2019.3.22
Nora Shih
Until now since the end of 2018, governments of tax haven jurisdictions have successively introduced legislation relating to economic substance, which requires that if enterprises within the scope of law seek to engage in statutory business, they shall have economic substance in order to carry out the anti-tax avoidance reform in the international community. It is very common to see commercial activities or asset planning by citizens via offshore companies, and economic substance legislation has certain impact on the establishment and utilization of offshore companies. Therefore, existing companies or companies to be set up in the future should have corresponding arrangements and planning. The laws and regulations of the Cayman Islands, which have proposed specific implementation rules, are the primary focus of the following discussion to illustrate legislative backgrounds and relevant details[1]:
1. Backgrounds for economic substance legislation[2]
The Organization Economic Cooperation and Development (OECD) issued the Report on Harmful Tax Competition in 1998 to put forward a framework and determination standard for harmful tax practices. The Forum of Harmful Tax Practices (FHTP), which was set up thereafter, is in charge of continued supervision and implementation of international tax reform. Such report used to determine a “tax haven” jurisdiction by considering four factors such as whether tax-free measures or nominal taxation is implemented in a particular jurisdiction, whether there is a lack of effective information exchange system, whether there is a lack of transparency and whether there is a lack of substantial activities. In particular, an absence of substantial activities may cause a jurisdiction to engage in harmful tax competition by attracting international investment and trade purely through a tax factor. In 2001, the FHTP only used the first three factors to determine the list of non-cooperative tax jurisdictions and did not include the factor of substantial activities. In 2015, the OECD proposed the Action Plan on Base Erosion and Profit Shifting (BEPS) (Action 5), namely, “Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance,” which mentions that a preferential regime should meet the requirements for substantial activities. To accommodate the above action plan, the FHTP agreed to resume the application of the substantial activities factor to no or only nominal tax jurisdictions under the Report on Harmful Tax Practices of 1998. The Inclusive Framework on BEPS at the end of 2018 proposed a document for the “resumption of application of substantial activities factor to no or only nominal tax jurisdictions” to illustrate how the substantial activities factor applies. For example, geographically mobile business, which includes business headquarters, distribution and service centers, finance, lending, fund management, banks, insurance, shipping, holding companies, intangible assets, etc., requires that the core income generating activities (CIGA) of enterprises engaging in the above business shall be conducted by the enterprise entities or carried out domestically. The economic substance legislation in tax haven jurisdictions seeks to carry out the above-mentioned international tax reform measures and to formulate laws and regulations by referencing relevant documents.
In addition, the European Union conducted a global review based on three criteria, namely, tax transparency, fair taxation and implementation of anti-BEPS measures in 2017 and included non-conforming jurisdictions in the list of non-cooperative jurisdictions. To avoid future economic and trade sanctions, some tax haven jurisdictions namely, the Cayman Islands, which are rated as those that ‘’facilitating offshore structures which attract profits without real economic activity’’ have promised to come up with legislation in reference to the economic substance requirements for geographically mobile business. The Cayman Islands government enacted the International Tax Co-Operation (Economic Substance) Law (hereinafter, the “Economic Substance Law”) on December 27, 2018 and promulgated the Economic Substance for Geographically Mobile Activities Guidance (hereinafter, the “Economic Substance Guidance”) on February 22 of the following year to respond to international tax reform requirements.
2. Scope of application and obligations under the Economic Substance Law
Under the Economic Substance Law, entities within the scope of the law (i.e., “relevant entities”) which engage in statutory items of business (i.e., “relevant activities”) shall satisfy the criteria in the economic substance test (i.e., “economic substance test”) or to be sanctioned or subject to revocation of registration.
(1) Relevant entities
With the exception of investment funds and tax residents outside the Cayman Islands, companies incorporated under the Cayman Islands Companies Law (not including domestic companies), limited liability companies registered under the Cayman Limited Liability Companies Law, companies incorporated outside of the Cayman Islands and registered under the Cayman Islands Companies Law, and limited partnerships registered under their limited partnership law are all regulated entities.
