The economic substance regime has been in place globally since 2019 and is aimed at determining where companies generate their core revenue and activities, ensuring that tax is incurred appropriately in the jurisdictions where revenue is earned.
With three years of regulatory responses and submissions completed, it's a crucial time for companies to revisit their business models and review the original economic substance assessment to see if it still holds up in light of emerging trends and findings from relevant regulators.
In this article, we sat down with George Jones, Managing Partner of Ocorian Law in Bermuda, to gain insights into the Island's implementation of an economic substance regime, including its requirements, compliance assessment and penalties for non-compliance.
1. What is economic substance?
The economic substance regime focuses on identifying where entities generate their core revenue and activities or where they record them from. It is a precursor to the OECD's and EU's anticipated minimum global tax. The intention is to determine where entities hold themselves as a tax resident.
2. Why was economic substance introduced?
The concept and requirement for economic substance was introduced to level the playing field for global corporations that had multiple holding companies in multiple jurisdictions as a means of tax-efficient planning. The law ensures that tax is correctly incurred in the jurisdictions where the revenue is earned. Although the law was initially intended to target big names, it currently captures everybody, including those who are not in the public eye.
3. What are the requirements for economic substance?
There are five requirements under economic substance that you must ideally meet. The first requirement is that you should create income or revenue in a particular jurisdiction. The other requirements are triggered if you meet this first requirement, and they include:
- What is your expenditure in that jurisdiction in terms of proportionality to the income you're earning?
- Are you actually doing mind and management?
- Are key decisions being made in that jurisdiction?
- Do you have a physical presence in that jurisdiction?
- Do you have sufficient employees?
It is important to note that the nature and complexity of your business can allow you to outsource some of these elements and still meet the obligations, but a proportionality rule still applies.
4. Which countries are subject to the economic substance regime?
The economic substance regime introduces a global minimum standard that originated from the Organisation for Economic Co-operation and Development (OECD). It primarily focuses on non-OECD member countries such as, but not limited to, Bermuda, Cayman, BVI, Mauritius, and Cyprus.
5. Which entities are subject to the economic substance requirements?
Economic substance requirements primarily apply to corporates and partnerships engaged in nine relevant activities:
- Distribution & service centres
- Finance & leasing
- Fund management
- Holding companies
- Intellectual property
There are further delineations and definitions as to what is in scope and what is out of scope for each relevant activity.
6. What are core income-generating activities?
Core income-generating activities are the activities that generate revenue for the entity. For example, if you are an insurance entity, your core income-generating activities would be premium collection and underwriting.
7. How is compliance with economic substance assessed?
Compliance with economic substance is assessed through a prescribed form that companies must complete annually. The form requires companies to disclose the revenue, activities conducted, number of meetings held, service provider facilities, and other relevant information. Companies must also make a declaration as to whether or not they believe themselves to be compliant with the obligations. In Bermuda, for instance, the Registrar of Companies is the relevant authority responsible for reviewing these submissions.
8. What if a company is formally registered for tax purposes in another jurisdiction?
If a company is operating in a jurisdiction but is officially tax resident in another jurisdiction, it can provide evidence of its tax residency to eliminate additional review on the part of the relevant regulators. As long as the company can show on an annual basis that its tax residency has not changed, it can avoid additional scrutiny. However, companies must still meet the relevant obligations and requirements of economic substance.
9. What are the penalties for non-compliance with economic substance regulations?
Companies that fail to comply with their local economic substance regulations may face financial penalties, which can increase over time. In Bermuda, for example, penalties range from $5,000 to $10,000 for a first instance of non-compliance and can go up to as much as $250,000 for a third instance. After three years of non-compliance, the government may move to have the company struck off the register.
10. How can companies determine if economic substance applies to them?
The best approach is to assume that the requirement to comply with local economic substance regulations applies until otherwise advised. Companies can consult with their resident experts in Bermuda or elsewhere to determine if they fall within one of the relevant activities and what filings they need to make. It is also important for companies to periodically revisit their determination as to whether they are compliant, particularly as their business plan evolves.
11. How can Ocorian help with economic substance compliance?
In Bermuda, Ocorian Law can assist companies with economic substance compliance in a number of ways. Firstly, we can conduct a desktop review of your company's organisation and situation to determine if you are compliant or identify areas where you need to improve. Secondly, we can provide a mock review of what is expected as part of the Economic Substance Declaration. Thirdly, for companies that have received non-compliance notes, we can help develop a remediation plan to mitigate and minimise the risk of further non-compliance going forward.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.