Labuan Tax: the 3% Regime, Substance Rules and When It Fails

Every Labuan brochure opens with the same number: 3%. It is accurate, and it is the least important fact about the regime.

The 3% is a rate on a base that most promoters describe loosely, granted only if you clear substance tests that are now enforced with worked examples naming a tea lady, and payable by an entity whose Malaysian counterparties may be denied a deduction on every ringgit they send it. The tax bill on a badly built Labuan structure usually does not land on the Labuan company at all. It lands on the Sdn Bhd that pays it.

This page covers what the statute says, what the Director General’s guidelines now require, and the situations where the honest answer is that Labuan is the wrong tool.

What does the 3% actually apply to?

Section 3 of the Labuan Business Activity Tax Act 1990 (LBATA) charges a Labuan entity to tax on its Labuan business activity. Everything else it does falls outside the Act and is taxed under the Income Tax Act 1967 (ITA) in the normal way, by force of s.2(3)(a).

A Labuan business activity is either a Labuan trading activity or a Labuan non-trading activity, carried on in, from or through Labuan, excluding anything that is an offence under written law.

	Labuan trading activity	Labuan non-trading activity
Definition	Banking, insurance, trading, management, licensing, shipping operations, or any other activity that is not a non-trading activity (s.2)	Holding investments in securities, stock, shares, loans, deposits or other property situated in Labuan, on its own behalf (s.2)
Charge	3% on chargeable profits (s.4(1))	Not charged to tax (s.9(1))
Base	Net profits as reflected in the audited accounts (s.4(2))	n/a
Fails substance	24% (s.2B(1A))	24% (s.2B(1A))

Two consequences follow that are routinely missed.

The base is audited net profit, not chargeable income. Section 4(2) says chargeable profits are the net profits in the audited accounts. There is no capital allowance computation, no add-back schedule and no loss carry-forward machinery of the kind Schedule 3 and s.44 of the ITA provide. Your accounting policies are your tax computation.

Mixing the two collapses into trading. Under s.2(2), an entity carrying on both a trading and a non-trading activity is deemed to carry on a trading activity. LHDN’s guideline of 10 December 2025 works this through: where an entity runs several trading activities plus a non-trading one, each trading activity must meet its own substance test, and the non-trading activity borrows the substance requirement of whichever trading activity is the core income generating activity — the one contributing the most income or having the most significant economic impact.

The intellectual property carve-out nobody mentions

Royalty income, and other income from an intellectual property right receivable as consideration for commercially exploiting that right, is excluded from the Labuan regime entirely. Sections 4(3) and 4(4) strip it out of trading profits; s.9(2) and s.9(3) strip it out of non-trading profits; s.2B(1C) and s.2B(1D) strip it out even of the 24% base. In every case it is taxed under the ITA 1967.

Section 4(5) defines the right broadly: patents, utility innovations, copyright, trade marks and service marks, industrial designs, layout-designs of integrated circuits, secret processes, formulae, know-how, geographical indications and plant variety protection, whether or not registered or registrable.

If the plan was to park your brand or your software in Labuan and licence it back, the plan does not work. It has not worked since the 2019 amendments.

What are the substance requirements?

Paragraph 2B(1)(b) of the LBATA requires an adequate number of full-time employees in Labuan and an adequate amount of annual operating expenditure in Labuan, as prescribed by the Minister. The prescription is the Labuan Business Activity Tax (Requirements for Labuan Business Activity) Regulations 2021, P.U.(A) 423/2021, gazetted 22 November 2021 and deemed to have come into operation on 1 January 2019 (regulation 3, on control and management, from 1 January 2021).

The First Schedule covers trading activities. A representative selection:

Labuan trading activity	Minimum full-time employees in Labuan	Minimum annual operating expenditure in Labuan
Labuan insurer, reinsurer, takaful or retakaful operator	3	RM200,000
Labuan bank, investment bank, Islamic bank or Islamic investment bank	3	RM200,000
Labuan underwriting manager, insurance manager or takaful manager	4	RM100,000
Labuan trust company	3	RM120,000
Labuan International Financial Exchange; self-regulatory organisation	2	RM120,000
Labuan insurance broker, credit token, development finance, building credit, factoring company, money broker, fund manager, securities licensee, fund administrator, company management	2	RM100,000
Labuan leasing company (not more than 10 related leasing companies)	2 per group of companies	RM100,000 per leasing company
Administrative, accounting, legal, backroom processing, payroll, talent management, agency, insolvency-related or other management services	2	RM50,000

