Economic substance laws and their impact on offshore companies

7 December 2023
Leading offshore centres, including the Cayman Islands and the British Virgin Islands, have sought to avoid potential blacklisting and reputational damage by enacting economic substance laws.

The regulations require relevant entities to prove that any income earned from certain activities is derived from business that actually takes place in the Cayman Islands or BVI. We look at the background of these moves to understand what construes a relevant entity and assess how businesses may be affected.

Hong Kong-listed entities usually have offshore companies in their corporate structures. There are several reasons for this. Many are attracted by the simple and easy registration process, a flexible operating environment, minimal restrictions, a high degree of confidentiality, and tax exemptions. However, in recent years, using offshore entities purely for tax avoidance has become a growing concern, prompting global bodies to clamp down on what they see as damaging tax-competition practices.

In 2017, the EU released a list of jurisdictions with no or only nominal tax rates (NOONS) judged to be “non-cooperative jurisdictions for tax purposes.” It required them to enact legislation aligned with the EU’s economic substance regulations – in other words, any profits declared must accurately reflect business activities in a territory – or face the prospect of sanctions, including a ban on access to capital from EU member states. The NOONS were assessed using several criteria, including transparency, fairness, and measures taken to counter profit shifting.

The list included the Cayman Islands and BVI, which, by the end of 2018, had made the necessary amendments to their laws with the introduction of economic substance regulations for relevant entities. They also sought to meet the EU Commission’s fair taxation standards.

The decision to execute the new regulations was hastened by the introduction of an OECD global standard on Base Erosion and Profit Shifting (BEPS). BEPS are tax-planning strategies designed to avoid or curtail any tax liability.

What is a relevant entity?

For the BVI, the term “relevant entity” covers companies and limited partnerships, as well as foreign companies and foreign limited partnerships, that are registered in the BVI under the Limited Partnerships Act 2017 or the BVI Business Companies Act 2004.

If any of the following “relevant activities” are performed by a company, then it is required to demonstrate economic substance in the BVI:

  • Fund management business
  • Insurance business
  • Banking business
  • Holding business
  • Headquarters Business
  • Distribution and service centre business
  • Finance and leasing business
  • Intellectual property business
  • Shipping business
Economic substance requirements

The scope of the economic-substance legislation is broadly the same in each territory. The rules lay down three tests that a relevant entity deemed to be operating within the scope of the economic-substance requirements must meet.

  • Directed and managed. A company must be directed and managed in the Cayman Islands or BVI. Board meetings should be conducted locally with the required number of board members present. Also, the directors must have an understanding of the business and what their duties entail. This requirement seeks to end the practice of appointing token directors with no knowledge of a particular company.
  • Core Income Generating Activity (CIGA). The company must show that appropriate CIGA has taken place in the offshore territory. Rules were also put in place to stop entities outsourcing activity but claiming it as a CIGA.
  • “Adequate” requirements. This test establishes whether those employed by the business in the offshore entity are suitably qualified. It also demands that an adequate number of people work for the company in that jurisdiction and establishes if they are being provided with the tools or environment required to do the job, such as functioning office space. A point to note is that the gauging of ‘adequate’ is done on a company-by-company basis: for example, larger entities will be expected to have a greater physical presence and vice versa.
Holding companies and intellectual property-related entities

Even if it is judged to be a relevant entity, the obligation to comply with economic substance requirements for a holding company that is mainly used to receive dividends would be much smaller. Very often, these entities simply need to fulfil their compliance duties and statutory obligations.

However, the implementation of economic substance laws is having a more significant impact on intellectual property holding companies, as they are subject to stricter substance requirements given the more intangible nature of their business. Such entities may want to consider whether the tax benefits derived from operating offshore still make it an attractive option. If the answer is no, then they may look to relocate.

Fulfil reporting requirements

From a reporting standpoint, companies should be aware of their obligations. For instance, in the BVI, relevant entities should take two important steps:

  1. Perform an “in-scope” or “out of scope” classification exercise to identify their status and establish economic substance requirements where required.
  2. Supply the relevant information and evidence to the BVI registered agent for reporting purposes.

The legal consequences for non-compliance are significant, including both fines and imprisonment. Deadlines should also be kept in mind. Companies incorporated between September 2019 and April 2020 need to fulfil their reporting obligations between March and October 2021.

Be prepared for change

All affected companies must conduct a holistic review from commercial, legal and taxation perspectives before making any decision regarding their continued presence in the Cayman Islands or BVI. In the face of global regulatory convergence, as long as an organisation reports in accordance with local laws and is clear about why it has established an offshore entity, then it should not cause an issue even with the new laws enacted. However, any review should not be a one-off event. Management teams should regularly monitor ongoing global efforts to combat tax avoidance so their businesses can prepare for further change.

This is a revised version of an article that was originally published on April 19, 2021.