Many jurisdictions have introduced and implemented economic substance rules. Some of them do this as an attempt to fight against tax avoidance from multiple corporations. Meanwhile, others just follow to prevent being listed on the EU blacklist. If you incorporate in a jurisdiction that enacts economic substance (ES), your company will need to fulfill certain requirements and reporting obligations. This guide will give you an overall picture of this matter so you know what to deal with.
1. Introduction to Economic Substance Rules
Many multinational corporations are using strategies to avoid paying taxes. They take advantage of gaps and mismatches between tax policies in different countries to ship profits to low-tax or no-tax jurisdictions. These are known as Base Erosion and Profit Shipping (BEPS) practices
It was reported that these practices have resulted in an annual loss of 4 - 10% in the world tax revenue. The figure can go up to 100 - 240 billion dollars. Although most BEPS strategies are legal (according to the policy of each jurisdiction), they create unfair and unequal competition between multinational corporations and domestic enterprises.
Those are the main reasons OECD (Organisation for Economic Co-operation and Development) and G20 countries built up an inclusive framework on BEPS. Up to date, they have worked with over 139 jurisdictions to implement the BEPS Package
The BEPS Package includes 15 actions that help governments deal with tax avoidance. By taking these actions, countries can make sure income is taxed where the value is created and not shifted to other places for tax evasion.
There are 4 minimum standards in the Package, those are:
Action 5 (Harmful tax practices),
Action 6 (Prevention of tax treaty abuse),
Action 12 (Country-by-country reporting)
Action 13 (Mutual Agreement Procedure),
Economic substance rules are one of the 3 key aspects in Action 5. It is regulated that certain kinds of income shall not be kept in no-tax jurisdictions unless there is a legitimate activity conducted in those places.
2. Reasons to Comply with Economic Substance Rules
The Council of European Union introduced the EU list of non-cooperative jurisdictions in 2017 (also known as the EU blacklist). It names non-EU jurisdictions that have harmful tax practices.
The list is updated twice a year. As of 22 February 2021, the list includes 12 jurisdictions:
American Samoa
Anguilla
Dominica (new)
Fiji
Guam
Palau
Panama
Samoa
Trinidad and Tobago
US Virgin Islands
Vanuatu
Seychelles
As a consequence, the non-cooperative jurisdictions will be subject to stricter monitoring and control measures. These places are also excluded from any EU funds or beneficial schemes, which will significantly hold back their economy.
To NOT be included in the EU blacklist, a jurisdiction must fulfill these 3 criteria::
Tax transparency
Fair taxation
Anti-BEPS measures
Regarding Anti-BEPS measures, a country has to gradually implement at least the minimum standards (Action 5, 6, 12, and 13). Therefore, many governments have changed their legislation to add on economic substance rules concerning Action 5. This is an attempt to avoid being listed on the EU blacklist and the aftermath consequences.
Those jurisdictions that have yet to fulfill these criteria but commit to doing so will be added to the EU greylist. If they meet all the criteria, they will be removed from the list, otherwise, they will be put on the blacklist.
Here are some places that have enacted economic substances rules from 2019:
Anguilla
Bahamas
Belize
Bahrain
Barbados
Bermuda
British Virgin Islands
Cayman Islands
Guernsey
Isle of Man
Jersey
Turks and Caicos Islands
UAE (subsequently amended on 10 August 2020)
RAK
St. Vincent & Grenadines (effective from 2021)
Marshall Islands
Mauritius
Panama
As a result, if you incorporate in these jurisdictions, you will need to follow their ES regulations.
3. Scope of Economic Substance Rules
The economic substance rules set out certain requirements on certain kinds of relevant business activities, including:
Banking;
Insurance;
Fund management;
Financing and leasing;
Distribution and service center;
Shipping;
Headquarters;
Holding business (pure equity holding); and
Intellectual property.
However, not all business entities that conduct those activities need to satisfy the requirements. Each jurisdiction has its own set of conditions to identify what types of entities will be subject to the ES rules. Normally, tax residency is taken into account as an essential factor.
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