The first quarter of 2019 has seen the passage of economic substance legislation in most offshore financial jurisdictions. This uniform adaptation of legislation can be traced to adoption by the European Union's Economic and Financial Affairs (ECOFIN) Council of the 2015 OECD recommendations1 to address tax base erosion and profit shifting. At its meeting in May 2016, ECOFIN decided to establish a list of non-cooperative jurisdictions for tax purposes.2 Council conclusions regarding the criteria for inclusion on the list followed in November 2016,3 and further conclusions were made in December 2017,4 when the work of the Code of Conduct Group on Business Taxation (CCG) in determining the relevant jurisdictions and analyzing and assessing their tax legislation was approved.
The upshot of this is that jurisdictions that did not meet the criteria established by ECOFIN and the CCG are placed on a list of non-cooperative jurisdictions until they meet the criteria. The criteria in question are broadly divided into three categories: transparency, fair taxation, and anti-Base Erosion and Profit Sharing (BEPS)5. It is this last category, anti-BEPS, from which the requirements for entities in a jurisdiction to show "real economic activity" and meet substantial economic presence tests derive.
In response to the EU's requirement that jurisdictions listed in its Annex II, that is, jurisdictions that have not met all of the EU's tax criteria but have given commitments to comply, economic substance legislation was passed. This list includes offshore jurisdictions such as Bermuda, British Virgin Islands, the Cayman Islands, Guernsey, and Jersey. In this article, the focus will be the British Virgin Islands, the Cayman Islands, and Jersey.
Since the genesis of the economic substance legislation for all these jurisdictions is the same, it is no surprise that the framework for legislation in each jurisdiction follows a similar pattern. The general framework requires entities claiming tax residence in an offshore jurisdiction to demonstrate that the entity has "economic substance" in that jurisdiction. However, only certain "relevant entities" that are conducting or engaging in "relevant activities" are required to demonstrate economic substance.
Since the genesis of the economic substance legislation for all these jurisdictions is the same, it is no surprise that the framework for legislation in each jurisdiction follows a similar pattern. The general framework requires entities claiming tax residence in an offshore jurisdiction to demonstrate that the entity has "economic substance" in that jurisdiction. However, only certain "relevant entities" that are conducting or engaging in "relevant activities" are required to demonstrate economic substance
Each jurisdiction identifies the type of entity that may be subject to the economic substance requirements. In all jurisdictions, companies incorporated in that jurisdiction, as well as foreign companies registered in that jurisdiction, are potentially caught by the economic substance legislation.
Broadly speaking, companies operating in jurisdictions with economic substance legislation are caught by the legislation but only to the extent that they are tax resident in the jurisdiction in question.
In the British Virgin Islands, all BVI companies are considered "legal entities" and are subject to the BVI's Economic Substance (Companies and Limited Partnerships) Act, 2018. But companies that are not tax resident in the BVI are not required to comply with the legislation.
In the Cayman Islands, "domestic companies" are not "relevant entities" and, therefore, are not caught by Cayman's International Tax Co-operation (Economic Substance) Law, 2018.6 A domestic company is one that is not part of an MNE Group7 (essentially a group of entities which has tax residence in different jurisdictions) and is carrying on business, locally, in the Cayman Islands. Other Cayman companies and Cayman limited liability companies are "relevant entities" under the Cayman legislation. Excluded companies include those that are centrally managed and tax resident outside of the Cayman Islands.
Under Jersey's Taxation (Companies—Economic Substance) (Jersey) Law 201, only "resident companies" that is, companies considered tax resident in Jersey under its Income Tax (Jersey) Law, 1961, are caught by its Law 201. By implication, therefore, companies not tax resident in Jersey are not caught by its economic substance Law.
However, in all the named jurisdictions and in compliance with the EU's economic substance criteria, entities that are not tax resident in the jurisdiction are not required to meet any economic substance test, as such entities will be liable to tax elsewhere. Likewise, in all these jurisdictions, foreign companies are subject to the economic substance legislation if they are tax resident in the offshore jurisdiction in question.
