Economic Substance

The Council of the EU adopted a resolution on a Code of Conduct for business taxation, the aim of which was counteracting the effects of zero tax and preferential tax regimes around the world.

In 2017 the Code of Conduct Group (Code Group) investigated the tax policies of both EU member states and third countries, assessing:

• tax transparency;
• fair taxation; and
• implementation of anti–BEPS measures (The OECD’s project on Base Erosion and Profit Shifting).

Following assessment by the Code Group, each non-EU relevant jurisdiction (which includes Bermuda, the British Virgin Islands, the Cayman Islands, Guernsey, Isle of Man and Jersey) was required to address the Code Group’s concerns about ‘economic substance’.

The governments in each of these jurisdictions worked closely with the Code Group to ensure that those concerns were adequately addressed. As a result of this engagement, new laws and regulations were adopted in each jurisdiction (Substance Regulations).

The precise scope of the Substance Regulations varies somewhat from jurisdiction to jurisdiction. As a general rule, most non-domestic companies, LLCs and partnerships will fall within the definition of “Relevant Entity” for the purposes of the Substance Regulations.  Again, while the exact mechanisms vary between jurisdictions, generally speaking each Relevant Entity will need to make certain filings under the Substance Regulations and, if a Relevant Entity conducts “Relevant Business” it will need to meet the applicable substance test.

While all relevant entities will be required to make a filing setting out particulars relating to their business, an in-scope entity will only be required to meet the economic substance test if it carries on a “relevant activity”. The precise definition of “relevant activity” varies somewhat between jurisdictions, but in general terms they are:

• banking;
• insurance;
• fund management;
• financing and leasing;
• headquarters;
• shipping;
• distribution and service centres;
• holding entity; and
• intellectual property.

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

• it is managed and directed in the jurisdiction;
• core income generating activities (CIGA) are undertaken in the jurisdiction in relation to the relevant activity;
• it maintains adequate physical premises in the jurisdiction;
• there are adequate employees in the jurisdiction with suitable qualifications;
• there is adequate expenditure incurred in the jurisdiction in relation to the relevant activity; 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.

Relevant entities acting as pure equity holding vehicles are subject to a less onerous test for compliance; those carrying out IP and in particular high-risk IP business are subject to a more stringent test.

The Substance Regulations also set out the circumstances where the above activities may be outsourced.

Appleby’s team of regulatory experts is available to help clients:

• determine whether or not the Substance Regulations apply to a particular entity;
• identify any potential exemptions or carve outs that may simplify compliance;
• if compliance is required, identify the applicable test and assist in forming strategies to ensure ongoing compliance.