The Second Schedule covers non-trading activities:

Labuan non-trading activity	Employees	Operating expenditure
Investment holding other than pure equity holding	1	RM20,000
Pure equity holding	Exempted under the Labuan Business Activity Tax (Exemption) Order 2020, P.U.(A) 177/2020	RM20,000

Note the structure of the leasing entries. For 11 to 20 related leasing companies the requirement rises to 3 employees per group, 21 to 30 gives 4, and beyond 30 the Schedule adds one further employee per group for every additional 10 related companies — while the RM100,000 applies per company, not per group. Ten Labuan leasing companies is RM1 million of Labuan operating expenditure, not RM100,000.

One activity-specific holiday is worth flagging. The Labuan Business Activity Tax (Exemption) Order 2026, P.U.(A) 34/2026 (gazetted 26 January 2026) grants a full exemption from Labuan business activity tax to a Labuan entity carrying on qualifying Syariah-based takaful and retakaful activities that use digital solutions — family and general takaful and retakaful, captive takaful for related or associated companies, takaful underwriting managers or managers, and takaful brokers — for YA2025 to YA2028. An entity carrying on both qualifying and non-qualifying activities must keep separate accounts, each a separate and distinct source.

Pure equity holding is not a free pass

Most guides report the employee exemption for pure equity holding and stop there. Two conditions survive.

The RM20,000 annual operating expenditure in Labuan still applies. And regulation 3 of P.U.(A) 423/2021, which exists specifically for item 2 of the Second Schedule, imposes control and management conditions:

• a board of directors meeting convened in Labuan at least once a year;
• the registered office situated in Labuan;
• the secretary appointed under the Labuan Companies Act 1990 resident in Labuan; and
• accounting and business records, including board minutes, kept in Labuan.

LHDN’s guideline adds a definitional limit: pure equity holding means the entity holds equity and derives income solely as dividends and capital gains. Add a shareholder loan bearing interest and you are in item 1 of the Second Schedule, which requires an employee.

Fit and proper: what changed in 2025

The Labuan Business Activity Tax (Requirements for Labuan Business Activity) (Amendment) Regulations 2025, P.U.(A) 325/2025 replaced the words full time employees with fit and proper full time employees throughout. LHDN issued guidelines on 5 November 2025 setting out what that means, and they are far more specific than anything published before.

A full-time employee counts only if all three of these hold:

1. the employee meets the fit and proper criteria;
2. the employee is employed by the Labuan entity on a permanent or contractual basis; and
3. the employee performs the work physically for the Labuan entity in Labuan.

Fit and proper is then broken down. The work must be relevant to the Labuan business activity and must consist of office-related duties, not general duties. The guideline gives a table. Office-related: director, manager, secretary, administrative or accounting clerk, receptionist. General duties, which do not count: despatch clerk, office cleaner, tea lady. The worked example is blunt — a Labuan trust company with a managing director, a general clerk and an office cleaner fails, because the cleaner is not a qualifying employee.

The employee must also have qualifications, skills and experience appropriate to the role, and must have no conflict of interest — no outside interests or responsibilities that could interfere with discharging the role.

Then the provision that invalidates a large share of existing structures:

a fit and proper full-time employee must have a contract of service with that Labuan entity, and any method of employment through outsourcing, permanent or contractual, does not count.

The example names the pattern directly: a Labuan company that engages contract workers through an employment agency and pays their salaries through that agency does not meet the substance requirements, because there is no contract of service between the workers and the Labuan entity. If your Labuan trust company supplies the bodies, the bodies are not yours.

Finally, entities in the same group may share office premises, but must segregate employees by entity and by activity, consistently. One team cannot count twice.

Physical presence must be evidenced — the guideline names time sheets, time attendance systems and other appropriate methods. This is an audit standard, not a declaration.

The licence condition

There is a further requirement that sits above all of this, stated at paragraph 2.2 of LHDN’s trading and non-trading guideline: a Labuan entity must be incorporated and registered under the relevant Labuan legislation and hold a valid and effective operating licence from Labuan FSA — for Labuan trading activity. An expired or surrendered licence is not a licensing problem alone: it costs the entity the 3% rate, because holding a valid and effective licence is a condition of qualifying for the preferential treatment.

