The arrival of new "economic substance" requirements on the British Virgin Islands, a move designed to avoid the proliferation of empty shell structures, has big implications. This article considers the details.

Economic substance is a fairly nebulous concept. In the context of zero- or low-tax jurisdictions, it refers primarily to the notion that companies and other entities should have adequate ‘presence’ or economic activity to justify any corresponding tax benefits. This article looks at the new regime in the British Virgin Islands. The article is by Josh Mangeot, senior associate, Harneys, BVI. The editors are pleased to share these views and invite readers to respond. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com and chris.hamblin@clearviewpublishing.com

The Economic Substance (Companies and Limited Partnerships) Act 2018 (the “Act”) is the statute that imposes economic substance requirements on the British Virgin Islands (BVI). The Act closely follows the approach taken by other major international financial centres, including the Crown Dependencies of the UK (Jersey, Guernsey and the Isle of Man) and the other Overseas Territories of the United Kingdom, which include the Cayman Islands and Bermuda. Their efforts spring ultimately from the European Union’s and Organisation for Economic Co-operation and Development’s initiatives against unfair tax practices and base erosion and profit shifting (BEPS) and particularly from the work of the EU Code of Conduct Group for Business Taxation. 

The Act came into force on 1 January 2019. BVI companies and other relevant “legal entities” which existed before that date were exempted for a transitional period but this ended on 30 June by default. The Act potentially applies to any “legal entity,” which includes all BVI companies as well as limited partnerships formed with legal personality and any foreign company or limited partnership with legal personality registered in the BVI. Most BVI vehicles are of course incorporated as companies. A “legal entity” is only potentially subject to the Act’s economic substance requirements if it carries on one or more of nine “relevant activities” and there is a simplified holding business regime for “pure equity holding entities.”

The finalised ITA rules
The BVI’s International Tax Authority (ITA) formally published its Rules on Economic Substance on 9 October (the “Rules”), having circulated an earlier draft of them on 22 April. The most obvious branding change from that earlier version is that it is no longer called a draft ‘code’ but is now a set of rules and supporting explanatory notes. The ITA’s position has remained largely unchanged. Let us dive into the detail of the changes to the April draft:

    • There are some potentially significant changes for intellectual property businesses, in part 9 and rules 22 and 23 of the Rules. The presumptions of non-compliance for certain BVI entities that are carrying on intellectual property business have been made much harder to rebut, which is further indication that the EU and OECD are focused on this subject. 

    • There are helpful additions for tax advisors in part 4 of the Rules. If an entity has applied for provisional exempted treatment as a non-‘resident’ and is trying to produce evidence of its foreign tax status, a reasonable period for the production of that evidence extends to two financial periods (including the one for which non-residence has been claimed). Tax advisors should take note of the greatly expanded concept of tax ‘residence’ under rule 4 for certain ‘transparent’ or disregarded entities and rule 5 regarding entities that are subject to tax on their income from relevant activities. 

Less helpfully, the ITA confirmed that a “pure equity holding entity” cannot benefit from rule 5 but many people expected this already.

    • There was some clarification in rule 11 to the effect that the concept of ‘expenditure’ in this context means expenditure incurred in the operation of the relevant activity.

    • The rules confirm, as expected, that if an entity is in liquidation it must still comply with the economic substance requirements. This is a key point for liquidators to note although, in our view, the requirements would only apply if the entity is still carrying on or receiving income from a relevant activity and is not “non-resident”.

    • There were some clarifications and amendments to the Beneficial Ownership Secure Search System Act 2017 or BOSS Act regarding the reporting requirements for economic substance information and we expect further guidance from the ITA on the timing and format of reporting generally.

