The issue of economic substance is not a new one. More and more, modern companies coupled with new technology and trading practices challenge the notion of "economic substance" for value creation in the traditional sense in terms of physical offices, management location, location of employees, core income-generating activities and expenditure. We have to look no further than Apple or Amazon to recognize that the issue is not as simple as it may seem. Both companies generate significant profits from areas where they have no substantive economic activity and can accordingly adapt their tax structure to maximize tax benefits. Apple, for example, pays over US$1.5 billion in taxes to Ireland, where Apple sales and distribution activities are executed by some of the 6,000 employees working there. Of course, the taxes would be much higher in the United States if those activities were conducted there. But without question, Apple has economic substance in Ireland and can therefore legitimately take those benefits. Of course, the bulk of its tax is paid in the U.S. where most of its design, development, and engineering works are carried out.
In the offshore sense, the issue has become increasingly important. Today, offshore financial centers like the British Virgin Islands have legislation in place that requires entities conducting certain relevant activities to demonstrate economic substance if claiming tax residency in the jurisdiction.
How Did We Get Here?
The European Union has, for many years, been at the heels of offshore financial centers. Specifically, the Code of Conduct Group (CCG) within the EU's Economic and Financial Affairs Council (ECOFIN) has determined that jurisdictions that fail to satisfy the CCG's requirement to end "preferential treatment" for non-resident companies are to be deemed "non-cooperative" and effectively blacklisted. Those that meet most CCG requirements and show an effort to resolve shortcomings are "grey-listed," while those that meet all requirements are "white-listed."
Essentially, the BVI meets the three main criteria—tax transparency, fair taxation, and compliance with the EU's Base Erosion and Profit Sharing policies. However, the EU has reported that on fair taxation the BVI and other low tax jurisdictions need to do more by adhering to the principle that jurisdictions "should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction."
To address the CCG's requirements, in December 2018 the BVI passed the Economic Substance (Companies and Limited Partnerships) Act, 2018 (ESA) which came into force on January 1, 2019. ESA sets out a framework for determining when certain BVI entities, or foreign entities operating in the BVI, may be required to demonstrate economic substance in the BVI. In October 2019, the BVI International Tax Authority (ITA) finalized the rules in relation to ESA which will guide how it is interpreted and applied (the ESA Rules). The ITA is responsible for determining whether an entity is in compliance with the economic substance requirements and has the power to request documentation and information from such entities and to impose fines where there is a breach. It is clear that ESA makes several new important distinctions that may impact BVI companies and limited partnerships, but notwithstanding this, the jurisdiction remains user-friendly and pro-business.
Only recently, the OECD Forum on Harmful Tax Practices (FHTP) acknowledged that the BVI's domestic legal framework meets the Substantial Activities Standard introduced in November 2018. The FHTP standard requires that core income-generating activities for certain sectors of business activity must be conducted with qualified employees and operating expenditure in the jurisdiction. The review by the OECD follows the BVI's implementation of ESA and is indeed good news.
The Substance in Economic Substance
Two prongs are used to determine whether an entity is subject to ESA—the entity type and its activity.
Entities considered to be subject to ESA include:
- Any foreign company registered in and operating in the BVI
- BVI companies
- Any foreign limited partnership with legal personality registered in and operating in the BVI
- BVI limited partnerships with legal personality
The second consideration is whether the entity is carrying on a "relevant activity;" and if so, it must meet the economic substance requirements set out in ESA, unless it is tax resident in another jurisdiction that is not on the EU's blacklist. Under the ESA Rules an entity which is tax resident outside the BVI in a jurisdiction that is not on the EU's blacklist is deemed a non-resident entity.
ESA regulates nine relevant activities, namely:
- Banking business
- Insurance business
- Fund management business
- Finance and leasing business
- Headquarters business
- Shipping business
- Holding business
- Intellectual property business
- Distribution and service center business
Qualifications for BVI Tax Residency
In order to claim valid tax residency in the BVI, an entity carrying on a relevant activity entity must meet the economic substance requirements set out in ESA, which include:
- Direction and management of the relevant activity of the entity in the BVI
- The entity having adequate and suitable employees, premises, and expenditure in the BVI to carry out core income-generating activities in the BVI
- The entity conducting core income-generating activities in the BVI
Allowance for outsourcing is made if the entity's outsourced core income-generating activity is based in the BVI, and the core-income generating activity can be linked to the entity claiming BVI tax residency.
An entity which is carrying on a relevant activity but is tax resident outside the BVI must produce evidence of tax residence outside of the BVI, namely: (a) a letter or certificate from, or issued by, the competent authority for the jurisdiction in question stating that the entity is considered to be resident for tax purposes in that jurisdiction; or (b) an assessment to tax on the entity, a confirmation of self-assessment to tax, a tax demand, evidence of payment of tax, or any other document, issued by the competent authority for the jurisdiction in question.
Two business types receive special treatment under ESA—intellectual property business and holding business.