The Economic Substance Guidance provides for the determination criteria for tax residents outside the Islands and their data submission and substantiation obligations. The tax residents outside the Islands refer to tax residents of other jurisdictions based on the criteria of residence, domicile or other similar criteria. An entity is required to submit documents such as the tax resident certificate, tax number, tax payment certificate or assessment issued by another jurisdiction to prove that it is indeed a tax resident outside the Islands. In addition, the entity must also provide details of its parent company, ultimate parent company, and ultimate beneficial owners, If an entity fails to provide supporting materials, the competent authority will treat it as a non-tax resident outside the Islands and the application of the Economic Substance Law will cover it.
(2) Relevant activities
If the relevant entities mentioned above engage in relevant activities, the statutory criteria in the economic substance test applicable to various types of activities shall be satisfied. Relevant activities include nine types of business, namely, banking business, distribution and service center business, financing and leasing business, fund management business, headquarters business, holding company business, insurance business, intellectual property business and shipping business, but the investment fund business is not included. The Economic Substance Guidance specifically defines relevant activities separately. For example, the banking business is defined under Section 2 of the Cayman’s Banks and Trust Companies Law, and the intellectual property business means the business of holding, exploiting or receiving income from intellectual property assets.
(3) Economic substance test
If an enterprise is a relevant entity defined under the Economic Substance Law and engages in relevant activities, it is required to satisfy the following criteria in the economic substance test. However, laws and regulations separately stipulate relaxed criteria for a pure holding company and impose more stringent applicable criteria for high risk intellectual property business.
1. Relevant entities shall conduct Cayman Islands core income generating activities in relation to that relevant activity:
The Economic Substance Guidance specifically stipulates the CIGAs for respective relevant activities. Take financing and leasing business for example. This includes commercial activity items such as the agreeing or negotiation for funding terms, identification and acquisition of assets to be leased, setting the terms and duration of a loan or lease, monitoring and revising financing or leasing agreements and managing risks associated with such financing or leasing agreements. The laws and regulations also recognize that relevant entities may outsource the above CIGA activities to third parties outside the Cayman Islands. However, the relevant entities shall manage and supervise them and such CIGA activities, and such CIGA activities shall be conducted within the Cayman Islands in order to be legally compliant.
2. Relevant entities shall be directed and managed in an appropriate manner in the Islands in relation to that relevant activity:
The management engaged by relevant entities in appropriate manners include the requirements that directors shall have appropriate management knowledge and expertise, board meetings shall be held at an appropriate frequency within the Cayman Islands, there shall be a quorum of directors present in the Islands during any such meetings, there shall be those board meeting minutes that record strategic decisions, and such board meeting’s minutes shall be kept within the Cayman Islands. The Economic Substance Guidance indicates that such requirements are imposed to ensure that there shall be an adequate number of board meetings held in the Cayman Islands. The “adequate number” should depend on the activities of the companies. Generally speaking, it should be perceived that the majority of board meetings will be held in the Cayman Islands. Even for a minimum of company activities, there shall be at least one board meeting each year.
3. Relevant entities shall have regard to the level of relevant income derived from the relevant activity carried out in the Islands, have an adequate amount of operating expenditure incurred in the Islands, have an adequate physical presence such as the business locations, assets and equipment in the Islands, have an adequate number of full-time employees or other personnel with appropriate qualifications in the Islands:
Although the Economic Substance Guidance describes what it means to be “adequate” and “appropriate,” still it indicates that specific determination shall still be based on facts associated with individual cases.
The above-mentioned three criteria in the economic substance test apply to general relevant activities. If relevant entities are pure equity holding companies, they only need to comply with the following matters in order to satisfy the economic substance test: (1) compliance with all filing requirements under the Cayman Companies Law; and (2) there are adequate human resources and adequate premises in the Islands for holding and managing equity participations in other entities. If relevant entities conduct high risk intellectual property business, they will be presumed not to have satisfied the economic substance test, unless they can demonstrate that there was a high degree of control over the development, exploitation, maintenance, enhancement and protection of the intangible asset, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities within the Islands, and provides sufficient information to the Authority in relation to that financial year to rebut this presumption.
