It seems from the commentary that these regulatory developments have generally been well received, being seen to underpin good governance in these already well-regulated jurisdictions. However, considering the volume of other regulatory and operational risk issues requiring to be managed by corporates in recent years, in areas such as data protection, Brexit and, of course, the operational resilience challenges presented by the pandemic, it might now be time for relevant organisations to review their compliance with economic substance regulations.

What are the economic substance regulations?

In response to the findings of an EU assessment of the taxation policies of certain non-EU jurisdictions, new regulations in key offshore jurisdictions were implemented which require entities carrying on certain types of business to demonstrate adequate economic substance in that jurisdiction (the “Substance Regulations”).

While there are differences between the enacting laws and regulations in each jurisdiction, the Substance Regulations are broadly similar, as they are all based on guidance and requirements issued by both the European Union and the Organisation for Economic Co-operation and Development. The common principle is that any in-scope entity which is tax resident in a relevant jurisdiction must demonstrate compliance with certain substance tests.

Broadly speaking, the Substance Regulations apply to all legal entities that are resident for tax purposes according to the laws of the respective jurisdiction, unless they are exempted or can demonstrate that they are tax resident elsewhere. Those within the scope of the Substance Regulations will be required to meet an economic substance compliance test if they are carrying one of the “relevant activities”, which are: banking, insurance, fund management, financing and leasing, headquarters business, shipping, distribution and service centres, holding company business and intellectual property.

An entity (other than a holding entity, and entities that conduct intellectual property business, for which there are different criteria) will satisfy the economic substance requirements if (in summary):

  • it is directed and managed in the jurisdiction;
  • its core income generating activities (CIGA) are undertaken in the jurisdiction in relation to the relevant activity;
  • it maintains adequate physical assets/premises, employees and expenditure in the jurisdiction; and
  • it files a confidential economic substance report each year with the applicable authority in its jurisdiction which will assist the authority in assessing compliance.

Respective governments have published detailed guidance on the subject and this continues to develop. Meanwhile various professional services providers in the jurisdictions have published their own commentary on how their clients should engage and comply with the new requirements. The consensus seems to be that in many cases by implementing appropriate measures companies should be able to routinely demonstrate compliance with Substance Regulations.

The consequences of non-compliance with these new substance laws vary from jurisdiction to jurisdiction, but are typically comprised of exchange of information with competent authorities in other jurisdictions, financial penalties and, ultimately, potential strike off of the relevant company or companies. In Jersey, for example, a penalty of up to GBP10,000 can be levied for the first year of non-compliance, with subsequent instances of non-compliance attracting a penalty of up to GBP100,000 or, in cases of persistent non-compliance, a notice that the offending company will be struck off the Jersey companies register.

Where are we now?

To date we have seen little in terms of enforcement of the Substance Regulations in any jurisdiction given they have only recently been introduced and there has been only one complete reporting cycle. In addition, national governments and intergovernmental organisations have focussed on tackling the global COVID-19 pandemic. Jersey, Guernsey, the British Virgin Islands, the Cayman Islands and Bermuda all introduced temporary limited relaxations of the Substance Regulations as a result of the COVID-19 pandemic, and all indicated they would take a pragmatic approach when considering non-compliance with certain aspects of the Substance Regulations (by failing to hold in-person board meetings in the relevant jurisdiction or issues caused by employees working outside of the jurisdiction and unable to travel, for example).

However, despite the continued disruption caused by the coronavirus, governments in offshore jurisdictions have continued to make significant progress in implementing the economic substance requirements, creating online reporting portals, issuing guidance and preparing notification and reporting templates and guidelines.

We therefore anticipate a refocussing by governments (both off and on-shore) to ensure that the Substance Regulations are enforced as the COVID-19 pandemic abates.

What issues do we envisage in regard to M&A?

From an Mergers and Acquisitions (M&A) perspective, economic substance considerations are likely to be a key feature of transaction structuring going forward. We would anticipate serious consideration of the Substance Regulations when using offshore holding vehicles in acquisition structures. We would also expect to see historic compliance with the Substance Regulations becoming an important part of diligence, with prudent buyers looking to ring-fence any potential liabilities arising out of non-compliance. Meanwhile potential sellers would be well advised to review compliance as part of their preparations for exit.

Beyond a transaction there will need to be consideration around ensuring ongoing compliance within corporate structures, including holding board meetings and making filings. We would expect to see increased obligations on management teams in investment and acquisition documentation to ensure compliance with local Substance Regulations during the investment cycle, so as to manage compliance risk while protecting the integrity of the corporate structure. The appointment of a suitable corporate services provider is likely to help companies manage their ongoing compliance.

How insurance can help?

Ultimately there will always remain a compliance risk and the possibility of challenge by the local regulator or other relevant authorities. There may be a need to defend the position or mitigate the costs of compliance remediation or enforcement action. The insurance market can be an effective solution, providing both cover for historic liabilities arising out of a diligence conducted on an M&A transaction and potentially future looking cover for the ongoing operations of a group. Tax insurance can offer a ‘complete solution’, providing cover for the tax liability, interest, penalties, defence costs and a gross-up (in the event the insurance proceeds were to be subject to tax).

With respect to potential liabilities arising out of historic non-compliance, tax liability insurance can be used in lieu of warranty cover, or a specific indemnity, being provided in the sale agreement. An insurance policy can be used to provide the seller(s) a clean exit, negate the need for a lengthy escrow and provide a policy which gives the buyer financial protection from highly rated Lloyd’s of London insurance cover. Tax policies frequently alleviate the “pain point” of tax risk on deals.

Tax liability insurance can also be used to provide comfort around future operations of a business. By working together with an insurer and in consultation with their legal advisors, a company can determine an operational ‘play book’, which will help remove some of the uncertainty in interpretation and application of the Substance Regulations.

Contact Us

If you have any questions about the Substance Regulations and how they may apply to your business or transaction, please contact Mark Brady or Andrew Weaver at Appleby. Appleby has created an online Economic Substance Entity Classification Questionnaire, which is available free of charge, and offers clear and concise guidance through the economic substance regimes of Bermuda, BVI, Cayman Islands, Guernsey, the Isle of Man and Jersey. Click here to access.

If you have any questions about insurance options available to cover any historic or future exposure related to the Substance Regulations, please contact Robert Coward or Michael Lock at Ed Broking or Dawn Bhoma at Icen Risk.

Mark Brady   [email protected]  +44 7829 759 928

Andrew Weaver [email protected]  +44 7700 700 160

Michael Lock [email protected]  +44 7547 657 642

Robert Coward  [email protected]  +44 7821 848 523

Dawn Bhoma   [email protected]    +44 7554 196 600


Ed Broking LLP is licensed by the Guernsey Financial Services Commission (GFSC Ref.22292007) and is licensed by the Jersey Financial Services Commission (JFSC Ref: GIMB0251).

Ed Broking LLP is registered in England No. OC339735. Authorised and regulated by the Financial Conduct Authority.


Icen Risk Limited is an appointed representative (FRN: 918259) of Nexit 2018 Limited, authorised by the FCA and the underwriter of the Travelers 2021 M&A Consortium at Lloyd’s.

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