Economic Substance in the time of COVID-19
The International Tax Co-operation (Economic Substance) Law (Revised) (the ES Law) came into force in the Cayman Islands (the Islands) on 1 January 2019.
Under the ES Law a “relevant entity” conducting any “relevant activity” is required to satisfy a 3-branch economic substance test (the ES Test) in respect of that activity. It must:
- conduct Cayman Islands core income-generating activity in relation to that relevant activity;
- be directed and managed in an appropriate manner in the Islands in relation to that activity;
- having regard to the level of relevant income derived from the relevant activity carried out in the Islands –
- have an adequate amount of operating expenditure incurred in the Islands;
- have adequate physical presence (including maintaining a place of business or plant, property and equipment) in the Islands; and
- have an adequate number of full-time employees or other personnel with appropriate qualifications in the Islands.
Cayman, like many other jurisdictions, introduced its ES Law in response to international pressure to demonstrate ‘substance’ for entities established within its tax neutral borders. It goes without saying that drafters of the ES Law did not have the Coronavirus and COVID-19 in their thoughts when formulating the ES Test. In all honesty, who but an elite group of epidemiologists and pandemic experts did? The reality though is that the ES Law continues to impose certain obligations on ‘relevant entities’ carrying on ‘relevant activities’, and in so doing, it raises the spectre of how does, or can, an entity comply with these obligations in the face of disruption as unprecedented as COVID-19?
Consider the case of a newly-incorporated Cayman Islands exempted company (Cayco), intent on carrying on a relevant activity and therefore required to meet the ES Test from the time of commencing its business activities. How would Cayco satisfy each prong of the ES Test in the current environment?
With borders closed and many businesses shuttered for the foreseeable future, commencing operations through physical premises in the Cayman Islands is likely to prove nearly impossible at this time. Fortunately, the ES Law does provide for the outsourcing of core income-generating activities to another provider within the jurisdiction, so long as the relevant entity is able to monitor and control the carrying out of that activity by that other person.
Core income-generating activities are specific to the type of relevant activity in which Cayco will engage. Within some sectors, such as those related to financial services, Cayman-based outsourcing options have been steadily expanding. Even where outsourcing is viable though, Cayco may find it challenging to assess its outsourcing options and settle on an appropriate partner in such uncertain times.
With respect to the “directed and managed” prong of the test, on 21 March 2020 the Department for International Tax Cooperation (DITC) (through a Ministry of Financial Services industry update) acknowledged that COVID-19 may impact travel in 2020, which may in turn affect the ability of some entities to hold their board of director meetings in Cayman during the year. The DITC went on to confirm that “where board of director meetings are required to be held virtually during this period of uncertainty, it would take that into consideration on a case-by-case basis when determining whether an entity has passed or failed the ES test in reporting, which is due in 2021”.
By its nature the final prong of the ES Test is a measure of proportionality – “having regard to the level of relevant income”. If Cayco has relevant income, it will have to assess whether its operating expenditure, premises and employees are adequate in relation to that income. In an era where hiring freezes and layoffs are the norm, work permits applications are largely on hold, commercial properties may only be shown via video and where many non-Caymanian residents within the Islands find themselves by necessity exploring a return to their home countries, how does Cayco successfully ramp up its operation, ensuring all the while that it is well positioned to comply with the ES Test? The problem is decidedly more acute where Cayco’s business operations require those with specific skill sets, already in short supply.
In late March the DITC announced an extension to the 2019 ES notification filing deadline from 31 March 2020 to 30 June 2020. That move, coupled with its pronouncement on board meetings during 2020, demonstrate some appreciation for the challenges facing existing market participants. All indications though appear to be pointing to COVID-19 continuing to dominate economies the world over for the balance of this year and possibly into 2021. It remains to be seen whether the DITC will revisit the ES Test to address market realities and the new economic landscape.