(4) Deadline for satisfying the economic substance test and the obligation to submit relevant materials
The Economic Substance Law came into effect on January 1, 2019 with a deadline for satisfying the criteria in the economic substance by relevant entities and an obligation to submit relevant materials, as separately discussed below:
1. Deadline for satisfying economic substance test:
Existing companies set up prior to January 1, 2019 are required to satisfy the criteria in the economic substance test, beginning with July 1, 2019, thanks to a six-month grace period under relevant laws and regulations. Companies that are newly established after January 1, 2019 are required to satisfy the criteria in the economic substance test when conducting relevant activities which require reporting.
2. Notification obligation:
Beginning with 2020, relevant entities are required to notify the following matters annually to the competent authority: (1) whether the enterprises carry on a relevant activity; (2) in case of relevant activities conducted by the enterprises, whether a portion or the entirety of such gross income is subject to tax in a jurisdiction outside of the islands as well as supporting materials; and (3) the date of the end of the enterprises’ financial year. In addition, notification shall be made by the deadline (which is the end of September 2020 as indicated in an example figure in the Economic Substance Guidance). In the future, the Cayman Islands government will launch an economic substance portal for electronic notification by enterprises.
3. Obligation to submit economic substance test compliance reports and their contents and deadline:
If an enterprise is a relevant entity which conducts a relevant activity requiring satisfaction of the economic substance test, a report indicating satisfaction of the economic substance test shall be submitted to the competent authority. Such report shall disclose the following information: the type of relevant activity; the amount and type of relevant income in respect of the relevant activity; the amount and type of expenses and assets in respect of the relevant activity; the location of the place of business or plant, property or equipment used for the relevant activity of the relevant entity in the Islands; the number of full-time employees for carrying on the relevant entity’s relevant activity; information about the relevant activity conducted; a declaration as to whether or not the relevant entity satisfies the economic substance test; a declaration as to whether high-risk intellectual property business is conducted if the relevant activity is intellectual property business, and a detailed business plan and detailed information about the employees to be hired in case such business is to be conducted, as well as other evidence indicating decisions are made inside the Islands and other documents sufficient to cause the competent authority to recognize that the enterprise satisfies the economic substance test; and detailed information concerning the multinational enterprise group (MNE Group) with which the relevant entity is affiliated.
A relevant entity shall submit the above report within 12 months after the end of the financial year for a relevant activity, and the competent authority has the right to request further supporting materials. Take a company adopting a calendar accounting year system for example. The first report shall be submitted to the competent authority by December 31, 2020. A relevant entity shall retain materials and data relating to the satisfaction of the economic substance test for a minimum of six years.
(5) Penalties
If the economic substance test is not satisfied, the competent authority will issue a notice demanding notification and impose a penalty of Cayman Island Dollar (CI$) 10,000. If the requirements are still not satisfied in the subsequent financial year, a penalty of CI$100,000 will be imposed. If the economic substance test is not satisfied for two consecutive years, the Registrar may apply to the Grand Court to issue an order to, for example, requiring the relevant entity to take a specified action, including for the purpose of satisfying such economic substance test, in the case of a relevant entity that is a defunct company or to strike off the registration of the company pursuant to law.
Any person willfully providing false or misleading information will be subject to a fine of CI$10,000 or with imprisonment for a term of 5 years.
(6) Information exchange by the competent authority of the Cayman Islands
The competent authority of the Cayman Islands may, pursuant to law and in accordance with an international agreement on information exchange with other competent authorities, exchange information in respect of each relevant entity that fails to satisfy the economic substance test in relation to relevant activities, in relation to high risk IP business, and in cases where an entity claims to be tax resident in a jurisdiction outside the Islands. The information so exchanged will include the local government authority where the parent companies of relevant entities are located, the local government authority where the ultimate parent companies of relevant entities are located, the local government authority where the ultimate beneficial owners of relevant entities are located, the local government authority for tax registration as asserted by non-tax residents, and the local government authority where the relevant entities incorporated outside the Island are incorporated.
