A question of substance

The high-tax, high-spending, high debt countries of Europe are continuing to attack low-tax jurisdictions, as if closing down successful countries will magically transform their own stalled economies. 

The OECD, based in France, where youth unemployment is almost 25 percent, is still pushing its Base Erosion and Profit Shifting (BEPS) project and has been joined by the U.K. – government deficit higher than Greece, even as a percentage of GDP – with its Diverted Profits Tax.

It may seem ludicrous that governments that have so utterly failed to manage their own economies are trying to impose their discredited tax systems on more successful jurisdictions, but that is how international politics now seems to operate.

Perhaps it is an extension of the Peter Principle; if politicians are “promoted to the level of their own incompetence,” the only thing to do with them once they have destroyed their own economy is to put them on the international stage to destroy the world’s.

But rather than trying to understand the bizarre practices of international politics, more important is to think about how international finance centers such as Cayman, and their practitioners, should react.

The solution 

The way forward, I strongly believe, is for international finance centers, and practitioners operating in them, to demonstrate even more strongly that they are substance jurisdictions rather than brass-plate ones.

By that I mean that they are demonstrably adding value, contributing both expertise from their personnel and useful innovation from their legal and regulatory structures.

The OECD BEPS project’s Action Item 5 is most clear, claiming as a priority the need for “requiring substantial activity for any preferential regime,” but in fact substance is a running thread throughout most of the project.

Those jurisdictions that promote and can demonstrate substance will still not have an easy ride; some of the European jurisdictions are so bankrupt (morally and philosophically as well as literally) that they will support any attacks on low-tax jurisdictions, believing that there is a hidden pot of gold that will stave off their need to reform their own systems. But the more reasoned (although still misguided) regulations that actually become part of our international tax system will make commercial life far more difficult for the “brass plate” jurisdictions that provide legal form but little else.

The history of substance 


This is actually nothing new, but is rather a continuation of a long-running movement in international tax law – a history that reinforces my conviction that it is a sustainable approach for jurisdictions and practitioners to take.

Substance as a concept in international tax law dates back over a hundred years; although the term was not necessarily used that early, the concept clearly was.

The de Beers test of company residence, first formulated in 1906 but still just as relevant today in common law jurisdictions, is that an incorporated body is resident not where it is incorporated but where its “central management and control” is exercised. What is needed is the “substance jurisdiction” where the added value of actual management takes place rather than the “brass plate jurisdiction” of legal incorporation.

But as the de Beers test was applied by the courts over the succeeding decades, the requirement for substance grew. This began over 50 years ago with the Unit Construction case (Unit Construction Co Ltd v Bullock (1960)), in which the court looked not just at where the board of directors met but pushed the substance concept a stage further, examining where the decisions about the company were actually being made.

In Unit Construction, the court held that the “directors … were standing aside in all matters of real importance.” Although under the company’s constitution the board had the legal power and duty to direct the company, they had actually allowed that power to be usurped and therefore the true substance of the company’s “central management and control” was located elsewhere.

Modern developments 

Global-Fin

This move towards substance has continued, and has been reinforced in recent years by the Laerstate decision (Laerstate BV v HMRC (2009)) in the U.K. and the Fundy case (St Michael Trust Corp v R; Re Fundy Settlement (2012)) in Canada.

In Laerstate the court made a distinction between formal ‘paper’ control, which should have been exercised by the board of directors, and the ‘actual’ control which was held to be exercised by the dominant shareholder: “the mere physical acts of signing resolutions or documents do not suffice for actual management” and a greater degree of substance was required.

Similarly in Fundy the Canadian courts, applying a similar test to the trustees of a trust, decided that although the trustees exercised formal control of the trust, and under the trust deeds were the body charged with exercising control, in practice they “had only a limited role – to provide administrative services – and little or no responsibility beyond that” and that the actual substance of control was elsewhere.

Practicalities 

So what does this mean in practice? How does a company or a trust, and its professional advisers, demonstrate the necessary substance?

This will be of increasing importance, not just in fighting technical legal challenges over a company’s place of “central management and control” but also in countering attacks under the OECD BEPS project and resultant national legislation such as the U.K.’s Diverted Profits Tax, both of which (as we shall see below) will make even greater demands on substance.

And where a company, trust, fund or other body is claiming residence in a low-tax jurisdiction, and claiming its right to be taxed there rather than in a high-tax, high-debt state, the requirements of the tax authorities will be even greater.

The “brass plate” jurisdiction has not been enough for a long time; merely pointing to the jurisdiction of incorporation and demanding to be taxed only there is not taken seriously as tax planning. But increasingly the “rubber stamp” jurisdiction, with a board of directors or trustees merely “signing resolutions” (to quote Laerstate) on the advice of people located in high-tax jurisdictions is increasingly unlikely to be accepted as genuinely exercising powers of “central management and control.”

