First and foremost, a happy and healthy 2019 to all our IFS newsletter readers. The start of the year heralds theend of an era where offshore centres can entertain structures which do not meet the ‘new’ substance criteria, or fall foul of the watchful eye of the OECD. I write ‘new’ but really all international tax practitioners should have always been advising clients on the need for all entities within a corporate structure to have the degree of substance required for the activities purportedly carried on by the entity. Dmitry has written an excellent article in this newsletter explaining the substance requirements initiated by Jersey, Guernsey and the Isle Man and also a few offshores much further away with effect from 1 January 2019. It may well be that these requirements, if they cannot be met in the country of incorporation, will trigger a new wave of corporate migration, where BVI companies (for example) migrate to say Malta or Cyprus, or re-domicile in higher tax countries such as the UK, Netherlands or Luxembourg. We will always be pleased to discuss such issues with you to ensure compliance in the current environment of transparency and integrity in international business structures. The International Business Structuring Association has held many discussion group meetings throughout 2018 preparing colleagues and clients for this eventuality, and will continue to feature this in 2019 events (see www.theibsa.org/events for further details).
With warm regards
Roy Saunders
New Offshore Economic Substance Laws
Dmitry Zapol ADIT (Affiliate) LL.M (Tax) LL.B (Hons)1
Amidst the Brexit hullabaloo and Mr Trump’s usual inciting tweets, one would be excused not to pay much heed to the announcement of the new offshore economic substance requirements at the end of 2018. Yet the legislation passed in the Crown Dependencies — Jersey, Guernsey and the Isle of Man, as well as in lands further afield such as the Cayman Islands, Bahamas and the BVI reflects the new normal; one where brass plate companies are no longer welcome.
In the last five years, the popularity of the “true” offshores has steadily declined, being the result of various anti-BEPS initiatives, receding secrecy of the beneficiaries’ identities and the unavailability of tax treaty benefits. Instead, greater use has been made of the low-tax “onshore” jurisdictions or of those with normally high taxes but offering special tax regimes for certain activities. However, the decline does not mean abandonment and a significant number of structures have merited the use of offshore companies paying nil tax and normally managed by corporate services providers. The new rules may lead to the forced review of established practices. Before looking at them in detail, it is worth examining the events that predate the changes.
Origins — BEPS and EU list of non-cooperative tax jurisdictions
In 2015, the OECD published its final Report on “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance.”2 In part, the report requires preferential regimes to impose the substantial activity obligation with the view to align taxation with substance and ensuring that taxable profits can no longer be artificially shifted away from the countries where value is created (24).3
The Report explains the importance of the substantial activity requirement in the context of IP regimes. Because IP regimes are designed to encourage R&D activities and contribute to growth and employment, the principle underlying the substantial activity requirement in the context of IP regimes is only to permit taxpayers that did in fact engage in such activities and did incur actual expenditures on such activities to benefit from the regimes. The substantial activity requirement establishes a link between expenditures, IP assets, and IP income. Expenditures are a proxy for activities, and IP assets are used to ensure that the income that receives benefits does in fact arise from the expenditures incurred by the qualifying taxpayer. The effect of this approach is therefore to link income and activities. (71, 72).
The Report imposes similar requirements in respect of other non-IP regimes, such as headquarters, distribution and service centres, financing or leasing, fund management, banking and insurance, shipping and finally holding regimes. In these cases, the substantial activity requirement should also establish a link between the income qualifying for benefits and the core activities necessary to earn the income. The core activities at issue are geographically mobile activities such as financial and other service activities. These activities may not require anything to link them to income because service activities could be seen as contributing directly to the income that receives benefits. In each situation, a more detailed consideration of the relevant core activities would need to be undertaken at the time and in the context of a specific regime being considered (72, 73).
On 5 December 2017, the first EU list of non-cooperative jurisdictions in taxation matters was published with the aim to promote good governance worldwide, in order to maximise efforts to prevent tax fraud and tax evasion.4 No direct penalties — financial or otherwise — were envisaged for the countries on the list; however, being on it could make their lives infinitely more complicated. The European Commission has prepared a comprehensive Q&A sheet, which is worth examining.5
Amongst the EU listing criteria was Fair Tax Competition. This required that the country should not have harmful tax regimes, which go against the principles of the EU’s Code of Conduct or OECD’s Forum on Harmful Tax Practices. Those that choose to have no or zero-rate corporate taxation should ensure that this does not encourage artificial offshore structures without real economic activity.