Apart from that, it was very much a case of “business as usual” and there was relatively little else to note. If your entity has been through the process of declaring its details already, has classified itself and is already in the process of putting any required economic substance in place, is there anything that has now been introduced that should really make you stop in your tracks and rethink the plans that you have put in place so far? The answer is “not really”. The bulk of the changes were to cross-referencing and there were some clarifications but there is nothing that should change the classification that you have received, unless your advisors were unaware of the few changes in the versions circulated to industry. Any classifications conducted through the Harneys online classification solution remain unaffected.

Classify, classify, classify
With the certainty provided by the final Rules, it is vital that all directors and operators of BVI entities should classify their entities as a matter of priority, if they have not already done so.

There is a continuing legal obligation on all BVI companies and other legal entities under the amended BOSS Act to identify whether they are carrying on any relevant activities (and if so, which ones). Failure to do so without “reasonable cause” is technically a criminal offence, although many entities have already considered their activities during the first compliance period and there are no immediate reporting requirements (subject to a fairly narrow point for certain “exempt persons” to be aware of, as noted below). 

Reporting of the prescribed economic substance information will generally begin in 2020 within six months of the end of the current compliance period, but the first compliance periods have started for all BVI companies.

All BVI companies and legal entities should therefore have determined their positions and obligations under the Act and ought to be taking steps to ensure they are compliant (if they are not already).

The reporting periods may start in 2020 but those are on a 'lookback' basis (similar to the US Foreign Accounts Tax Compliance Act or FATCA and the OECD Common Reporting Standard). Reporting will be on what the entity did in the previous year and how it complied. The reports and any supporting evidence required will need to demonstrate the way in this was done and BVI entities therefore ought to think about this now.

There is one further wrinkle in the BOSS Act of which “exempt persons” ought to be aware. As of 1 October, if the entity was a previously “exempt person” (broadly, (i) a BVI mutual fund, (ii) listed on a recognised stock exchange, (iii) a “licensee” under certain financial services legislation, or (iv) a subsidiary of (i) or (ii)) then, if it carries on any relevant activity, it will cease to be so exempt.  This means that it then needs to identify information prescribed by the BOSS Act and identify/report on beneficial owners within 15 days of any change.  This is catching some people out.  Again, failure to do so without reasonable cause is an offence.

We know that some people may have been waiting to see the final rules before they felt comfortable classifying their businesses. The primary legislation and draft guidance has been in place for a while but, in some marginal cases, clients wanted clear guidance before continuing. Now the Rules are here, there is no reason to keep on waiting and they should classify their entities as soon as possible. Every entity's financial period has started (and in many cases it could have started earlier this year, so the first compliance period may be nearly done). The possibility of any claim to a reasonable cause for not classifying the entity on the basis of awaiting further guidance has now gone away.

We should not be unduly alarmist. The ITA has stated that it will take a pragmatic approach and it does appreciate the timing difficulties that it has caused the BVI. The requirements are not intended to make people impose artificial substance or to make changes that do not make sense commercially. That said, the ITA has been clear that people cannot stick their heads in the sand and ignore the new rulebook. The ITA has indicated that, if an entity has been “wrong-footed” by a material change between the April version and the October version of the Rules, it is likely to take that into account. So, for example, rule 5 has been changed in a way which could have affected a “pure equity holding entity,” although this is likely to be quite a narrow category.

Industry updates – what to expect this year and in 2020
The ITA and BVI Finance (the promotional agency for the BVI’s financial sector) have also spoken to the industry on several public occasions recently. The most recent session was the first public presentation since the Rules came out last month. It explored the changes that the Government had made between the April version and the final version, with some comments to the industry about what to expect towards the end of this year and in 2020. There were several items on the agenda.

The first point to note is that there will be a second version of the Rules, with some further amendments, in 2020. Nobody expects these to be truly seismic or to displace people's classifications but there is likely to be some information in there about related amendments to the company and partnership laws in the BVI and some other consequential changes that will flow from the way in which the economic substance regime works. The second version of the rules is going to have to be approved by the EU tax Code of Conduct Group.

