The Elephant in the Room - Economic Substance
Contributed by Sentient International
28 December, 2020
Economic substance legislation came into effect on 1st January 2019 in low tax jurisdictions including Bermuda, British Virgin Islands, Cayman Islands, Mauritius, Guernsey, the Isle of Man and Jersey. The aim, to counter criticism from the EU/OECD concerning the use of such jurisdictions to the detriment of higher tax jurisdictions.
The legislation aims to protect the reputation of offshore jurisdictions by ensuring that income streams from certain activities are based on actual local activity and as such, substantiate the use of low tax jurisdictions.
The legislation is similar across all seven jurisdictions and the Crown Dependencies have issued a joint set of guidance notes on how the local tax authority will interpret the new legislation.
There are two key questions to establish how substance regulations will have an impact on an entity in any given jurisdiction:
- Is the entity a relevant entity that carries out income generating activities within a relevant sector?
- If the entity is carrying out a relevant activity, does it meet the substance requirements?
The substance rules only apply to 'relevant entities' that are carrying out income generating activities within certain 'relevant sectors', which are:
- Fund management (not fund vehicles)
- Financing and leasing
- Holding companies (pure equity holding companies - not investment companies i.e. must hold a controlling (more than 50% interest in the underlying investment)
- IP companies and high risk IP companies
- Shipping - means commercial shipping business, it excludes pleasure craft
- Headquarters - where strategy/coordination type services are provided to other group entities
- Distribution and services centres - where the Company purchases goods from a group company and re-sells them for a percentage of profit, or if the Company is providing management services to group companies
Upon being determined a relevant entity that is carrying out a relevant activity, as described by local regulations, the entity has to satisfy the 'adequate substance' test.
A relevant sector company will need to consider whether it has adequate substance in the jurisdiction.
Except for a pure equity holding company, in order to demonstrate adequate substance in the Isle of Man, a relevant sector Company must:
- be directed and managed on the Isle of Man;
- have an adequate number of (qualified) employees proportionate to the level of activity carried out on the Isle of Man;
- have adequate expenditure proportionate to the level of activity carried out on the Isle of Man;
- have an adequate physical presence on the Isle of Man; and,
- conduct its core income-generating activity ('CIGA') on the Isle of Man.
There is additional detailed criteria for each of the points above, most notably around core income generating activities and outsourcing. There are also special rules for 'high-risk IP companies, which set a higher standard of evidentiary requirements.
Once substance is established, the entity must file an economic substance report every year, which in the case of the Isle of Man forms part of the annual tax return.
The Isle of Man legislation includes specific powers to request additional information in relation to any substance information provided on, or with, the income tax return. This also includes specific sanctions to address circumstances where companies have acted to avoid or seek to avoid the application of the economic substance requirements.
Penalties for failure to comply with the new substance rules range from increasing fines, removal from the register through to imprisonment.
- GBP 10,000 for the first non-compliance (GBP 50,000 for high risk IP companies)
- Any subsequent failure can increase to GBP 100,000 per notice issued
- Removal from the Companies Register
- Further provision has been included for the introduction of a penalty of GBP 5,000 or a custodial sentence of up to seven years, for any person who provides false or misleading information to the Tax Authorities
As you can see from the list above, the majority of companies do not conduct business in 'Relevant Sectors' and therefore the economic substance requirements are irrelevant and will not need to be met.
For example, consulting, property ownership, investment portfolios, telecoms, eGaming, manufacturing and general trading companies are outside the scope of these provisions.
Complying with the new substance regulations should not be underestimated, as the consequences, given the level of penalties, could be detrimental to your overall planning.
Here at Sentient International, we can help you navigate through the complexities of the new legislation and ensure that you and your entity are meeting the requirements. To find out whether your entity may fall under this new legislation and if so, what you need to do, email us or call +44 1624 616544.
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