to ordinary principles of statutory interpretation, be construed liberally and to give as broad effect as possible to its protective provisions. Accordingly it is likely that a Court would hold that, where a licensed trust company provides trustee services to a trust through a servant or agent, such as a Trust officer, a director or a subsidiary offshore company, “at least one of the trustees is a trust company “ within the meaning of the definition of a Labuan “offshore trust” in section 7 of LOTA. For the avoidance of doubt, a written agency agreement could be executed in such instances. www.ectrustco.com 2 As LOTA is a beneficial Act, it should not be construed as being prescriptive of all trusts created in Labuan – there is no sanction for the creation of trusts which are not defined as LOTA “offshore trusts”. In general, such trusts do not gain the express benefits of LOTA, but are regulated by equitable principles with which lawyers and judges of common law countries are familiar. It should be noted in this regard that the highest Court in Malaysia was, until 1985, the Privy Council. The Privy Council’s decisions are still regarded as authoritative, though no longer binding, by Malaysian Courts. 2. 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; “qualified person” means a person who is not a resident of Malaysia; “resident” means any person - (a) who is a citizen or permanent resident of Malaysia; or (b) 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. www.ectrustco.com 3 Section 3 of LOTA defines a trust as follows – “3. A trust exists where a person holds or has vested in him or is deemed to hold or have vested in him property of which he is not the owner in his own right and is under an obligation as a trustee to deal with that property - (a) for the benefit of any beneficiary, whether or not ascertained or in existence; (b) for any purpose which is not for the benefit of the trustee; or (c) for both such benefit and purpose mentioned in paragraphs (a) and (b). “ 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  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 – www.ectrustco.com 4 “10.(1) Where an offshore trust is validly created in accordance with or as provided by this Act, the Court shall not vary it or set it aside or recognise the validity of any claim against the trust property pursuant to the law of another jurisdiction or the order of a court of another jurisdiction in respect of – (a) the personal and proprietary consequences of marriage or the termination of marriage; (b) succession rights, whether testate or intestate, including the fixed shares of spouses or relatives; (c) any claims or orders of court with regard to matters referred to in paragraph (a) or (b) in reference to the personal laws of the settlor or the beneficiaries; or (d) the claims of creditors in an insolvency subject to the provisions of section 11.” 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 section 11 of LOTA, and only on the basis of proof beyond reasonable doubt; “11.(1) Where it is proved beyond reasonable doubt, the onus of which is on the claiming creditor, that an offshore trust created or registered in Labuan, or property disposed of to such an offshore trust – (a) was so created or registered or disposed of by or on behalf of the settlor with principal intent to defraud that creditor of the settlor; and (b) did, at the time such creation or registration or disposition took place, render the settlor, insolvent or without property by which that creditor's claim, if successful, could have been satisfied, then such creation, registration or disposition shall not be void or voidable and the offshore trust shall be liable to satisfy the creditor's claim out of the property which but for the creation, registration or disposition would have been available to satisfy the creditor's claim and such liability shall only be to the extent of the interest that the settlor had in the property prior to the creation, registration or disposition, and any accumulation to the property, if any, subsequent thereto.” 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. www.ectrustco.com 5 Subsections 11(3) to (5) place further statutory barriers in the way of creditors who may seek to attack a Labuan offshore trust - (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 - (a) 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 (b) 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. (5) A settlor shall not have imputed to him an intent to defraud a creditor solely by reason that the settlor - (a) 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 (b) 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 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 – “41.(1) Subject to the terms of the trust and to any order of the Court given on special and exceptional grounds, a trustee or any other person shall not be required to disclose to any person any document or information which discloses – (a) his deliberations as to how he should exercise or has exercised his functions as trustee; (b) the reasons for any decision made in the exercise of those functions; www.ectrustco.com 6 (c) any material upon which such a decision was or might have been based; (d) any part of the accounts of the trust; or (e) any letter of wishes given by the settlor or beneficiary. (2) Notwithstanding subsection (1), where a request for the disclosure of any document or information relating to or forming part of the accounts of the trust is made by a beneficiary under the trust or, in the case of a trust for a charitable purpose, by a charity referred to by name in the trust instrument as a beneficiary under the trust, the trustee shall be obliged to disclose the document or other information requested. (3) Except as is required, permitted or otherwise provided by this Act, or by the terms of the trust or as may be necessary for the purposes of the trust, and notwithstanding the provisions of any other law - (a) every trustee and every other person shall at all times regard and deal with all documents and information relating to a trust as secret and confidential; (b) no trustee or other person shall at any time be required to produce to or before any court, tribunal, board, committee of inquiry or any other authority or to divulge to any such authority any matter or thing coming to his notice or being in his possession for any reason, where such matter or thing relates to a trust. (4) Any trustee or other person who, except as is required, permitted or otherwise provided by this Act, or by the terms of the trust or by the Court, at any time communicates or attempts to communicate any matter of thing relating to a trust to any person shall be guilty of an offence. Penalty: Imprisonment for five years or thirty thousand ringgit or both.” Where a Labuan Trustee is an offshore company rather than a “Trust company” the confidentiality regime under the Offshore Companies Act 1990 (‘the OCA”), applies. 