Phil Taylor, Product Owner
...the onward march of Economic Substance regulations
I'm sure many of you reading this are familiar with the term "brass plate" company. If not, let me outline what is meant by this term. A brass plate company is a phrase used to describe a legally incorporated company who's only presence (in the jurisdiction where it is incorporated) is the name plate on the wall. No legions of staff, no gleaming office block, no underground car park, no on-site gym, no staff restaurant, nothing. Just the brass plate attached to the wall outside it's registered office. They are traditionally associated with international finance centres, and in-part, thanks to the Panama Papers affair, thousands were uncovered and were brought to the forefront of many people's (and indeed financial regulators) consciousness.
Flexing the muscles
The European Union's Code of Conduct Group (Business Taxation) have decided to get tough on jurisdictions that are traditionally associated with brass plate companies, and ensure that businesses registered there can demonstrate that they have sufficient "substance" in the jurisdiction in which they are operating.
The EU is concerned that some of the tens of thousands of brass plate companies are routing company profits through various offshore financial centres, where they pay little or no tax, and potentially deprive EU member states of income to spend on essential public services like schools and hospitals.
Jurisdictions that do not comply with this ruling could be for the high jump. We've already seen evidence of this, when in late 2017 and early 2018, the EU placed the British Virgin Islands the Cayman Islands, Bermuda and the Crown dependencies (Jersey, Guernsey and the Isle of Man) (along with 59 other places) on an anti-tax-avoidance "grey list" due to concerns relating to their economic substance. It threatened to blacklist the BVI as a non-compliant tax jurisdiction if the territory did not satisfactorily address the EU's concerns regarding economic substance. In reaction to this, the BVI approved legislation to address these concerns over its financial services sector. As recently as March 2019, the EU placed Bermuda on its black list, following the EU's assertion that the island had "been playing games" in an effort to dodge the EU requirements. The Crown Dependencies reacted by introducing legislation that will be effective for accounting periods on or after 1st January 2019, with companies being fined up to £100,000 if they cannot prove they have a sufficient physical presence in the islands.
Who's required to prove their economic substance?
In the Crown Dependencies it is those types of business sectors which are both geographically mobile (and therefore can move their operations between different jurisdictions) and have traditionally been the focus of preferential tax regimes (i.e. businesses whose profits are subject to low or no tax). The regulators refer to these businesses as carrying on 'relevant activities'.
Businesses conducting relevant activities are:
- fund management
- finance and leasing
- intellectual property
- holding companies that generate income from any of the above activities
- holding companies that hold shares in other companies
But how does one go about demonstrating sufficient economic substance? It doesn't necessarily equate to the presence of an on-site gym, gleaming sky scraper or a fancy staff restaurant (although I'm sure that would help). No, the Crown Dependencies have defined economic substance as follows; ‘the company is being directed and managed in the island, conducting Core Income Generating Activities (CIGA) in the island, and having adequate people, premises and expenditure in the island’.
What is a CIGA? Well, it depends on the industry sector. For a fund management company based in Guernsey these are defined as:
- Taking decisions on the holding and selling of investments
- Taking decisions on currency or interest fluctuations and hedging positions
- Preparing relevant regulatory or other reports for governmental or regulatory authorities and investors
How is evidence of sufficient economic substance to be provided to the authorities?
Proving economic substance will typically form part of a company's income tax filing process. The Crown Dependencies are in the process of redesigning their tax returns to ensure that all tax resident companies will be required to provide additional information concerning their activities and income to ensure the above activities can be identified.
As part of their income tax filing process, all companies are required to provide details on:
- Business/income types (in order to identify the type of relevant activity), and
Amount and type of gross income.
Companies carrying on relevant activities must also provide:
- Amount of operating expenditure
- Details of premises
- Number of (qualified) employees, specifying the number of full time equivalents
- Confirmation of the CIGAs conducted for each relevant activity
- The financial statements, and
- Confirmation of whether any CIGAs have been outsourced and if so relevant details.
What's the end game?
You could argue that this direction of travel goes beyond loss of taxation revenues and money laundering, but is actually about shoring up local industries that could otherwise be harmed by the traditional offshore locations embracing the globalisation that technology brings. Whether that is true or not, what is clear is that economic substance is going to be the new front on jurisdictional competition, with the Channel Islands in particular using it to bolster their position as a leading centre of wealth management.
Want to know more?
The power and flexibility of 5Series means that our customers are already well placed to record and report this information, but we're following developments keenly. If you'd like to chat with me or the wider product team about this, just send an email to us at email@example.com.
Philip Taylor is a Product Owner at Microgen Financial Systems.
You can find Philip on LinkedIn