The EU’s economic substance rules threaten to damage the long-term competitiveness of offshore financial centres. Vistra’s latest research – surveying corporate services leaders – suggests the added compliance costs could be substantial enough to reduce demand in these jurisdictions. But not everyone in the industry believes that is inevitable.
When added to other tax and regulatory initiatives aimed at increasing transparency and compliance, many observers think the EU’s economic substance rules may hasten the decline of offshore financial centres.
The results of Vistra’s latest corporate services industry study – surveying 620 executives – appear to support this view. Three-fifths (59%) of respondents agree that the EU rules will reduce the demand for offshore financial centres by increasing the cost of doing business there.
New compliance hurdles
The first EU blacklist of non-cooperative jurisdictions for tax purposes came out in December 2017, along with a grey list of jurisdictions that had committed to implement rules that satisfied the EU.
The EU’s stated objective was to stop companies availing of light-touch tax and regulatory environments in jurisdictions where they did not carry out sufficient business activity.
The rules have increased the cost and complexity of incorporating and maintaining corporate vehicles in these jurisdictions. A partner at a Hong Kong-based law firm says: “It’s gone from a simple annual registered office fee and annual government fee, to a whole hurdle of compliance and regulation that you have to jump through with your bank and sometimes with the regulator, and then economic substance classification and filing. We feel like we’re at a point where the cost and effort has been amplified.”
The rules have also encouraged corporate and individual investors to look again at midshore and onshore centres when considering structuring decisions.
“On forming a new entity, whereas before, you would have favoured offshore jurisdictions for flexibility and cost, that cost legitimacy now falls away” says the legal head of a corporate services firm. “And midshore financial centres are levelling up on flexibility and the legal framework too,”
Singapore, with its variable capital company regime, and Hong Kong, whose limited partnership fund legislation took effect at the end of August 2020, are clearly angling for business that may have traditionally been set up offshore.
Accusations of unfairness
The new rules certainly have their critics, especially from those who feel they do nothing to address questions about the economic substance of companies incorporated in EU member states, with favourable tax and corporate rules. It doesn’t seem likely that this will happen soon either.
“Never expect these rules to be logical or academically defensible. It's all about power. It’s easier for the EU to lord it over offshore financial centres, but they can't do it within the EU because, at least for now, you need unanimity among member states,” says a tax consultant in the Hong Kong office of an international law firm.
In addition to what some see as a lack of logic in the jurisdictions listed, the rules have the potential to cause some unintended consequences because of the way they target businesses in specific sectors.
Not everyone agrees that tougher economic substance requirements will hurt international financial centres as much as forecast.
Even if some companies decide, for reputational reasons, to move their vehicles to onshore or midshore locations, this is likely to be limited to companies from a small number of industry sectors, and mainly from within Europe and the US — which are not the main drivers of offshore business.
Meanwhile, for some clients, steps to make the legal and regulatory environments in offshore centres even more robust will increase confidence in doing business there. For private equity firms, for instance, the ability to demonstrate they are operating in highly regulated, transparent jurisdictions is important in building trust with their investors.
And after years of regulatory disruption, the authorities in these centres are well-versed in adapting their regimes for private and corporate vehicles – as well as the supporting infrastructure – to remain relevant.
For the British Overseas Territories and Crown Dependencies, at least, the threat posed by substance rules is very unlikely to be an existential one. Though as they weather this storm, the next may already be on its way, as the OECD leads international discussions about the imposition of a global minimum tax rate. News on that is expected towards the end of 2020.
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