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: www.ectrustco.com 7 “I do not consider that it is imperative to determine whether that document is a ‘trust document’ (as I think it is) or whether the respondent, as a beneficiary, has a proprietary interest in it (as I am also inclined to think he does). Much of the law on the subject of access to documents has conventionally been expressed in terms of the ‘proprietary interest’ in the document of the party seeking access to it. Thus, it has been held that a cestui que trust has a ‘proprietary right’ to seek all documents relating to the trust: see O'Rourke v Darbishire (at 601, 603). This approach is unsatisfactory. Access should not be limited to documents in which a proprietary right may be established. Such rights may be sufficient; but they are not necessary to a right of access which the courts will enforce to uphold the cestui que trust’s entitlement to a reasonable assurance of the manifest integrity of the administration of the trust by the trustees.” 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 3. The Taxation of Labuan Trusts The Labuan Offshore Business Activity Tax Act, 1990 (“LOBATA”), provides for the taxation of offshore trusts by defining offshore companies to include Labuan offshore trusts (sub-section 2(1). 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 (Approximately USD5,420). 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. The above is a broad summary of the taxation treatment of Labuan offshore trusts. www.ectrustco.com 8 However, as noted in the introduction, there are many instances in which Labuan Trusts may be considered “offshore trusts” in general terms, but 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. Consider a case in which an offshore company incorporated under the OCA, rather than a trust company, is trustee of a trust. This requires a more careful analysis of the relevant taxing provisions. The starting point is section 3B of the Income Tax Act, 1967, which provides that “tax shall not be charged under this Act in respect of income from its offshore business activity carried on by an offshore company.” (emphasis added). The section 3B exemption is very broad and precludes taxation of an offshore company under the sections 61 to 63 dealing with “Trusts Generally”, but only in respect of “offshore business activity carried on by an offshore company.” Under section 2(1) of LOBATA, “"offshore business activity" means an offshore trading or an offshore non-trading activity carried on in or from Labuan in a currency other than the Malaysian currency by an offshore company with non-residents or with another offshore company, but does not include shipping operations:…….” “"offshore non-trading activity" means an activity relating to the holding of investments in securities, stock, shares, loans, deposits and immovable properties by an offshore company on its own behalf;” (emphasis added). Thus, “offshore non-trading activity” does not include investment income derived by an offshore company acting as trustee of a trust. Section 2(1) of LOBATA defines offshore trading activity inclusively as follows - "offshore trading activity" includes banking, insurance, trading, management, licensing or any other activity which is not an offshore non-trading activity;” Thus, “offshore non-trading activity” includes investment income derived by an offshore company acting as trustee of a trust. Such income is therefore taxed under LOBATA in the hands of an offshore company acting as trustee of a trust (or trusts) at the rate of either 3% of its audited offshore trading profits or, upon election, at a fixed rate of MR20,000. Of course, if the offshore company is a subsidiary of a trust company and is acting as agent for and on behalf of a trust company, the better view is that the trust is a Labuan offshore trust. In such a case, income from offshore non-trading activity would not be taxable. www.ectrustco.com 9 4. The Taxation of Labuan Trusts by High Tax Jurisdictions High tax jurisdictions tax trusts both directly and indirectly. The direct method of taxation often involves treating the trust as a resident of the high tax jurisdiction. Usually this will occur if the trusteee, or one of the trustees, is a resident of the high tax jurisdiction. It will also occur if the “central management and control” of the trust estate is in the high tax jurisdiction at any time of the year of income. Some high tax jurisdictions tax the trust estate if the settlor of the trust is a resident of the high tax jurisdiction. Taxpayers who wish to settle or create a trust estate should check the tax rules of their domestic jurisdiction and seek professional advice in relation to those rules. The indirect method of taxation is commonly an adjunct to Controlled Foreign Corporation (“CFC”) legislation. Such legislation taxes “controlled foreign corporations” on an accruals basis to the resident “controller” of the corporation on certain types of income. The design of CFC legislation varies from country to country depending on the policy objectives of that particular country. For example, Australia only attributes passive (investment) income and “tainted” income (income derived from dealings with associates). My understanding is that New Zealand attributes all the net income of the CFC unless the CFC is a resident of one of six high tax countries. My understanding is that the UK considers attribution where the tax rate in the CFC’s country of residence is less than 75% of the UK corporate rate (previously 50%), unless the motive for the use of the CFC isn’t tax avoidance. The first jurisdiction to pass such legislation was the United States (in 1962) and many high tax jurisdictions have since followed suit (e.g. UK in 1984, New Zealand in 1989, and Australia in 1990). An example of a modern accruals system as it applies to non-resident trust estates is the Australian