The European Union, through its Code of Conduct Group on Business Taxation, is drawing up a blacklist of “non-cooperative jurisdictions” that will be subject to sanctions.
The main threat behind the blacklist was of tax sanctions, which could include denying deductibility for business payments by EU taxpayers to entities in a non-cooperative jurisdiction, and “increased audit risks for taxpayers benefiting from the regimes.” But there are also threats of non-tax sanctions, including denial of access to EU development funds and a vague proposal for the EU and its member states to “take the EU list of non-cooperative jurisdictions … into account in foreign policy [and] economic relations.”
If that sounds threatening, it is intended to. These sanctions were specifically designed to bully non-EU jurisdictions into complying with their demands, or as the EU put it, to “effectively discourage non-cooperative practices in the jurisdictions placed on the list.”
The blacklist requirements include the usual exchange of information and lack of harmful tax regimes, but in 2017 they added a new requirement, that entities based in a low-tax jurisdiction will have to demonstrate that they have “economic substance” there.
The onus is on the governments of lower-tax jurisdictions to design and enforce these rules, and report back to the EU on the results. Failure to do so to the Code of Conduct Group’s satisfaction will see the jurisdiction added to the EU blacklist.
In response, the governments of various international finance centers made commitments to the EU that they would introduce “economic substance” requirements so that companies, funds, trusts and others located there would be required to demonstrate a sufficient level of local activity.
The Cayman Islands government made this commitment towards the end of 2017, as did Jersey and most of the other significant international finance centers, promising to put the required systems in place by the end of 2018.
They therefore have just a few months, until Dec. 31, to fulfil this commitment, but because of the vagaries of the EU’s demands, and the difficultly of applying substance tests to the finance industry, we still have very little idea of what the tests will actually look like.
What is economic substance?
One problem with the EU’s process has been a lack of agreement or certainty as to what “economic substance” actually is, and there has been criticism that finance center governments have signed up “blind” to an open-ended commitment.
The International Chamber of Commerce has said that “the challenge with any economic substance requirements is their factual nature and the wide leeway for varying interpretations of their content,” which is a reasonable summary, although it does not go far enough. The fundamental problem with the “economic substance” approach is that once you depart from the certainty of whether there is a legal entity, there are no definite answers. How much substance is needed for any particular business is an open-ended question.
There was some broad understanding of economic substance over recent years, in particular from various court cases looking at the residence of companies and trusts. A leading example is the Laerstate case (Laerstate BV v HMRC (2009)), a decision of the U.K. tax tribunal on whether the board of directors of a company actually controlled the company, or if the true “management and control,” and hence tax residence, was elsewhere.
One of the tests adopted in the Laerstate case was whether the directors had the “minimum amount of information … in order to be able to make a decision.” This was effectively an early substance requirement, insisting not just on formal control by the board of directors but that the directors had the ability to actually exercise that control in a meaningful way.
A similar requirement was seen in the Barings case (re Barings plc, Secretary of States for Trade and Industry v. Baker (No.5) (1999)), where the court held that a company’s directors must “acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors.”
Although not a tax case, the requirement in Barings was similar to Laerstate; not just the formal right to control the company and going through the correct forms, but also the need to show that the board had the necessary knowledge and resources to actually consider and take the relevant decisions.
Other countries have used similar tests; the Supreme Court of Canada in the Fundy case (re Fundy Settlement (2012)) held that the trustees of a trust “had only a limited role – to provide administrative services – and little or no responsibility beyond that,” so that although the trustees had formal control, in reality they did not actually exercise it.
In the Cayman Islands, of course, there was the Weavering case (Weavering Macro Fixed Income Fund Limited (In Liquidation) v Peterson and Ekstrom (2011)); again, not a tax case, but once again looking at the ability and capacity of a company’s directors to see whether they were actually controlling the company.
Other jurisdictions have adopted other tests of substance, for example the Netherlands require that, to be resident there, a company must have least half its board members resident in the Netherlands, and that those board members should be sufficiently qualified to carry out their duties, such as “evaluating and making strategic decisions.”
So, we thought we had a rough understanding of what economic substance might mean, and the Learstate line of cases gave a reasonable requirement to comply with. Unfortunately, the EU had different ideas.
Moving beyond a board test
Our understanding of substance, from these residence rules, was effectively a board-level one (or trustee-level for a trust). What was important was that the company or trust was actually and genuinely being run from the jurisdiction that was claimed, and to demonstrate that you had to be able to show that the people who claimed they were running it had the ability and capacity to actually do so.
But the OECD and EU are now demanding more. They are looking not just at the strategic management level, but at actual day-to-day business activity.
There have been a few signs of this before; for example, the tax treaty between India and Singapore requires that, for a Singapore company to benefit from the treaty, it needs to demonstrate sufficient economic ties to Singapore by incurring at least S$200,000 (~US$150,000) of costs and expenses there. That has the benefit of simplicity, but is very inflexible, not taking account of the different situations of different organizations.