Both the British Virgin Islands and the Cayman Islands, consider limited partnerships as "legal entities" and "relevant entities," respectively, but only to the extent that they have separate legal personality and are tax resident in the British Virgin Islands or the Cayman Islands, as the case may be. The Jersey legislation does not address limited partnerships.
Legislation in the British Virgin Islands, Cayman Islands, and Jersey all use the term "relevant activity," and all refer to the same nine types of activity that are regulated. If an in-scope or relevant entity is engaged in a relevant activity, then it must demonstrate sufficient economic substance to be tax resident in the jurisdiction in question. The nine relevant activities are:
- banking business;
- distribution and service center business;
- financing and leasing business;
- fund management business;
- headquarters business;
- holding company business;
- insurance business;
- intellectual property business; or
- shipping business.
Economic substance test
The immediate consequence for an in-scope entity that is engaged in a relevant activity is that it must satisfy the economic substance test in the jurisdiction in which it is operating. There are three main parts to that test, and these are identical across the British Virgin Islands, Cayman Islands, and Jersey. To satisfy the test, the entity must show that it:
- is directing and managing the relevant entity from the jurisdiction in question;
- is conducting core income-generating activities in the jurisdiction in question; and
- in the jurisdiction in question, has
- an adequate number of employees;
- adequate expenditure; and
- adequate physical offices or premises,8 presence,9 or assets,10 having regard to the "nature and scale"11 of, "level"12 of, or "level of income"13 derived from, the relevant activity.
In this, the British Virgin Islands and Jersey approaches are similar. The Cayman test refers specifically to the level of income, and so a significantly different approach might be adopted in the Cayman Islands in determining adequacy.
Also, both the British Virgin Islands and Jersey legislation explicitly add a fourth limb to the test, which is where core income-generating activities are undertaken by a third party, the relevant entity can monitor and control the carrying out of that activity by the other entity. The Cayman legislation contains a similar provision so that a relevant entity can satisfy the economic substance test if it can monitor and control the core income generating activities being carried out by a third party. The British Virgin Islands legislation goes on to require that no core income generating activity is carried on outside the British Virgin Islands and only the activities carried on by the third party for the entity shall count. The British Virgin Islands, Cayman, and Jersey legislation, therefore, all contemplate the outsourcing of core income generating activities by a third party, under specified circumstances.
Core income generating activities
As noted above, a crucial part of the economic substance test is the notion of core income generating activities (CIGA). The activities and functions that make up CIGA are dependent on the relevant activity. Each relevant activity is linked to a specific CIGA, which are essentially key business functions carried out by an entity engaged in that relevant activity; or as the Cayman Islands legislation refers to them, "activities that are of central importance to a relevant entity in terms of generating income." For example, concerning banking business, each jurisdiction under consideration counts raising funds and managing credit, currency, and interest risk as a core income-generating activity for that business.
For determining compliance under the economic substance test, CIGA must be conducted in the jurisdiction, though, as mentioned above, there is scope for outsourced CIGA. However, outsourced activities must occur within the jurisdiction and the entity must be able to monitor and control the third party in the carrying out of the CIGA.
The economic substance legislation of the three jurisdictions treat intellectual property holding companies and equity holding companies differently.
Intellectual property holding companies, including those that did not create the intellectual property or that acquired the intellectual property from a related party and then license that intellectual property to related persons, are considered "high risk" intellectual property companies. In the British Virgin Islands, such companies are subject to a presumption that CIGA is not being conducted in the jurisdiction. In the Cayman Islands and Jersey, a relevant entity doing high-risk intellectual property business is presumed not to have met the economic substance test.
In all cases, the high-risk intellectual property company can rebut the presumption and demonstrate that it does meet the economic substance test but the onus is on the high-risk intellectual property company to do so. Further, whether or not the high-risk intellectual property entity meets the economic substance test, in each jurisdiction information disclosed by that entity will be reported to the competent authority in the foreign jurisdiction where the parent company, ultimate parent company, or ultimate beneficial owner resides and the foreign jurisdiction where the entity was incorporated.14
The British Virgin Islands and the Cayman Islands legislation both incorporate the concept of a "pure equity holding" entity. Whereas the high-risk intellectual property holding company has to fulfill enhanced obligations to satisfy the economic substance test, the pure equity holding entity is subject to a reduced economic substance test.15 A pure equity holding entity will, therefore, meet the economic substance test if it is in compliance with its incorporating legislation and has adequate premises and human resources for holding or managing its equity participations. While the Jersey legislation does have a concept similar to the pure equity holding entity in its definition of "holding company business," the Jersey Taxation (Companies Economic Substance) Law does not set out any special CIGA for this type of business.
