Grasping what is meant by "substance" when it comes to setting up structures in international financial centres is a crucial point in satisfying regulatory and other requirements today.
The shifting world of international financial centres mean that when individuals and organisations create an offshore structure, authorities such as tax collectors want to know that it has “substance”. In concrete terms, does an offshore office have staff, actual activity and an infrastructure, rather than just a fancy brass plate and a listing in a register? Without passing such a test, tax authorities in this increasingly transparent age are likely to take a dim view. The same test applies to wealth structures such as trusts and foundations.
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The only thing that is constant is change. These ancient words of Heraclitus ring loud as many will be forced to review their offshore structures, including even the most standard ones, in light of a new rising tide in the form of the so-called EU Economic Substance Requirements, which have been translated into legislation with effect from 1 January 2019.
In 2016, the EU Finance Ministers instructed the EU Code of Conduct Group to undertake a screening process whereby non-EU jurisdictions, 92 in total, were assessed in respect of: (i) tax transparency; (ii) fair taxation; and (iii) compliance with anti-base erosion and profit shifting measures.
Guernsey, Jersey, the Isle of Man, British Virgin Islands (BVI), Cayman, Bermuda and Vanuatu were found not to have a formal tax legal substance requirement for entities doing business in or through their respective jurisdictions and were put on an “EU grey list”. These jurisdictions all committed to adopting “Economic Substance Requirement” legislation by the end of 2018, in response to the threat of being blacklisted by the EU for not adhering to its proposals.
The proposals are aimed at addressing the EU’s concern that these jurisdictions’ tax systems facilitate artificial offshore structures without real economic activity. In other words, structures that attract profits which are not supported by sufficient economic activity or presence in the relevant jurisdiction.
Mauritius underwent a similar review, following which it committed to introducing relevant measures. The EU has, however, grouped Mauritius with jurisdictions required to “Improve Fair Taxation” and not with the aforementioned jurisdictions, which are required only to “Introduce Substance Requirements”. Malta does not feature in the list of reviewed jurisdictions by virtue of its being an EU Member State.
Guernsey, Jersey and the Isle of Man were the first to release draft “Economic Substance Requirement” legislation and worked closely together to ensure a uniform approach to implementation. The BVI, Cayman, Bermuda and Bahamas followed shortly after, each with their own legislative approach, with effect from 1 January 2019.
Generally, a jurisdiction’s economic substance rules apply to entities that are tax resident in that jurisdiction. As there is no tax residence concept in the BVI, the tax residence requirement has been cast in the negative. Where an entity can show that it is tax resident elsewhere, it will not be caught under the BVI substance requirements.
In broad terms, the substance requirements target “relevant activities” that are deemed “high risk” from a lack of substance perspective, because they are geographically mobile. These are as follows:
· Fund management
· Finance and leasing
· Distribution and service centre
· Intellectual property holding
· Holding company
In Guernsey, Jersey and the Isle of Man, carrying on a relevant activity is not enough for the economic substance test to kick in. The entity has to derive income from the relevant activity. The BVI legislation, in contrast, does not require there to be income from the relevant activity.
Once an entity has been identified as undertaking a relevant activity, and meets any other relevant criteria such as income and tax residence, it will be required to satisfy the economic substance test. In general, this test centres on the entity being directed and managed in the relevant jurisdiction, conducting its core income-generating activities in that jurisdiction and having adequate people, premises and expenditure in that jurisdiction. To the extent possible, depending on the relevant activities carried on, the test can be satisfied by engaging with a corporate service provider in the relevant jurisdiction.
Entities will have to report annually on their economic substance credentials and a formal hierarchy of sanctions for non-compliant entities will be enforced. Meeting the economic substance test, for example, may well imply certain additional expenses and regulatory filings in the relevant jurisdiction, directors resident in, or board meetings held in, the relevant jurisdiction.
The economic substance test thresholds are increased for intellectual property holding companies, which are seen as higher risk, and reduced for holding companies or pure equity holding companies, which are seen as lower risk.
The fact that pure equity holding companies are included in the list of relevant activities, indicates the breadth of the potential impact of the rapidly rising EU economic substance tide. Most offshore trusts, for a variety of reasons, have underlying companies (also known as a standard “trust-and-company” structure).
Though the exact definition of a “holding company” and a “pure equity holding company” varies slightly from one jurisdiction to the next, and guidance on certain matters of interpretation is still awaited, an underlying company in this context (trust-and-company structure) could qualify as a “holding company” or “pure equity holding company”, thereby triggering the substance requirements.
In practice, an entity should not be caught by more than one jurisdiction’s substance requirements. But it may have to comply with corporate requirements in its jurisdiction of incorporation and substance requirements in another jurisdiction if it is tax resident there.
It is furthermore expected that discrepancies in the Economic Substance Requirements legislation of the listed jurisdictions will be ironed out over time under the scrutiny of the EU Code of Conduct Group. Hence, it is unlikely that reliance on arbitrages created by such discrepancies would provide a long-term solution.
The safest and most cost-effective route in the long run might therefore be to consolidate one’s offshore structure to a single credible offshore jurisdiction - one where existing local regulations provide a strong economic substance framework that is likely to withstand the ebb and flow of the new EU substance tide for years to come.