Capacity 

One essential requirement, following from the Laerstate judgment, is to demonstrate that “the directors have the absolute minimum amount of information … in order to be able to make a decision”; if they do not then it will be easy, in the new climate, for hostile tax authorities to demonstrate that they cannot be truly carrying out the central management and control of that company. The same will apply to trustees of a trust or investment fund.

But to satisfy the tax authorities, to reliably demonstrate substance, will increasingly require much more than merely having “the absolute minimum amount of information.”

To show that a board of directors is genuinely carrying out its powers of “central management and control” of the company, or that trustees are genuinely taking the relevant decisions of a trust, to demonstrate substance, it will be necessary to be able to show that the board has the capacity to genuinely take board-level decisions.

The 1999 Barings case, although not about tax, still illustrates what is required of directors: ‘’Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors.”

If the directors are not capable of exercising management and control, and it cannot clearly be shown that they are capable of exercising management and control, then the tax authorities will not believe that they are actually doing so.

Practical points 


This demonstration of substance will have to be broad ranging, covering aspects such as:

  • The ability of the directors or trustees, as evidenced by experience and qualifications;
  • Their expertise and knowledge of the relevant business sectors;
  • Their experience of either board-level management in other entities or of the specific business or investment sector;
  • Their capacity, in terms of the time they have available from other duties to devote to their board responsibilities (which will be particularly important for non-executive directors who have other outside responsibilities).

And for the jurisdiction, it will be increasingly important to be able to point to a legal and regulatory framework that adds value, so that tax is not seen as the only or dominant reason for the decision to locate there.

Cayman Islands 

Cayman readers will, I am sure, be thinking of the Weavering case as they read this (Weavering Macro Fixed Income Fund Limited (In Liquidation) v Peterson and Ekstrom (2011)).
Although not a case about tax residence, the Weavering case demonstrates how the courts now approach questions of corporate control.

The Cayman Grand Court held that directors “must apply their minds and exercise an independent judgment,” a test that I expect tax authorities to increasingly demand evidence for.
It is therefore going to be increasingly important for a jurisdiction, particularly an international finance center, in order to demonstrate that it is a “substance jurisdiction” rather than a “brass plate” one, to be able to point to a broad pool of talent from which its directors, trustees and advisers can be drawn.

Only by having people with the relevant skills to actually exercise the relevant “independent judgment” about a body’s business or investment decisions will it be possible to prove that a substantial number of entities are actually located there.

BEPS 


This concept will be even broader, and even more important, under the OECD BEPS project.

Running through the BEPS documents are requirements for substance, taking the substance concept much further than the traditional rules of company or trust residence.

Even if an entity is legally resident in the required jurisdiction, it will increasingly be necessary to pass additional tests of substance in order to successfully argue that income actually arises there or that profits of a global multinational can ‘legitimately’ be attributed, and so taxed, there.

This will require not just the general skills of trustees or non-executive directors, but increasingly tax authorities are likely to also be looking for evidence of specific skills within the jurisdiction. This could be underwriting experience for a captive insurance company, intellectual property expertise for a patent-holding company, or sector-specific investment knowledge for a specialized collective investment scheme.

The UK’s Diverted Profits Tax, based on the same concerns as the BEPS agenda, is targeted at arrangements that lack “insufficient economic substance”; again making it important to demonstrate the commercial and legal advantages of using an international finance center to offset the claim that the entity has only been located there “to secure [a] tax reduction.”
Impact on IFCs

The general reaction of international finance centers to BEPS and related initiatives has been to regard them as a threat, or at least as another hurdle to be surmounted, but in my view they are also an opportunity.

The more that ‘substance’ is required, and required to be evidenced, the more ‘added value’ that low-tax jurisdictions will need to be able to provide and demonstrate.

This will need not low-grade administrative staff, capable of “only a limited role – to provide administrative services” (to quote Fundy), but highly skilled, high value staff with demonstrable expertise and qualifications relevant to their particular business sectors.

Yes, this may require more training for local staff, and recruiting higher grades of imported staff. But fundamentally the process of demonstrating substance will mean that much more of the added value in the multinational corporate chain will have to take place in the international finance center.

 

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Richard Teather
Richard acts as a tax policy consultant, including advising the Jersey parliament on their recent tax reforms, is a Fellow of the Adam Smith Institute. and is an editor or member of the editorial board of various journals. His book, "The Benefits of Tax Competition", is published by the London-based Institute for Economic Affairs. His work has been the subject of a debate in the UK Parliament and quoted in government studies in the UK, EU and Australia, and hit the national press when the UK government tried to suppress its own civil servants favourable comments on it.Richard TeatherSenior Lecturer Tax LawBournemouth UniversityChristchurch House C206Poole, BH12 5BBUKT: 01202 961870E: rteather@bournemouth.ac.ukW: bournemouth.ac.uk   

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