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 firstname.lastname@example.org and email@example.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.