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Article:

New substance requirements for offshore companies from 2019

23 August 2018

The EU has put pressure on offshore centres such as Jersey, Guernsey and the Isle of Man to make sure that companies which are tax resident there have genuine local substance. Recently issued guidelines extend the scope of the EU’s Code of Conduct for Business Taxation with respect to companies located in zero tax territories. Jersey, Guernsey and the Isle of Man are three such territories and have voluntarily committed to comply with the code.

We understand that the three crown dependencies intend to adopt broadly the same measures. In brief, a company resident in any of them will be expected to meet substance requirements that are commensurate with the activities carried on, and income generated, in that jurisdiction.

 

Reporting and proving local substance

There will be reporting requirements (in company tax returns) and tax audits will be carried out to review substance. Where a company has insufficient substance, there will be penalties, ranging from fines to striking off the company (the sanction of last resort). It is thought more likely that the territory will take the option of spontaneously providing information (potentially under EU directive DAC6) to tax authorities in other countries where shareholders and/or parties conducting business with the company are located.

Jersey and Guernsey have published detailed consultations setting out the proposed requirements and similar proposals are under review in the IoM (the rules may also apply for companies registered in Alderney as they are subject to Guernsey tax law).

The consultations suggest that companies will be required to show how they carry on the “core income generating activities” in the territory. They will have to demonstrate that there is:

  • An adequate level of (qualified) employees in the jurisdiction proportionate to the activities of the company
  • An adequate level of annual expenditure incurred in the jurisdiction proportionate to the activities of the company, and
  • Adequate physical offices and/or premises in the jurisdiction for the activities of the company.

These tests can be met through outsourcing to other companies, but only where that other company is conducting its activity in the same territory. However, companies that outsource activities to providers in other jurisdictions may come under enquiry.

For example, it is not uncommon for investment funds to be registered on the islands (often for regulatory reasons) but to subcontract the investment management activities to London-based investment managers. In such cases, if the profits in the local company were excessive in relation to its business substance on the island, then the local authorities would take enforcement action.

Similarly, ‘captive’ group finance vehicles or group insurers, companies holding group IP and other group service companies may face enquiry where local activity is minor and transfer pricing arrangements within the group do not reflect the local business substance.

 

Transfer pricing parallels

The OECD’s updated transfer pricing guidelines seek to allocate profits within groups to the companies that are, in substance, controlling the risks and managing the assets of the business. In particular, for intangibles, a company ought to recognise little or no profit arising from holding IP unless it actually exercises control of the functions relevant to the development, enhancement, maintenance, protection and exploitation of the IP assets

While the crown dependencies and a number of other countries have not implemented OECD-style transfer pricing rules, strict application of the substance standards contemplated in the consultation document seems likely to lead to a similar outcome. Indeed, international information exchange prompted by a substance review is likely to lead other countries to commence a transfer pricing audit. The ultimate penalty, striking off the company) is a more disruptive sanction than a simple transfer pricing adjustment: this may cause businesses to focus on substance issues rather more attentively in future.

 

Next steps

It is proposed that the new measures will be finalised by 31 December 2018 and will apply for 2019 and subsequent years. Companies which may struggle with these requirements have only a short time, therefore, to address any organisational changes that may be needed either to create sufficient substance or to move assets/activities elsewhere.

Potentially affected companies should start to review the impact, and any changes they may need to consider making to their structure or business model, as soon as possible. Please speak to your normal BDO contact or Tim Ferris if you would like help and advice on any business substance issues.