More recently, the U.K.’s Diverted Profits Tax of 2015 has an “insufficient economic substance condition,” under which the “non-tax benefits referable to the contribution … by that person, in terms of the functions or activities that that person’s staff perform, would exceed the financial benefit of the tax reduction.”
This moves away from the Laerstate approach, looking not just at the directors of the company and their ability to take strategic decisions, but at the value created by the company’s workers.
Under the U.K. test, the level of economic activity required has to be greater than the tax benefits, to demonstrate an economic effect of the structure that outweighs any tax motives.
The EU’s approach
In June 2018 the European Union issued some guidance on how it will approach economic substance, finally giving the finance centers some idea of what they have signed up for.
Unfortunately, their guidelines are still very inconclusive, and difficult to apply to most of the business activity in the Cayman Islands, leaving business and investors in a state of great uncertainty.
The circumstances when substance might be required are very broad, including where “there is an express obligation in a regime that business should be conducted outside the state or territory,” or when the jurisdiction “does not specify a requirement that activities need to be … real economic activities,” or even when “a regime allows an activity that may under certain circumstances be considered not to constitute a real economic activity.” This seems designed to catch anything that the Code of Conduct Group wishes to object to.
Also, many of the activities carried out in international finance centers are specifically listed by the EU as being likely to require investigation, including “intra-group financial services, intra-group captive insurance, and co-ordination centers.”
What the Code of Conduct Group requires is “an adequate number of employees with necessary qualifications and an adequate amount of operating expenditure with regard to the core income generating activities.” Those core activities might include:
- For financial services, “agreeing on funding terms, monitoring and revising agreements and managing risks”;
- For insurance, “predicting and calculating risk, insuring or re-insuring against risk and providing client service.”
- However, “pure equity holding companies” need only perform more administrative roles, such as “must respect all applicable corporate law filing requirements.”
This shows one of the practical difficulties of the economic substance test; the level of activity that might be expected will be different for different businesses.
One major change for jurisdictions like the Cayman Islands is that the EU is also insisting that finance centers must monitor the economic substance of the entities in their jurisdiction. This is going to require much more information to be collected from companies, funds, trusts and other registered bodies, which is going to cause additional costs, for both business and government, and lack of privacy.
The well-priced model of many international finance centers, getting the level of regulation right, neither too lax nor too expensive, is in danger of being destroyed.
The jurisdiction also has to provide aggregate information to the EU, such as “the number of taxpayers benefiting from the regime” and “the aggregate amount of net income benefiting from the regime.” The concern here is that the Code of Conduct Group will use this information to launch further attacks on those finance centers that continue to be successful, using their compulsory information powers to find where they think they can grab the most money.
For the Cayman Islands, one very important question will be how to deal with investment funds. Predictably the EU does not give any guidance on this.
What level of activity would be expected for an investment fund?
Surely very little; where there is a separate fund manager, the only normal activities of the fund would be administration and a certain amount of high-level management, both of which can be done on Cayman already. So, it may be that investment funds will not be greatly affected by these changes.
Might the Code of Conduct Group go further and insist on the day to day fund management being carried out on Cayman in order for a fund to be regarded as having economic substance there? That would be absurd; the whole point of investment advisers is that the management of investments can be (and usually is) separated from ownership of the assets.
Doing so would cause problems for investment management around the world.
So, what does the future hold for those finance centers that have committed to following the European Union’s economic substance rules?
One problem is that the requirements are vague, but there is no independent system to rule on whether jurisdictions have complied. The sole arbiter is the EU Code of Conduct Group, and if it decides that a jurisdiction is not demonstrating sufficient commitment to economic substance – in its laws, its enforcement and its reporting – then that jurisdiction can be placed on the blacklist.
The EU has been attacking international finance centers for over twenty years now, so we have some experience of their way of operating. Sadly, what we have seen very clearly is that compliance with the EU’s demands does not make you its trusted partner. Whenever offshore finance jurisdictions have changed their systems to comply with the EU or OECD demands, rather than satisfying them it merely means that those demands are very soon increased. What may be acceptable to the Code of Conduct Group in 2019 is unlikely to remain so in 2022.
How will Cayman fare? That depends on how much and what economic substance the EU demands for its main business sectors. Up to a point, Cayman can provide more substance, and benefit from it; it can expand, up-skill, perform more business activities than it currently does, and benefit from capturing a bigger proportion of each company’s operations as they move more activities offshore to demonstrate substance. However, at a certain point the physical limitations of a small island will make further expansion difficult. But what we will not see overall is operations and investments, or taxable profits, returning to the EU.
Studies into the reaction of businesses and investors to these requirements have found that, rather than moving operations back to high tax countries and facing ever-increasing tax bills, they will do the opposite and move more of their actual activities to low-tax locations, to make it easier to demonstrate economic substance there.
This will be a huge problem for the European Union, because when those economic activities are moved out, they do not only lose corporation tax, but they lose jobs, income and employee taxes as well. The competition will not be between Cayman and the high-tax EU countries, but between Cayman and the low-tax ‘onshore’ centers – Ireland, Estonia, Luxembourg, which can more easily handle more activities and so have more scope to demonstrate substance.