Economic Substance Requirements

Private Wealth

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In 2019, many tax havens have enacted similar legislation introducing economic substance requirements with yearly filing to registrars. Failure to comply means penalties (ranging from $5,000 to $400,000), spontaneous reporting to the BO’s residence, and deregistration. On the other hand, economic substance in, say the Marshall Islands, spread out over 29 coral atolls, seems illusory.

Harmful Tax Competition

In 1997, the EU Council created the Code of Conduct Group on Business Taxation (CoCG) to roll back and bring to a standstill harmful tax competition in (i) Member States and (ii) dependent and associated territories ("external challenges to the EU’s tax base"). Its Code of Conduct defined potentially harmful tax measures (Gateway criterion) as "[providing] for a significantly lower effective level of taxation, including zero taxation, than those levels which generally apply in Member States" in particular if:

Criterion 1: Advantages are accorded only to non-residents

Criterion 2: Advantages are ring fenced from the domestic market

Criterion 3: Advantages are granted even without any real economic activity and substantial economic presence

Criterion 4: Transfer pricing rules depart from OECD Transfer Pricing Guidelines

Criterion 5: Tax measures lack transparency, including where legal provisions are relaxed at administrative level in a non-transparent way.

EU Blacklist

In response to the April 2016 Panama Papers, the European Union's CoCG started a global screening of preferential tax regimes according to criteria in the field of (i) tax transparency (status of CRS implementation, BO registers) (ii) fair taxation (above Criteria 1-5) (iii) implementation of anti-BEPS measures.

The result was the EU list of non-cooperative jurisdictions for tax purposes (in different versions 2017 / 2019 / 2020).

Defensive Measures Against Harmful Tax Competition

Defensive measures for non-cooperation include:

• reinforced transactions monitoring
• increased audit risks
• non-deductibility of costs
• CFC rules
• WHT measures
• limitation of participation exemption
• switch-over rule (exempted low-tax income is imputed to parent)
• reversal of the burden of proof
• special documentation requirements
• DAC6 regarding aggressive cross-border schemes

Scope of the New Legislative Packages on Economic Substance

In scope are (i) registered entities (LTD, LLP, FZE) (ii) in tax haven jurisdictions (Bahamas, Belize, Bermuda, BVI, Cayman Islands, Guernsey, Jersey, Isle of Man, Marshall Islands, UAE) engaged in (iii) relevant activities (banking, finance, insurance, fund management, finance, leasing, distribution and service center, headquarter, (pure) holding company [subject to reduced substance requirements], intellectual property, shipping).

Companies may outsource to service providers which are, however, subject to the same substance requirements.

Economic Substance Requirements

Companies meeting these criteria are deemed compliant:

• Local managers and directors ("Directed and Managed Test")
• Adequate number of full-time, suitably qualified, local employees, local operating expenditures and local premises ("Adequate Test")
• Core income-generating activity conducted locally ("CIGA-Test")
• Local investment / risk management personnel (for equity holding entity)
• Taking of strategic (operational) decisions locally, management of principal risks locally, carrying out of trading activities locally
• Specific local equipment, or physical assets (for IP business)

We would be glad to conduct an impact assessment in light of the new requirements depending on (i) jurisdiction (ii) type of activity and (iii) readiness to restructure.