The last issue of Tax Tips (The Final Days of Tax Havens – 10 December 2018) discussed the paper “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”) issued by the OECD Inclusive Framework on BEPS Action 5, and forewarned the changes ahead: tax haven companies will be required by law to hire an adequate number of full-time qualified employees and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in.
Tax Havens including the well-known Cayman Islands and the British Virgin Islands (BVI) have swiftly introduced economic substance legislation. Cayman Islands passed The International Tax Co-operation (Economic Substance) Law, 2018 on 17 December and the BVI’s Economic Substance (Companies and Limited Partnerships) Act, 2018 was passed into law on 19 December 2018. These laws have become effective on 1 January 2019.
The rush to pass these laws before the end of 2018 was due to the commitment made to the European Union (EU). The Cayman Islands and BVI, together with countries such as Bermuda, Guernsey, Jersey and Isle of Man were included in a list of countries whose tax policies and economic substance caused concern for the EU Code of Conduct Group (Business Taxation). These countries were given the deadline of 31 December 2018 to introduce laws (the “Economic Substance Law” hereinafter) to avoid blacklisting by the EU.
Economic Substance Law
The economic substance required by the EU is basically identical to those set out in the Paper. Although the Economic Substance Laws have been passed, the Tax Havens still need to wait for the EU to confirm that the EU requirements have been met. However, from the reports on the visit by the OECD representatives (including the Director of the Centre for Tax Policy and Administration Mr. Pascal Saint-Aman) to the Cayman Islands in early January 2019, it seems that things are on the right track. Although the legislation introduced by different countries are broadly similar, details are different and Readers using Tax Haven vehicles should study the specific legislation to analyse the impact.
Not all Tax Haven entities will be affected. Here are the general steps one could take to assess if a company shall comply.
Step 1: Is the company a “Relevant Entity”
The Economic Substance Laws generally apply only to entities that are not tax residents outside of the Tax Haven country (the Relevant Entities). For example, if a BVI company is registered to carry on business in Hong Kong, it will likely be regarded a tax resident in Hong Kong and thus out of scope for the BVI Economic Substance Law.
Step 2: Is the Relevant Entity conducting the “Relevant Activities”
Corporates and individuals use Tax Haven entities for various activities but only the “Relevant Activities” are subject to the substance requirements. Generally, the geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and the below Non-IP activities would be considered the Relevant Activities:
- Distribution centres
- Service centres
- Fund management
- Equity holding
Relevant Entities will likely be required to file notices to inform the authorities whether they are conducting Relevant Activities or not. Those conducting Relevant Activities will then need to provide information covering items such as income, expenses, assets, premises, management, employees and physical presence. If the economic substance of the Relevant Entity falls short of the requirements, it will be asked to make an improvement. Persistent failure to fulfil the substance requirement may be subject to fines and even result in being struck-off.
Step 3: Meeting the Economic Substance Requirement
In general, a Relevant Entity conducting any of the above Relevant Activities complies with the economic substance requirements if:
(a) the Relevant Activity is directed and managed locally (i.e. in the Tax Haven);
(b) having regard to the nature and scale of the relevant activity:
- there are an adequate number of suitably qualified employees in relation to that activity who are physically present locally;
- there is adequate expenditure incurred locally;
- there are physical offices or premises as may be appropriate for the core income-generating activities; and
- where the Relevant Activity is IP business and requires the use of specific equipment, that equipment is located locally; and
(c) the Relevant Entity conducts core income-generating activity.
A pure equity holding entity, which carries on no Relevant Activity other than holding equity participations in other entities and earning dividends and capital gains, are subject to the reduced requirement and would be considered to have adequate substance if it:
(a) complies with its statutory obligations under the relevant company laws; and
(b) has adequate employees and premises for holding equitable interests or shares and, where it manages those equitable interests or shares, has adequate employees and premises for carrying out that management.
On the other hand, more stringent rules apply to high-risk intellectual property holding companies.
As to what is “adequate”, one has to wait for the details to be announced by each country. The Mauritius example mentioned in Tax Tips (18) would give some indications of what is to come.
Outsourcing of Core Income Generating Activities
The economic substance requirements generally allow for outsourcing of the core income generating activities to third-party within the jurisdiction. The Relevant Entity must, however, be able to prove that it is able to monitor and control the core income generating activities being carried out are conducted locally.
The below flowchart downloaded from the Jersey Government website is a good reference on how the laws work in general.
The Common Reporting Standard (CRS) and Economic Substance Laws are bringing tax residencies of companies and individuals into the limelight. Hong Kong businesses are faced with questions from their bankers that ask them to identify the tax residency of their Tax Haven companies which have bank accounts in Hong Kong. Thanks to creative tax planning advice Hong Kong businesses acted on in the past, many of them use the bank accounts in the following situations:
- There is a group company in Mainland China manufacturing goods for domestic sales. Orders of overseas customers are accepted in China and are shipped out without export declaration. The overseas customers pay to the Hong Kong bank account of the group BVI company, and some of the cash received would be used to pay Hong Kong suppliers who provide the raw materials in China. These sales and purchases would not be booked by the manufacturer in China.
- Services are provided in Hong Kong or China to overseas clients and they are asked to pay to the Hong Kong bank account of a BVI company. Income is booked in the BVI company while the costs of services are incurred in Hong Kong or China with tax deduction allowed unchallenged.
- IPs such as brands, trademarks, designs, rights etc are owned by BVI companies and earning hefty royalty income from group companies or unrelated parties, while the work related to the development, exploitation, maintenance, protection and enhancement of the IPs are carried out in Hong Kong, and the costs of such activities have been fully tax-deducted.
In the above examples, there would be under-reporting of income as profits have been shifted to entities that do not carry out value-creation activities. Once the tax offices in Hong Kong or China have become aware of the situations (which has become more likely these days with all the reporting and information exchange arrangements), they may, for example, treat the BVI companies as carrying on business in Hong Kong or managed and controlled in China, as the case may be, and assess tax on the under-reported amount and impose heavy penalties. On the other hand, from now on the groups in question also need to maintain substance of these BVI companies in the BVI or they risk the companies being struck-off. Things will become more complicated if the shareholders of the companies become Chinese tax residents by spending 183 days or more in China in a calendar year.
As mentioned in Tax Tips (1), “Base Erosion and Profit Shifting” (BEPS) refers to the tax planning strategy of multinational groups (big or small) making use of differences and mismatches of tax rules across different countries and artificially transferring profits to low or no-tax jurisdictions with little or no economic activity. The pressure now felt by taxpayers is indeed the intended effect of OECD’s project against BEPS. At the same time, the compliance costs of Tax Haven entities are rising. Taxpayers should take action to restructure their operations and shift profits back to where the activities are. There will be an increase in tax burden, but a managed transition would help minimise the tax costs and avoid heavy penalties: tax offices like to punish aggressive taxpayers with the highest penalties.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 24 January 2019: https://manageyourtax.com/HKEJ Forum 19)
Members of the Inclusive Framework on BEPS: http://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf
BVI Economic Substance Law:
OECD visit to the Cayman Islands:
Bermuda Economic Substance Act: