Economic substance required

As from 1st January 2019, economic substance requirements have been introduced in a number of jurisdictions, meaning that certain companies and partnerships are required to declare annually if they are engaged in what is called a “relevant activity” and demonstrate – where applicable – that they are satisfying the economic substance test for this activity.

These jurisdictions include, but are not limited to:

• the Bahamas
• Barbados
• Bermuda
• British Virgin Islands
• Cayman Islands
• Jersey, Channel Islands

In other jurisdictions, such as Mauritius, the local tax and corporate regimes have been adapted to ensure that economic substance is taken into account in a manner coherent with the OECD and EC objectives.

Are there penalties for non-compliance?

Yes, there are both financial and criminal penalties. Also, the entity may be struck off if it fails to meet the economic substance requirements.

In 2019 the Forum on Harmful Tax Practices started its work on this new “global standard” on substantial activities in no or only nominal tax jurisdictions. This coincides with work being done through the European Union’s Code of Conduct Group assessing low or no-tax jurisdictions on tax transparency, fair taxation and compliance with the Base Erosion and Profit Shifting’s project.

Under the threat of yet another black-list the EU required a number of jurisdictions (Anguilla, Bahamas, Bahrain, British Virgin Islands, Cayman Islands, Isle of Man, Jersey, Marshall Islands, Turks and Caicos Islands, United Arab Emirates and Vanuatu) to adopt, in a very short timeframe, economic substance requirements for businesses based there.

Without going into the detail of the specific legislation being introduced in each jurisdiction it should be noted that the British Crown Dependencies and British Overseas Territories have all adopted, or are in the process of adopting very similar legislation, with or without specific guidance on the practical requirements to meet economic substance tests depending on the nature of the business activity.

The legislation generally applies so that the economic substance requirements are applicable to legal entities carrying on the “relevant activities” below:

• banking business
• insurance business
• fund management business
• finance and leasing business
• headquarters business
• shipping business
• holding business (defined as “pure holding companies”)
• intellectual property business
• distribution and service centre business

The specific requirements for economic substance will depend on the relevant activity, and are being defined by each jurisdiction locally.

Trusts are not in scope but corporate trustees are in scope depending on the circumstances.
If the entity does not have adequate substance in that territory it may be possible to confirm that the business is being undertaken elsewhere, which may be subject to different levels of proof being required. It is specifically worth noting that the place of effective management will be included in the BVI BOSS registry. The information concerning non-compliance may be exchanged with the jurisdiction where the “real” economic activity is being undertaken, leading to tax enquiries in that country.

If the substance requirements are not met, or if the company is not seen to be managed elsewhere then there may be sanctions and penalties imposed, with the company eventually being struck off.

The deadlines for application and implementation of the law will vary locally. For the BVI and Caymans the legislation is effective from 1 January, 2019 for newly incorporated entities.

Next step:

You might use this opportunity to review the suitability of the structure to ensure that it is robust taking into account the expected longer term aims of the OECD BEPS project and the EU aims of a common consolidated tax base, and minimum levels of corporate taxation, and the push towards publicly available information on beneficial ownership of entities.

First you should consider the relevant legislation in the place of registration of the business entity.

Then you will need to review whether or not the entity is a relevant entity. This will also depend on the relevant period under consideration, and will probably require the production and analysis of accounts for the relevant period.

Then you will need to consider the local substance requirements for that activity, and review whether or not the entity already meets those requirements.

If the entity is not effectively managed in that jurisdiction where should it be considered to be managed? This will depend on many factors, such as the location of directors, physical offices, and where decisions are being taken in respect of the core activities. You will need to consider what proof can be obtained in respect of this alternative jurisdiction (eg tax assessments), and whether or not there are other tax effects in that jurisdiction resulting from this classification.