The consequence of failing

Subsection 2B(1A) charges tax at 24% on chargeable profits for that year of assessment. Subsection 2B(1B) defines chargeable profits as the same net audited profit figure. The 5 November 2025 guideline states it without qualification: an entity that fails on the number or the criteria of employees is not entitled to the 3% rate for trading activity or the non-chargeability for non-trading activity, and is taxed at 24%.

The test is applied per basis period. There is no cure period, no grandfathering, and no averaging across years.

Why the deduction restriction is the real risk

Here is the part the sales material does not lead with, and the reason a Labuan structure can cost money even when the Labuan company itself is fully compliant.

Paragraph 39(1)(r) of the Income Tax Act 1967 restricts deductions for payments made by a Malaysian resident to a Labuan company, in the manner prescribed by rules made by the Minister — the Income Tax (Deductions Not Allowed for Payment Made to Labuan Company by Resident) Rules 2018, P.U.(A) 375/2018, as amended by P.U.(A) 376/2020.

Read that again with the parties the right way round. The Labuan company keeps its 3%. The Malaysian payer loses part of its deduction. If your Sdn Bhd pays a management fee, interest or rent to your own Labuan company, the group’s tax cost is a disallowed expense at 24% onshore, set against a 3% saving offshore. That arithmetic frequently goes the wrong way.

The rules distinguish payment types and disallow different proportions of each, with interest and lease rental treated more favourably than general payments. As amended by P.U.(A) 376/2020, item 1 — interest, including any commission, facility fee or advance fee in connection with financing — and item 2 — lease rental — each disallow 25% of the payment, while item 3 — all other payments — remains at 97% disallowed, so only 3% of a general payment is deductible. The 2020 amendment substituted 25% for the former 33% in items 1 and 2 and left item 3 untouched; it is deemed in force from 1 January 2019.

The exemption, and its expiry date

Relief exists. Labuan FSA circular 269/2021 sets out the Minister’s exemption under P.U.(A) 425/2021, which exempts a Malaysian resident from paragraph 39(1)(r) for payments made:

• to a Labuan company undertaking a qualifying activity under the Global Incentives for Trading (GIFT) programme;
• to a Labuan company that has made an election under s.3A of the LBATA; and
• to a Labuan company carrying on a Labuan business activity under s.2B.

The circular then states the effective period: from year of assessment 2019 to year of assessment 2025.

That window closed at the end of YA2025 — but only partly. The Income Tax (Labuan Company) (Exemption) Order 2026, P.U.(A) 147/2026 (made 18 March 2026, gazetted 31 March 2026) renewed the s.39(1)(r) exemption from YA2026 to YA2030, but only for payments to a Labuan company undertaking a qualifying Global Incentives for Trading (GIFT) activity — a Labuan International Commodity Trading Company licensed under s.92 of Act 704 (the Labuan Financial Services and Securities Act 2010), trading physical commodities and related derivatives. It does not renew the two broader categories P.U.(A) 425/2021 also covered — the s.3A-electing company and the general s.2B Labuan-business-activity company. No renewing order for those was located, so for an ordinary (non-GIFT) Labuan company the exemption lapsed after YA2025 and every Malaysian payer making deductible payments to it is back inside the restriction. Verify the current position with LHDN before filing.

Such a company carries its own substance test. Under the Labuan Business Activity Tax (Requirements for Labuan International Commodity Trading Company) Regulations 2021, P.U.(A) 482/2021 — as amended by P.U.(A) 326/2025, which added the fit and proper conditions — a Labuan International Commodity Trading Company must employ at least three fit and proper full-time employees, including at least two in its Labuan business operational office (per group of companies, with one more in Labuan for every five related companies beyond five), and incur at least RM3,000,000 of annual operating expenditure in Malaysia, including RM100,000 in Labuan for each company. These figures derive from the regulations and supersede the older Labuan FSA circular 239/2020.

One naming caution, because it causes confusion in searches: Labuan FSA titles P.U.(A) 425/2021 the Income Tax (Exemption) (No. 11) Order 2021, while several firm alerts call it the (No. 22) Order 2021. Cite the P.U.(A) number.

The irrevocable election into the Income Tax Act 1967

Section 3A(1) lets a Labuan entity make an irrevocable election that its profits be charged under the ITA 1967 instead of the LBATA, for the basis period elected and every subsequent basis period.

