What is the background to the economic substance laws and regulations?
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 Organisation for Economic Co-operation and Development‘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 economic substance laws and regulations were adopted in each jurisdiction.
Which entities are subject to economic substance rules?
The precise scope of the economic 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 economic substance legislation. Again, while the exact mechanisms vary between jurisdictions, generally speaking each ‘relevant entity’ will need to make certain filings under the economic substance law and, if a ‘relevant entity’ conducts ‘relevant business’, it will need to meet the applicable substance test.
What is a relevant activity under economic substance legislation?
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.
Certain exemptions and carve outs may apply (for example, where a relevant entity carries out a relevant activity the profits of which are taxed elsewhere).
What are the economic substance requirements?
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 economic substance regulations also set out the circumstances where the above activities may be outsourced.
Economic substance in our jurisdictions
The legal services provided in Bermuda, BVI, Cayman, Guernsey, Isle of Man, Jersey, Mauritius and Seychelles regarding economic substance will vary depending on each jurisdiction’s specific economic substance legislation and regulations.
Appleby’s team of regulatory experts is available to help clients:
- determine whether or not any economic substance legislation applies to a particular entity;
- identify any potential exemptions or carve outs that may simplify compliance; and
- if compliance is required, identify the applicable test and assist in forming strategies to ensure ongoing compliance.
What is economic substance?
Economic substance refers to the requirement that a transaction or activity has a real economic purpose beyond just obtaining a tax advantage, and means companies must, for example, maintain an adequate presence and/or conduct core income-generating activities in the jurisdiction that they are tax resident.
How do you file an Economic Substance Notification?
The process for filing an Economic Substance Notification (ESN) can vary depending on the jurisdiction in which the entity is located. However, in general, ESNs are typically filed through the relevant regulatory authority’s online portal or by submitting a paper form. Consulting with a legal or tax professional can help ensure compliance with local regulations and to avoid penalties or other legal consequences for the submission of either later or inaccurate information.
