What are the Economic Substance Requirements?
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Economic Substance is originally a doctrine in the United States tax law which requires that a transaction must have a substantial purpose other than simply the reduction of tax liability as well as an economic effect other than reducing taxes in order to qualify for the tax benefits that it provides.
Later, the European Union made a similar move by imposing widespread economic substance requirements on International Financial Centres (IFCs) and Tax Havens that were suspected of aiding taxpayers to unfairly evade taxes in their home countries through insubstantial transactions for tax purposes alone. These economic substance requirements are now expected to become a global OECD standard.
In this article we provide information on the background of Economic Substance Requirements in the USA and the EU. We also explore in more detail the purpose of economic substance requirements which were introduced by the Council of the EU, the type of entities that these requirements apply to, and what the requirements are that need to be complied with.
Background on Economic Substance Requirements
Table of Contents:
- Background On Economic Substance Requirements
- Economic Substance Doctrine In The United States Of America
- The Introduction Of Economic Substance Requirements By The EU And OECD
- Purpose Of The Economic Substance Requirements
- Which Entities Do The Economic Substance Requirements Apply To?
- What Are The Economic Substance Requirements?
Economic Substance Doctrine in the United States of America
The economic substance doctrine is a United States common law judicial doctrine that was codified in section 7701(o) by section 1409 of the Health Care and Education Reconciliation Act of 2010. The doctrine disallows tax benefits of a transaction if the transaction in question lacks economic substance or business purpose. Section 7701(o)(1) states that:
“A transaction has economic substance if: (1) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position; and (2) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”
The IRS later released Notice 2014-58 which provides additional clarification about the definition of “transaction” in terms of being able to apply the economic substance doctrine, along with other relevant guidance.
The Introduction of Economic Substance Requirements by the EU and OECD
In 2017, the EU followed suit with The Council of the EU introducing a new Code of Conduct on economic substance requirements for all EU member states as well as third party countries. The aim of these new rules was to counteract harmful tax practices in known International Financial Centres (IFCs) with preferential tax regimes.
The new regulations focused on non-EU tax havens such as Bermuda, Cayman Islands, Isle of Man, British Virgin Islands, etc. which, although had already met all OECD standards for transparency and various reporting requirements, faced concerns about the level of genuine ‘economic substance’ of business operations on their shores.
These IFCs were forced to comply by introducing legislation for substance requirements for specific financial entities before 2019, or face EU blacklisting. As such, by 2019, most of these jurisdictions complied with the new requirements set forth. These economic substance requirements were later endorsed by the OECD’s Forum on Harmful Tax Practices and are therefore likely to become a global OECD standard in the near future.
The EU’s economic substance requirements can be seen as more overarching and widespread than the USA’s economic substance doctrine. This is because, rather than focusing on individual transactions of taxpayers, it requires entire companies and other financial entities that are incorporated in IFCs to prove that they have sufficient economic substance other than just being a vehicle for tax reduction.
The remainder of this article focuses specifically on these Economic Substance Requirements introduced by the EU.
Purpose of the Economic Substance Requirements
The Economic Substance Requirements were primarily introduced to combat the widespread practice of using offshore companies such as shell/holding companies purely as a vehicle to avoid taxes. These companies served no substantial business purpose other than helping the owners to escape taxes in their home countries.
A set of economic substance requirements was thus implemented by the EU and supported by the OECD in an attempt to improve tax transparency and fairness. The imposition of these requirements makes it more difficult to use offshore companies and other financial structures for tax avoidance, but certainly not impossible.
Which Entities Do the Economic Substance Requirements Apply To?
There was a great deal of uncertainty surrounding the economic substance legislations when they were first released, and many entities were unsure if they would be able to continue operating with the same structure after the new regulations came into effect.
It was later found that a large proportion of business entities are actually outside of the scope of these new regulations, and that complying with the rules for those that are within the scope is actually simpler than originally expected.
In particular, the scope of the economic substance legislation is such that it is only applicable to companies carrying out any of the following “relevant activities”:
- Fund Management
- Intellectual Property
- Distribution and Service Centres
- Holding Companies
Therefore, if your business entity does not perform any of the above activities or receive income from any of these activities, it is outside the scope of the economic substance requirements legislation.
If your business entity does perform any of these activities (and does not qualify as an exception) then it is within the scope of the law and the economic substance requirements need to be understood and adhered to.
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What Are the Economic Substance Requirements?
The economic substance requirements for entities conducting any of the relevant activities previously discussed (the exception is holding companies, for which there are reduced requirements) are as follows:
- The entity must have physical premises in the jurisdiction in which it is incorporated.
- Its core income generating activities (CIGA) must be undertaken in the jurisdiction and they must be related to the relevant activity.
- It must be managed and directed locally in the relevant jurisdiction. This includes local board meetings, the quorum of the board to be physically present in the jurisdiction, minutes of meetings to be kept in the jurisdiction, etc.
- Its operating expenditure must be realistic and proportionate to the relevant business activity it is undertaking.
- It must have sufficient employees hired locally who are suitably qualified.
- It must file a confidential economic substance report annually with the relevant authorities in the jurisdiction so as to aid the authority in determining the business’ compliance with economic substance requirements.
For pure equity holding companies who engage in no relevant activities aside from holding equity shares in other corporate entities, and earning dividends and capital gains from these holdings, the economic substance requirements are reduced. They only include:
- Complying with statutory regulations in the jurisdiction in question, which includes fulfilling the standard annual reporting requirements of all business entities within that jurisdiction. This could include information regarding the directors, beneficial owners, financial reports, etc.
- Maintaining sufficient employees and physical premises needed for holding equitable interests. These employees and premises must be maintained locally in the relevant jurisdiction. These services are usually allowed to be outsourced, in which case providing details about the registered agent who is providing the registered office services of the company is adequate to fulfil the substance requirements.
It can be seen that the requirements needed to satisfy an economic substance test are not overly arduous or difficult to fulfil. However, the penalties for non-compliance can be severe and may include heavy fines and even a complete shut-down of the business entity depending on the specific regulations within the jurisdiction in which it is operating.
It is therefore strongly recommended to ensure that your business satisfies all requirements to prove economic substance where it is based, or failing that being a possibility, to relocate to a new jurisdiction where it is possible to satisfy the requirements.
Codes of Conduct that have been put in place to encourage greater tax transparency and make it more difficult for offshore entities to be used to avoid taxes are steadily increasing. The OECD and other regulatory bodies have implemented numerous tax policies and reporting standards in recent years which place increasing pressure on individual taxpayers, corporate entities, and offshore jurisdictions themselves.
The Economic Substance Requirements introduced by the Council of the EU and fully implemented in 2019 are yet another set of tax and reporting rules to be aware of and adhere to. Fortunately, they are not overly strict or difficult to comply with, but if you own or manage an offshore entity in an IFC, it is important to do your necessary due diligence and ensure that you are fully compliant with the regulations if your business falls within the scope of the relevant activities.
It is advisable to consult with an offshore tax expert who can help you to ascertain whether you are compliant with all global tax and reporting standards, such as the Economic Substance Requirements, and guide you towards becoming compliant and avoiding penalties if you are not already.