Section 3A(2) sets the deadline: the election must be made in the prescribed form and furnished to the Director General within three months after the beginning of the basis period for a year of assessment, or any extended period the Director General allows.

When is this the right move?

• The entity is loss-making or thin-margin and wants ITA machinery — capital allowances, loss carry-forward, group relief — instead of a flat charge on audited net profit.
• Substance in Labuan is genuinely unachievable, and 24% under s.2B(1A) with no deductions is worse than 24% under the ITA with them.
• Malaysian counterparties are the main customers and the s.39(1)(r) problem dominates the analysis — though the exemption that once covered electing companies (P.U.(A) 425/2021) lapsed after YA2025, and P.U.(A) 147/2026 now reaches only GIFT commodity-trading companies.
• Treaty access matters and the counterparty jurisdiction is one that will not extend benefits to an entity taxed under the LBATA.

The word to hold on to is irrevocable. There is no election out in a better year. Model the decision across the life of the structure, not the next twelve months.

What a Labuan company may and may not do onshore

The commonest myth in both directions is about dealings with Malaysia. Both the absolute prohibition and the unrestricted freedom are wrong. Section 7 of the Labuan Companies Act 1990 says:

• s.7(1) — a Labuan company may be incorporated for any lawful purpose and, subject to other written laws on financial services applicable to Labuan, shall carry out business only in, from or through Labuan.
• s.7(2) — subject to s.7(3), a Labuan company may carry on business with a resident.

The ringgit prohibition and the notification duty are repealed

Most published guidance — and Labuan FSA’s own consolidated copy of the Act — still sets out a s.7(4) prohibition on carrying on business in ringgit, a s.7(5) duty to notify Labuan FSA within ten working days of transacting with a resident, and a s.7(6) list of exceptions to that notification.

All three subsections were deleted by the Labuan Companies (Amendment) Act 2022 (Act A1653), s.4(b), deemed in force from 1 January 2019. The related restriction on ringgit-denominated shares in s.47(1)(a) was replaced by Act A1756 (2025) with “expressed in any currency”.

This is worth stating plainly because the error is everywhere, including on the regulator’s own website. If you are relying on a guide that describes a ten-working-day notification duty, that guide is citing law repealed seven years ago.

What survives is s.7(1): business only in, from or through Labuan. That is an operating-location test, not a customer test — it constrains where the company operates, not who it may deal with.

There is a related trap on the tax side. LHDN’s guideline restricts non-trading activity in other property to immovable property comprising land and buildings located within the boundaries of Labuan only. The worked example uses property in Thailand: an entity holding foreign immovable property is not carrying on a Labuan business activity at all in respect of it, and that income falls under the ITA 1967. The same logic reaches Kuala Lumpur property.

Residence, treaties and the parts that are not settled

Section 3B provides that, for the purposes of double taxation arrangements under s.132 of the ITA 1967, a Labuan entity carrying on a business is resident in Malaysia if the management and control of that business is exercised in Malaysia at any time in the basis period, and any other Labuan entity is resident if management and control of its affairs is exercised in Malaysia by its directors, partners, trustees or other controlling authority.

That establishes residence. It does not establish that a treaty partner will give benefits. A number of Malaysia’s treaty partners have historically limited or excluded Labuan entities from treaty relief. Which agreements, and on what terms, is a question to put to your adviser with the specific treaty in front of you — we have not verified a current list and are not publishing one.

Dormancy and filing

LHDN’s guidelines on dormant Labuan entities (20 October 2022) confirm that dormant or struck-off entities, including those in winding up or liquidation, that derive no income need not comply with the substance requirements. But an entity holding shares, real property, fixed deposits or similar investments is not dormant, even if it does nothing else. The worked example refuses dormant status to a holding company for as long as its sole subsidiary remains unliquidated.

The permitted expenses of a dormant entity are narrow: annual return filing under the Labuan Companies Act 1990, the secretarial fee for it, the tax filing fee, audit fee and accounting fee. Dormant entities submit Form LE1 with audited or management accounts.

If an entity resumes operations mid-period, substance must be complied with from that point — employees from the date operations commence, operating expenditure by the end of the accounting period.

On filing, note that Labuan moved from a preceding-year to a current-year basis of assessment from YA2025, announced in Budget 2024 and circulated by Labuan FSA in November 2023. The LHDN filing programme for 2026 accordingly requires the Labuan entity return (e-LE1) within seven months from the last day of the accounting period that is the basis period, with a one-month grace period for e-Filing. Most guides still reproduce the old rule of three months from the commencement of the year of assessment, which came from s.5 and s.10 of the Act as reprinted in 2021.