3. Legislative impact and analysis
(1) Impact from the economic substance legislation of the Cayman Islands
Based on the foregoing, offshore companies set up in tax haven jurisdictions are not compelled to have local substantial economic activities and are entitled to tax incentives before economic substance legislation. The Economic Substance Law requires a relevant entity engaging in relevant activities to satisfy the economic substance test that CIGA activities shall be conducted locally and that there shall be a local office with board meetings convened at a certain frequency and the employment of a sufficient number of appropriate full-time employees. Therefore, an offshore enterprise should reflect upon itself to determine if it is a relative entity and governed by the Economic Substance Law and to review if its activities fall within the statutory scope and thus require the economic substance requirements to be fulfilled, resulting in increased compliance and operation costs. It should be noted that if an enterprise is a statutory relevant entity, it is required to report relevant matters to the competent authority each year. If an enterprise seeks to calm to be a tax resident outside the Islands which is excluded from the application of the Economic Substance Law, it is required to prepare relevant supporting materials for submission to the competent authority and to pay attention to the subsequent actual status of law enforcement by the competent authority. In addition, the Economic Substance Law specifically provides that the competent authority may exchange information with other countries pursuant to relevant agreements. This should also be generally considered since this may potentially affect the existing tax planning and business model arrangements of a multinational enterprise group.
(2)Legislative reform in other tax haven jurisdictions
To accommodate the European Union’s list of non-cooperative jurisdictions and the global trend of anti-tax avoidance reform, other tax haven jurisdictions such as the British Virgin Islands and Bermuda have successively introduced relevant economic substance legislation. Their contents are similar to the above legal regime of the Cayman Islands, even though there may be differences in detail. Take the Economic Substance (Companies and Limited Partnership) Act for example[3]. A company or limited partnership which is a non-tax resident may be excluded from the application of the Economic Substance Act, provided that it is resident for tax purposes in a jurisdiction outside the Virgin Islands which is not on the EU list of non-cooperative jurisdictions for tax purposes. In case of an existing company, it shall comply with the economic substance requirements by June 30, 2019 and submit a report on economic substance compliance in one year. A new company established after January 1, 2019 is required to comply with the economic substance requirements and to submit a report within one year after its incorporation date. Relevant materials will be integrated into the original Beneficial Ownership Secure Search System. The Economic Substance Law is a new piece of legislation. For specifics, continued attention should be paid to subsequent enforcement status and relevant announcements of competent authorities in various countries to thoroughly comply with each legal regime.
(3) Overall comprehensive considerations of relevant tax systems and overall review of organizational planning and commercial arrangements
To promote the sound development of international tax fairness, improve tax transparency and carry out anti-tax avoidance reform, international organizations and various countries have promoted all kinds of tax reform and information exchange systems in recent years, e.g., the BEPS report and 15 action plans and subsequent measures, the Common Reporting Standard for Automatic Exchange of Financial Account Information, transfer pricing documentation and country-by-country reports, the controlled foreign company system, and the place of effective management. All kinds of tax systems mutually affect each other and are changing frequently. In addition to the consideration of the local economic substance legislation where existing offshore companies are located with respect to the organization and structure of enterprise groups, the establishment and utilization of offshore companies and relevant tax planning, it is also necessary to review relevant tax laws, regulations and systems in various countries, make overall observation and give comprehensive considerations based on factors such as the actual circumstances of enterprise groups, business as operated, relevant cost considerations, business decisions and organizational structure, as well as consultation with experts, in order to make proper arrangements.
[1] Department for International Tax Cooperation- Economic Substance Legislation and Resources http://www.tia.gov.ky/pdf/Economic_Substance.pdf。
[2] Economic Substance Guidance v1.0- I Legislative Framework A. ES Law and VII External Reference Materials http://www.tia.gov.ky/pdf/Economic_Substance_-_Guidance_v1.0.pdf。
[3] The Economic Substance (Companies and Limited Partnerships) Act, 2018 https://eservices.gov.vg/gazette/content/recent-gazettes.http://bvifinance.vg/News-Resources/ArticleID/3001/BVI-Government-Plans-Legislation-to-Address-EU-Concerns-on-Economic-Substance。