There has been a third amendment to the BOSS Act (published on 31 October) to bring it into line with the final version of the Rules. The changes are fairly technical and not something that ought to excite most people.

However, every BVI legal entity will have to tell the ITA whether it carried on any relevant activity in a period (and if so, which ones) – so “nil returns” will be required. We expect that every relevant BVI entity will report this through its BVI registered agent, even if that entity is then going to go on to claim tax non-residence under part 4 of the rules.

This is for various reasons. There are some rules (rule 5, in particular) about tax residence that cannot work mechanically unless you ask the questions in that way. This is a helpful clarification and we also expect this to be a ‘filing’ that every company or entity may have to make every year (even if it is just to confirm that no relevant activities have taken place) to ensure that the information that is ultimately being presented back to the ITA (and, in some cases, to overseas tax authorities) is accurate and to make sure that entities have thought about this.

With that in mind, the ITA was very clear about the continuing obligation that all affected legal entities – which includes all BVI companies – have to identify whether or not they perform a relevant activity. This obligation commenced on 1 October. The ITA is encouraging people to take appropriate legal and professional advice if they are unsure about the formal classification of their activities or their tax status, because that cannot be done by their BVI registered agents. That is something that the entity has to do itself and the directors or general partners of the entity may well feel that they ought to take advice on the economic substance classification to discharge their own duties to the entity.

The ITA has also been very clear that it is going to expect every entity to have ‘robust’ written records that set out the basis for its classification (and, if necessary, these may refer to the fact that the entity sought professional advice). Broadly speaking, we expect that if an entity has reasonably relied on legal advice, it may have a reasonable cause for improperly identifying activities in its efforts to comply with the BOSS Act, if the ITA were to challenge that entity’s position. The ITA might still investigate the entity and impose administrative fines and penalties if it decides that the entity has failed to comply with any applicable economic substance requirements but, unless there is some more impropriety involved or misleading information has been provided, it may be less likely to pursue criminal proceedings.

We have also been told to expect some changes to the BOSS Act system itself. We should have an outline of those before January 2020 because registered agents and entities are going to have to know what information and what data they are going to submit when the economic substance reporting really starts in earnest in 2020. We expect the timing and format of reporting to be set out in some new regulations or rules to be published. We have been told that each entity will have 6 months to give that information to its registered agent after the end of the relevant financial period, which depends on the incorporation date and whether the entity has elected or applied to the ITA to change the default periods in accordance with the Act.

We are expecting some interesting communications regarding collective investment vehicles and funds in general. As most people know, the BVI (alongside the Cayman Islands, Bermuda and the Bahamas) is awaiting further technical guidance from the EU regarding collective investment vehicles generally. Both the public and private sectors are working hard on that front in the BVI.

We have also heard clients asking whether economic substance requires a trade licence or some other licence in the BVI. The short answer to that is that it depends. If your entity is carrying on a relevant activity, cannot claim non-residence and is a passive “pure equity holding entity,” the answer is probably no. In such cases, we expect that many such entities may rely on their existing registered agent and registered office provider. That does not require a trade licence of itself because that provider should already be licensed appropriately. Any BVI professional directors are generally employed by licensees already.

Conversely, if the entity does one of the other types of relevant activity and is going to need to introduce “boots on the ground” in the BVI, then that may require some form of licence. If the activity is a banking business, an insurance business or a fund management business, you should already have a licence under the relevant financial services legislation. If you are one of the other types and you are going to be bringing human resources into the BVI, then this may well require a trade licence and work permit(s). The BVI Government stands ready to help clients with that and we have been told that the BVI Labour and Immigration Departments are lined up to make that process as smooth as possible.

Our key message remains unchanged: “classify, classify, classify”. Once you have conducted the initial entity classification, the rest of the entity’s obligations flow from there.

* Josh Mangeot can be reached on +1 284 852 4387 or at joshua.mangeot@harneys.com