Tax unpaid 30 days after service of a notice of assessment is increased by 10% under s.13A(2).

When Labuan is the wrong answer

Say it plainly, because almost nobody selling Labuan will.

It is the wrong answer when your customers and suppliers are Malaysian. Not because of the old ringgit and notification rules — those were repealed in 2022 with retrospective effect to 2019 — but because s.7(1) still requires the business to be carried on in, from or through Labuan, and because s.39(1)(r) sits on the deduction your Malaysian counterparty wanted.

It is the wrong answer for intellectual property. Royalty and IP income is carved out of the 3%, the 0% and even the 24% base, by four separate provisions.

It is the wrong answer if the substance is a fiction. Two fit and proper employees physically in Labuan on a direct contract of service, plus RM50,000 to RM200,000 of Labuan operating expenditure, is a real annual cost. Against a saving of 21 percentage points, that cost only pays for itself at a meaningful profit level — and if you cannot afford it, you do not get 3%, you get 24% on audited profit with no deductions.

It is the wrong answer for a small holding structure. RM20,000 of Labuan operating expenditure, a Labuan-resident secretary, a Labuan registered office and an annual board meeting held in Labuan is a lot of machinery to shelter a dividend flow that may already be exempt.

It is the wrong answer if the driver is secrecy. Beneficial ownership, common reporting standard exchange and the substance regime have all moved against that use case since 2019.

It is the wrong answer if you are relying on repealed law. The flat RM20,000 election under the old s.7 of the LBATA — still quoted on promotional pages — was deleted. The section header now reads Election and the body reads [Deleted]. If an adviser mentions the RM20,000 option, they are working from a pre-2019 script.

Labuan is the right answer when there is a genuine cross-border business — a licensed activity, a captive insurer, a regional treasury, a commodity trading operation under GIFT — that can and will be staffed and expensed in Labuan, and whose counterparties are outside Malaysia.

Common mistakes

• Treating the 3% as automatic. It is conditional on substance, per year, per activity, and now on each employee being fit and proper.
• Counting the wrong people. Cleaners, despatch clerks and outsourced agency staff do not count. Employees shared across group entities without consistent segregation do not count twice.
• Forgetting operating expenditure for pure equity holding. The employee requirement is exempted; the RM20,000 is not, and neither are the four control and management conditions in regulation 3.
• Structuring IP into Labuan. Excluded by s.4(3), s.9(2) and s.2B(1C).
• Analysing the Labuan company in isolation. Section 39(1)(r) taxes the Malaysian payer. Model both sides or you have modelled nothing.
• Assuming the s.39(1)(r) exemption still runs. P.U.(A) 425/2021 covered YA2019 to YA2025; P.U.(A) 147/2026 renews it only for GIFT commodity-trading companies (YA2026 to YA2030). For an ordinary Labuan company it has lapsed.
• Making a s.3A election as a tactical move. It binds every subsequent basis period, permanently.
• Using the three-month filing rule. Under the current-year basis the LHDN 2026 filing programme gives seven months from the end of the accounting period, plus a one-month e-Filing grace.
• Relying on a guide that still cites s.7(4), s.7(5) or s.7(6). Those subsections were deleted by Act A1653 with effect from 1 January 2019. Guidance repeating them — including Labuan FSA’s own consolidated Act — is describing law that no longer exists.
• Buying a Labuan company for Malaysian-facing e-commerce. The s.7(1) operating-location test and the s.39(1)(r) deduction restriction both point the other way.

What’s next

If you already run a Labuan entity, the immediate work is documentary: confirm that each employee counted toward the Schedule has a contract of service directly with the entity, works physically in Labuan with attendance evidence, and performs office-related work relevant to the activity. Then confirm the operating expenditure figure is expenditure in Labuan, not group recharges.

If you are being sold a Labuan structure, ask the promoter three questions: which item of the First or Second Schedule applies, what the s.39(1)(r) position of the Malaysian payer will be for the coming year of assessment, and whether any of the projected income is royalty or intellectual property income.

If the answers are vague, the structure is not ready — and a structure that fails substance is taxed at 24% on audited profit with no deductions, which is worse than the ordinary corporate position it was meant to improve on.