Depending on various undertakings, the listed countries would move between “black” and “grey” sub-lists or would be removed from the list altogether. From the start, in November 2017 Guernsey, Isle of Man and Jersey amongst others, gave reassurances on the lack of a substance requirement for companies tax resident in their territories. In August 2018 the three Crown Dependencies launched public consultations on proposed corporate substance legislation effectively warning those potentially affected that the other shoe is about to drop.
The proverbial shoe did drop in November 2018 with the release of the formal guidance document (“Guidance”)6 detailing the scope of the rules, which would become law on 1 January 2019. This article quotes from the Guidance extensively and readers are encouraged to peruse it.
Economic substance rules
The following discussion revolves around Jersey legislation7 detailing the scope of the new economic substance rules, which is similar in many respects to legislation passed in the other Crown Dependencies. Also, a quick online search will reveal announcements of similar legislation that has been enacted in the Cayman Islands, Bahamas and the BVI.
The legislation has been designed to address concerns that companies could be used to artificially attract profits that are not commensurate with economic activities and substantial economic presence in the Crown Dependencies. With this in mind, the legislation requires certain companies to demonstrate they have substance in the Island by:
- being directed and managed in the Island;
- conducting Core Income Generating Activities (CIGA) in the Island; and
- taking orders, and
- having adequate people, premises and expenditure in the Island.
These substance requirements apply to companies with any income from geographically mobile financial and other service activities referred to in the BEPS Action 5 Report such as headquarters, distribution and service centres, financing, leasing, fund management, banking and insurance, shipping, holding regimes and finally IP holding regimes (“relevant activities”).
A company is not required to meet the economic substance test if it has no gross income in relation to a relevant activity carried on by it, although, is expected that the carrying on of relevant activities will result in the generation of income. If there is any indication that a company is seeking to manipulate or artificially suppress its income to avoid being subject to the substance requirements the respective Tax Administrations will take the appropriate action.
Directed and Managed in Jersey
To meet the economic substance test, the company should be directed and managed in Jersey. There are specific requirements regarding the number of board meetings, composition and competence of the board, keeping the minutes. Although similar to, this requirement is not the same as the management and control test, which determines where the company is tax resident. The new test emphasises the procedural aspects that reflect that the company is physically directed and managed in Jersey. For example, it is expected that even for companies with a minimal level of activity there will be at least one meeting of its board of directors in the Island.
This approach signifies a marked departure from the pre-2019 customs, when corporate stakeholders — UBOs, the non-Jersey directors and shadow directors — were content with having board meetings anywhere other than in the countries where they did not want the Jersey company to be resident. In this paradigm, most Jersey-hosted board meetings would be perfunctory affairs run by corporate services providers to rubberstamp the decisions taken elsewhere.
Under the new rules, clients will have to appoint competent local directors (whether the Island has enough professionals is a different question), which is reminiscent of the recent Dutch substance requirements,8 that impose the minimum wage cost to be incurred by certain domestic companies. Alternatively, foreign directors will have to make an adequate number of meetings in Jersey; “adequate” meaning that the majority of board meetings will be held in the Island.
Core Income Generating Activities (CIGA)
Another requirement necessary to meet the economic substance test is for the Jersey company to have its CIGA in Jersey. These are the key essential and valuable activities that generate the income of the company. The Law in article 4 provides a list of the CIGA for each of the relevant activities that should be performed in Jersey. For example, in respect of the distribution and service centre business the CIGA are:
- transporting and storing goods, components and materials,
- managing stocks,
- taking orders, and
- providing consulting or other administrative services.
However, to demonstrate substance, the company does not have to perform all of the listed CIGA — only those that are relevant in its circumstances. Also, activities that do not form CIGA such as IT or back-office support can be outsourced elsewhere. The scope of CIGA varies from very detailed (e.g. in respect of the IP holding business) to very broad (e.g. in respect of holding company business, which includes all activities related to that business). Anyone caring about meeting the new requirements should peruse them together with the descriptions of the relevant activities to which they apply, since they can yield surprising outcomes.