legislation, which relevantly provides in section 102AAT of the Income Tax Assessment Act, 1936 as follows – “Accruals system of taxation—attributable taxpayer (1) ….. an entity is an attributable taxpayer ….. in relation to a particular trust estate if, and only if: (a) either of the following subparagraphs applies: (i) all of the following conditions are satisfied: (A) the trust estate was a discretionary trust estate at any time during the entity's current year of income; (B) the trust estate was not a public unit trust at all times during the entity's current year of income; (C) the entity has transferred property or services to the trust estate at a time (in this subparagraph called the transfer time ) before or during the entity's current year of income; www.ectrustco.com 10 (D) ….. (E) if the underlying transfer was made under an arm's length transaction otherwise than in the course of carrying on a business—the entity was in a position, at any time after the transfer time and before the end of the entity's current year of income, to control the trust estate; ……” Sub-paragraph (i) covers cases where the entity has transferred property or services to the trust and is in a position, either alone or with the aid of “associates”, to control the trust estate. Section 102AAG defines when an entity is considered to “control” a trust estate as follows – “For the purposes of this Division, an entity is taken to be in a position to control a trust estate if, and only if: (a) a group in relation to the entity had the power by means of the exercise by the group of any power of appointment or revocation or otherwise, to obtain, with or without the consent of any other entity, the beneficial enjoyment of the corpus or income of the trust estate; or (b) a group in relation to the entity was able in any manner whatsoever, whether directly or indirectly, to control the application of the corpus or income of the trust estate; or (c) a group in relation to the entity was capable under a scheme of gaining the enjoyment or the control referred to in paragraph (a) or (b); or (d) a trustee of the trust estate was accustomed or under an obligation (whether formally or informally) or might reasonably be expected to act in accordance with the directions, instructions or wishes of a group in relation to the entity; or (e) a group in relation to the entity was able to remove or appoint the trustee, or any of the trustees, of the trust estate. “ If the entity, commonly called the “transferor” is in a position to “control” the trust estate, it may have attributed to it all the net income derived by the non-resident trust estate. In this regard, it is usually the case that, where the trustee acts properly and independently and is not able to be directed by the transferor or its associates, the transferor would not be taken to be in control of the trust estate. If an entity in a high tax jurisdiction transfers property or services to a non-resident trust estate, and the trust estate derives taxable income, it should usually only do so in circumstances where neither the entity nor any of its associates are in a position to “control” the non-resident trust estate. In such an instance, if the transferor is in a position to control the trust estate, all of the net income of the trust estate would be attributable to the transferor. In this regard, any foreign tax paid is deducted to determine the net income. This is generally less advantageous than giving a credit for foreign tax paid. If, on the other hand, the trust estate were the holding entity for an offshore company, the “subsidiary” offshore company would be treated as a CFC for CFC purposes. The www.ectrustco.com 11 issue would be the characterization of the CFC’s income as either passive, tainted or active as the case may be. Passive and tainted income are attributable, whereas, active income is not attributable. That is, the Labuan company will be a CFC as it is owned by the transferor trust, but the attribution from the CFC is confined to the passive and tainted income of the CFC, not all of its net income, as would be the case if the operations of the CFC had been conducted by the trust. Note, however, that there would be no section 23AJ exemption in respect of dividends or distributions paid by the CFC through the Labuan offshore trust to any controller in Australia or other high tax jurisdiction with similar legislation, usually called a “participation exemption”. Even where an individual in a high tax jurisdiction transfers property to a non-resident trust estate, and continues to control the trust thereafter, provided the property of the trust is only an appreciating asset which pays no income, for example shares in a Labuan company, there is usually no attributable income. If the individual is only a “mere discretionary object” (Gartside v IRC  AC 553) of the trust, so as not to have an “asset” deemed to be disposed of when he ceases to be a resident of a high tax country, he can cease to be a resident of such a country before the trust realises the capital gain, and avoid the attribution of the capital gain when it is subsequently realised. In each instance, the applicable legislation in the “controller” or “transferor’s domestic jurisdiction should be carefully considered. Disclaimer This paper does not constitute advice. It should not be relied on as such. Persons wishing to explore the opportunity to use offshore trusts should seek professional advice. PETER K. SEARLE http://www.ectrustco.com/ 23 March, 2006 Peter Searle has been a tax specialist for nearly 30 years. He commenced his tax career in 1977 in the Compliance and Appeals Divisions of the Australian Taxation Office. He obtained a Masters of Law in Taxation at Monash University after having completed an Honours degree in Law, including International Law, at the Australian National University. After his admission as a Solicitor and Barrister in the Supreme Court of Victoria he worked as a Senior Taxation Manager at Coopers and Lybrand where his clients included large multinational corporate groups. From 1986 until 2001 he practiced as an Australian barrister specializing in Revenue Law and appeared in taxation and other commercial cases in the High Court of Australia, the Federal Court of Australia and the State Supreme Courts. He is a resident of the Federal Territory of Labuan, Malaysia, where he is a Director and Trust Officer of EC Trust (Labuan) Bhd. www.ectrustco.com 12