Administrative authority for administering legislation
In each jurisdiction, a single administrative body has the power to make decisions regarding the satisfaction of the economic substance test as well as reporting and enforcement powers. In the British Virgin Islands, it is the International Tax Authority; in Cayman, it is the Tax Information Authority; and in Jersey, it is the Comptroller of Taxes. Also, each jurisdiction's administrative authority has the power to request documentation and information from relevant entities, determine if the entity has satisfied the economic substance test, to levy fines for non-compliance with the legislation; and report to foreign jurisdictions on entities, where applicable.
Time for compliance
Under the British Virgin Islands, Cayman Islands, and Jersey legislation, entities are required to comply with the economic substance requirements during any financial year of that entity's existence. Jersey companies must comply with the economic substance requirements from 1 January 2019. Entities in the British Virgin Islands and the Cayman Islands must comply as of 1 January 2019, if formed or incorporated after that date, and from 30 June 2019, for existing entities.
As indicated above, each of the administrative authorities has the power to impose fines for non-compliance. In the British Virgin Islands and the Cayman Islands, failure to comply with a second non-compliance notice could result in an entity being struck off the register. Under the Jersey legislation, a penalty imposed by the Comptroller is enforceable in the same way as if it were an income tax charged in an assessment.
In all cases, there is a right of appeal to the courts in the British Virgin Islands and the Cayman Islands and a Commission of Appeal in Jersey.
The EU has reviewed the economic substance legislation passed into law, respectively, by the British Virgin Islands, the Cayman Islands, and Jersey. Jersey has, as a result, been removed from the EU's Annex II "grey list." However, the British Virgin Islands and the Cayman Islands remain on the Annex II list, pending the EU's request for clarification on the treatment of collective investment funds. The EU is expected to provide additional guidelines for investment funds during the first half of 2019. The British Virgin Islands and the Cayman Islands will then have until the end of 2019 to amend their legislation to address this final matter. Both jurisdictions expect to make the appropriate amendments before the EU's deadline.
1. Also known as the Action Plan on Base Erosion and Profit Shifting.
2. European Union: Council of the European Union (2016), Outcome of The Council Meeting 3468th Council meeting Brussels, 25 May 2016.
3. European Union: Council of the European Union (2016), Outcome of The Council Meeting 3495th Council meeting Brussels, 8 November 2016.
4. European Union: Council of the European Union (2017), Council Conclusions on the EU list of Non-cooperative Jurisdictions for Tax Purposes. Brussels, 5 December 2017.
5. European Union: Council of the European Union (2017) Council Conclusions, Annex V.
6. See section 1 and definition of 'relevant entity'
7. Defined in s. 2(1) of the Cayman Tax Information Authority (International Tax Compliance) (Country-By-Country Reporting) Regulations, 2017 as any Group that - (a)includes two or more enterprises for which the tax residence is in different jurisdictions or includes an enterprise that is resident for tax purposes in one jurisdiction and is subject to tax with respect to the business carried out through a permanent establishment in another jurisdiction; and (b)is not an Excluded MNE Group.
8. British Virgin Islands.
9. Cayman Islands.
11. British Virgin Islands.
13. Cayman Islands.
14. For more see, s. 2 Schedule 4 and s. 9 BVI Economic Substance Act; 2. 4(7) and s. 10(2) Cayman International Tax Co-operation (Economic Substance) Law, 2018.; s. 6(3) and s. 8(2) Jersey Taxation (Companies Economic Substance) Law.
15. s. 8(2) BVI Economic Substance Act; s. 4(5) Cayman International Tax Co-operation (Economic Substance) Law, 2018.
Originally published by Trusts & Trustees.
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