Intellectual Property Business: Entities conducting intellectual property business are treated slightly different and most will be subject to a presumption that they are not carrying out core income- generating activities in the BVI and therefore do not have sufficient economic substance in the BVI.
However, the presumption can be rebutted by, for example, showing that the entity in question takes strategic decisions and manages the principal risks related to the acquisition, development, and exploitation of the IP asset in or from the BVI.
Holding Business: If the entity is conducting pure equity holding business (which means it only holds equity participations in other entities), then it satisfies the economic substance requirements, as long as:
(i) it is in compliance with its statutory obligations under the Limited Partnership Act, 2017 or the BVI Business Companies Act, 2004 (as amended) as appropriate; and
(ii) it has adequate employees and premises in the BVI for holding or managing the equity interests it holds or manages.
The ESA Rules acknowledge that holding of equity participations can be (and, in many cases, is) entirely passive in nature and that in such cases the requirement for adequate employees and premises may be capable of being met by the BVI registered agent and the existing registered office.
Core Income-Generating Activities
The meaning of core income-generating activities varies in relation to each relevant activity but generally includes the following:
Banking business: raising funds, managing risk (including credit, currency and interest risk); taking hedging positions; providing loans, credit or other financial services to customers; managing regulatory capital; and preparing regulatory reports and returns.
Insurance business: predicting and calculating risk; insuring or re-insuring against risk; and providing insurance business services to clients.
Fund management business: taking decisions on the holding and selling of investments; calculating risk and reserves; taking decisions on currency or interest fluctuations and hedging positions; and preparing regulatory and other reports for government authorities and investors.
Financing or leasing business: agreeing to funding terms; identifying and acquiring assets to be leased (in the case of leasing); setting the terms and duration of any financing or leasing; monitoring and revising any agreements; and managing any risks.
Headquarters business: provision of senior management; assumption or control of material risk; or the provision of substantive advice in connection with risk, as each relate to any entity in the same group.
Shipping business: managing the crew (including hiring, paying, and overseeing crew members); hauling and maintaining ships; overseeing and tracking deliveries; determining what goods to order and when to deliver them; and organizing and overseeing voyages.
Intellectual property business: where the business concerns intellectual property assets such as patents, research, and development; and where the business concerns non-trade intangible assets such as brand, trademark, and customer data and marketing, branding, and distribution.
Distribution and service centre business: transporting and storing goods; managing stocks; taking orders; and providing consulting or other administrative services.
Classification of an entity and whether it is carrying on a relevant activity is one of the key steps that each entity needs to undertake. Each entity must make that determination with the help of advisors, which would typically involve lawyers and ideally such action should be noted in the entity's records by way of a resolution.
Entity and Registered Agent Obligations
All entities which are subject to ESA need to consider what additional information they will now be required report to their registered agent which, in turn, is required to report certain information to the ITA via the Beneficial Ownership Secure Search (BOSS) system.
In particular, from October 1, 2019 there is an ongoing legal obligation on such entities to identify whether the entity carries on one or more relevant activities (and, if so, which activities), under the BOSS Act. Existing business activities will therefore need to be reviewed and classified accordingly and future changes monitored to ensure compliance with ESA.
Reporting Requirements and Enforcement
An entity's financial year is the period during which ESA considers its activities. An entity that is carrying on any relevant activity during its financial year must also comply with the BVI economic substance requirements during that period.
All entities to which ESA applies are required to report at the end of their financial year regarding activities carried out during that fiscal year. New companies and limited partnerships, i.e., those incorporated or formed after January 1, 2019, must select a date within 12 months of incorporation or formation as the end of its financial year. An existing entity's financial year will begin on a date no later than June 2019. In either case, the entity's financial year and reporting responsibilities run for one year from the initially selected date.
Enforcement of ESA falls under the ITA, which may determine that an entity has not complied with economic substance requirements for any financial period ending on or after December 31, 2019.
The entity's registered agent will enter its fiscal report in the BOSS system, including information about the entity which may include the entity's total turnover; number of employees engaged in the relevant activity, both in and outside of the BVI; the entity's BVI address; and the names of persons responsible for the management and direction of the entity and whether they are located in the BVI. The precise requirements are expected to be published in the near future.
If the ITA determines there is non-compliance, it must issue a notice and may impose a fine. The fines escalate if the entity does not remedy a non-compliance breach identified by the ITA. It is expected that the ITA will apply a pragmatic approach as entities familiarize themselves with the new regime.
Entities have the right to appeal to the BVI High Court, which can vary, cancel, or confirm the ITA's determination and fines.
The BVI continues to ensure that it complies with international standards and it is good to see that recognized in the OECD's FHTP report mentioned above. The issue of economic substance in the BVI is a crucial one, and as users of the jurisdiction begin to analyze their operations and prepare to comply, the practical requirements of the legislation have become clearer. Notwithstanding, BVI service providers (including law firms, registered agents, accounting firms, and others), along with the BVI Government and related authorities, are keen on ensuring that the BVI remains at the forefront of providing solutions for clients, globally, so that where substance is required—similar to Apple in Ireland—it can be proven without unnecessary burden!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.