For example, the law imposes strict requirements on companies pursuing IP holding activities. Broadly, any company that receives IP income is presumed to have failed the substance requirements unless it proves to the Jersey tax authorities that the IP was created in Jersey (the Guidance provides details of the high evidential threshold). The IP CIGA depend on the nature of the IP asset and how it is being exploited — for example, for patents the CIGA include R&D activities; for brands and trademarks they include marketing, branding and distribution activities.
However, the author has seen very few Jersey-based companies receiving IP income due to the high withholding taxes imposed at source in the absence of comprehensive double taxation agreements. More often, such companies are used as passive IP-holding entities holding the assets for the group. As mentioned earlier, provided that the passive IP company has no gross income in relation to this activity, it falls outside the scope of the economic substance rules altogether. The group only should be careful to ensure that the company’s activity does not fall under other headings, for example, the headquarters business.
Another example is the distribution and service centre business which means the business of either or both of the following (a) purchasing from foreign connected persons (i) component parts or materials for goods, or (ii) goods ready for sale; and reselling such component parts, materials or goods; or (b) providing services to foreign connected persons in connection with the business. The key condition that moves the international trading activity within the scope of the new rules is dealing with a foreign connected person — presumably buying goods and services from a connected supplier in a low-cost jurisdiction and selling them with a high profit margin elsewhere. Conversely, where the Jersey company is acting as a stand-alone entity engaged in foreign trade, presumably the new substance requirements will not be an issue.
Penalties for Non-Compliance
The Law and the Guidance prescribe various pieces of information that the local companies should submit to the tax authorities. Like with all things new, the requirements might seem excessive but with the passage of time, their subjects will learn the right ways to do it. However, considering the significant financial penalties for non-compliance, clients might wish to choose corporate services providers who follow up-to-date company management practices. Recent news from Cyprus demonstrate how lax attitudes towards fulfilling local tax and compliance obligations (non-payment of the annual €350 corporate registration fee), which are probably unknown to the foreign shareholders may lead to financial penalties. 9
Besides the fines, the Law stipulates that the tax authorities may exchange information about the non-compliant Jersey-registered companies with the tax authorities in the EU Member State where their holding companies and UBOs are resident. Only if the Jersey-resident company is incorporated outside Jersey can information be provided outside the EU. Interestingly, in the BVI, the worst that can happen to a non-compliant company beside paying the fine is to be struck off the corporate register.10 Presumably, the group would then run the greater risk of attribution of the Jersey-allocated profits to the foreign jurisdictions although whether this would be included in or additional to the country-by-country reporting regime remains to be seen.
Conclusion
The news of the impending corporate substance requirements took many by surprise in the pre-Christmas period, but this should not have been so — the public was forewarned although admittedly in the dog days of 2018! In truth, this should have been expected since the publication of the Action 5 BEPS report almost four years ago. The only uncertainty had been the names of the countries that would implement the changes but then again, an attentive visitor of the EU Commission’s webpage should have spotted these as well. Whether other offshore States not mentioned here will follow the suit remains to be seen; however, arguably one should not be advised to associate with them in any case.
Readers with businesses in the Crown Dependencies should take an active role in auditing their corporate arrangements with the view to either bring in the necessary level of corporate substance or find courage to disassociate themselves with the offshore world. Luckily for them, the likes of the UK, Cyprus, Malta, Hong Kong Singapore and many other onshore jurisdictions provide adequate, cost-effective and compliant solutions.
Law as stated and links accessed on 7 January 2018
1 Partner, IFS Consultants, London (www.interfis.com, Dmitry@interfis.com)
2 https://bit.ly/2C7GAST
3 Here and in the following two paragraphs the references are to the paragraph numbers of the Report.
4 https://bit.ly/2IMX2dg
5 https://bit.ly/2nxaZWB
6 https://bit.ly/2GYm1Ov
7 “Taxation (Companies – Economic Substance) (Jersey) Law 201-” https://bit.ly/2LTQEmY
8 https://bit.ly/2AvFbp5
9 https://bit.ly/2TxpODK
10 https://bit.ly/2C41x13
ROY SAUNDERS AND DMITRY ZAPOL