Substance over form: Part Two – the sine qua non of international tax planning in the age of transparency and the post Base Erosion and Profit Shifting (BEPS) world

In the first part of this two-part article published in October 2017 , I introduced the 15 BEPS Reports/Action points and provided background information on the project. I also discussed in great detail the new rules on permanent establishments. In this article, I shall focus on the transfer pricing rules which also call for the creation of greater substance.

However, before delving into this, I shall bring a related issue to the attention of readers. The European Union is threatening to blacklist several international financial centers in the Caribbean, including British Overseas Territories such as my native Anguilla and the Cayman Islands. The putative purpose of this new campaign is to ensure that a sufficient level of economic substance is created by companies located therein conducting certain relevant activities.

EU calls for economic substance

In 2016, the EU Code of Conduct Group (Business Taxation) started engaging in a review of 213 jurisdictions to ensure that they were compliant with the evolving international standards related to the Organisation for Economic Cooperation and Development (OECD)’s BEPS project, especially with regards to the issue of economic substance of companies domiciled within their geographical confines. In December 2017, a list of 17 non-cooperative tax jurisdictions was agreed by the Finance Ministers of EU Member States during their meeting in Brussels and announced via a press release which stated that these jurisdictions were so labelled “for failing to meet agreed tax good governance standards.” In assessing the jurisdictions, the EU looked at three criteria:

  • Transparency: The country should comply with international standards on automatic exchange of information and information exchange on request. It should also have ratified the OECD’s multilateral convention or signed bilateral agreements with all Member States, to facilitate this information exchange. Until June 2019, the EU only requires two out of three of the transparency criteria. After that, countries will have to meet all three transparency requirements to avoid being listed.
  • Fair Tax Competition: The country should not have harmful tax regimes, which go against the principles of the EU’s Code of Conduct or OECD’s Forum on Harmful Tax Practices. Those that choose to have no or zero-rate corporate taxation should ensure that this does not encourage artificial offshore structures without real economic activity.
  • BEPS implementation: The country must have committed to implement the (BEPS) minimum standards.

It is interesting to note that the reference to fair tax competition is reminiscent of the OECD’s 1998 Harmful Tax Competition which started the project to clamp down on global tax competition and which, some of us believe, was the starting point for a move towards global harmonized corporate and personal income taxes to prevent companies and citizens moving from high tax jurisdictions to lower tax ones.

The Dec. 5, 2017, press release added that in addition, “47 countries have committed to addressing deficiencies in their tax systems and to meet the required criteria, following contacts with the EU.”

It went on to say that this unprecedented exercise should raise the level of tax good governance globally and help prevent the large-scale tax abuse exposed in recent scandals such as the “Paradise Papers”.

In commenting on the development, Pierre Moscovici, Commissioner for Economic and Financial Affairs, Taxation and Customs, said: “The adoption of the first ever EU blacklist of tax havens marks a key victory for transparency and fairness. But the process does not stop here. We must intensify the pressure on listed countries to change their ways. Blacklisted jurisdictions must face consequences in the form of dissuasive sanctions, while those that have made commitments must follow up on them quickly and credibly. There must be no naivety: promises must be turned into actions. No one must get a free pass.”

The idea of an EU list was originally conceived by the EU Commission and subsequently taken forward by member states. Compilation of the list has prompted active engagement from many of the EU’s international partners. However, work must now continue as 47 more countries should meet EU criteria by the end of 2018, or 2019 for developing countries without financial centers, to avoid being listed. The Commission also expects member states to continue towards strong and dissuasive countermeasures for listed jurisdictions which can complement the existing EU-level defensive measures related to funding.

The EU stated that the listing process is a dynamic one, which would continue into 2018 and as a first step, a letter would be sent to all jurisdictions on the EU list, explaining the decision and what they could do to be de-listed. The release stated that the Commission and member states (in the Code of Conduct Group) would continue to monitor all jurisdictions closely, to ensure that commitments are fulfilled and to determine whether any other countries should be listed in the future. The EU list would be updated at least once a year.

The BOTS were given until the end of December 2018 to implement the economic substance requirements following in some cases, a truncated period of consultation with stakeholders including the private sector. The EU made it clear, despite there being no definition of what constitutes “economic substance,” that said requirements will apply to entities domiciled in the assessed jurisdictions which are engaged in a relevant activity. The latter includes the following types of activities being conducted by companies that would require economic substance and were defined in the background documents:

  1. Financing and leasing – an entity whose main or only activity is to earn income from leasing or financing activities, examples of which activities include agreeing funding terms; identifying and acquiring assets to be leased (in the case of leasing); setting the terms and duration of any financing or leasing; monitoring and revising any agreements; and managing any risks.
  2. Distribution and service center – an entity whose main or only activity is to earn income from (i) purchasing raw materials and finished products from other group members and re-selling them for a small percentage of profits or (ii) providing services to other entities of the same group, examples of which activities include transporting and storing goods; managing the stocks and taking orders; and providing consulting or other administrative services.
  3. Shipping – an entity whose main or only activity is to earn income from shipping activities, examples of which activities include managing the crew (including hiring, paying, and overseeing crewmembers); hauling and maintaining ships; overseeing and tracking deliveries; determining what goods to order and when to deliver them; and organizing and overseeing voyages.
  4. Headquarters – an entity whose main or only activity is to earn income from providing services such as managing, coordinating or controlling business activities for a group with which it is affiliated, whether for the group as a whole or for members of the group in a specific geographical area, examples of which activities include taking relevant management decisions; incurring expenditures on behalf of group entities; and coordinating group activities.
  5. Holding company – an entity whose main or only activity is to hold (i) one or more assets, not including intellectual property, from which income is earned (e.g. interest, rents, royalties) or (ii) equity participations from which dividends or capital gains are earned.

At the time of writing this article, the legislation in Anguilla was not enacted and a draft Bill was not even published. However, in the Cayman Islands a Bill was gazetted on Dec. 6, 2018, aptly titled: A Bill for a Law to Provide for an Economic Subtstance Test to be Satisfied by Certain Entities, and so I will use that to indicate what the likely outline of the economic substance requirements will be.

The Cayman bill demands, as required by the EU, that certain relevant entities, described above, satisfy an economic substance test. As per section 4(2), a relevant entity satisfies the economic substance test in relation to a relevant activity, if the relevant entity –

(a) conducts Cayman Islands core income generating activities in relation to that relevant activity;
(b) is directed and managed in an appropriate manner in or from within the Islands in relation to that relevant activity; and
(c) having regard to the level of relevant income derived from the relevant activity carried out in or from within the Islands – (i) has an adequate amount of operating expenditure incurred in or from within the Islands; (ii) has an adequate physical presence (including maintaining a place of business or plant, property and equipment) in the Islands; and (iii) has an adequate number of full-time employees or other personnel with appropriate qualifications in the Islands.

(3) A relevant entity complies with subsection (2)(b) if in relation to a relevant activity –

the relevant entity’s board of directors, as a whole, has the appropriate knowledge and expertise to discharge its duties as a board of directors;
meetings of the board of directors are held in the Islands at adequate frequencies given the level of decision making required;
during a meeting of the board of directors described in paragraph (b), there is a quorum of directors present in the Islands;
the minutes of the meetings of the board of directors described in paragraph (b) record the making of strategic decisions of the relevant entity at the meeting; and
the minutes of all meetings of the board of directors and appropriate records of the relevant entity are kept in the Islands.

(4) A relevant entity satisfies the economic substance test in relation to a relevant activity if its Cayman Islands core income generating activities in relation to that relevant activity are conducted by any other person and the relevant entity is able to monitor and control the carrying out of the Cayman Islands core income generating activities by that other person.

(5) A relevant entity that is only carrying on a relevant activity that is the business of a pure equity holding company is subject to a reduced economic substance test which is satisfied if the relevant entity confirms that – (a) it has complied with all applicable filing requirements under the Companies Law (2018 Revision); and (b) it has adequate human resources and adequate premises in the Islands for holding and managing equity participations in other entities.

(6) A relevant entity that is carrying on a relevant activity shall satisfy the economic substance test from the date prescribed.

(7) A relevant entity that is carrying on a relevant activity that is a high risk intellectual property business is presumed not to have met the economic substance test for a financial year, even if there are core income generating activities relevant to the business and the intellectual property assets being carried out in or from within the Islands, unless the relevant entity – (a) can demonstrate that there was, and historically has been, a high degree of control over the development, exploitation, maintenance, enhancement and protection of the intangible asset, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities within the Islands; and (b) provides sufficient information under section 7(4)(j) to the Authority in relation to that financial year to rebut this presumption.”

We will await the final enactment of the legislation in the various BOTS. I now turn to second element of the BEPS Action Points which I wish to discuss in detail as presaged earlier in this and the first part of this article.

The transfer pricing rules

Transfer pricing occurs whenever two companies that are part of the same multinational group trade with each other; e.g. when a U.S.-based subsidiary of Coca-Cola, for example, buys something from a French-based subsidiary of Coca-Cola. When the two companies establish a price for the transaction, this is called transfer pricing. If two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as “arms-length” trading, because it is the product of genuine negotiation in a market. This arm’s length price is usually considered to be acceptable for tax purposes.

However, when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimize the overall tax bill. This might, for example, help it record as much of its profit as possible in an offshore jurisdiction such as Anguilla which is a zero or low tax IFC. This is the basis of the problem with the current rules as seen by the OECD and tax administrators who believe that revenue authorities are being denied additional revenues as a result of manipulation of transfer pricing rules.

The new proposals regarding these rules are detailed and complex and far too wide-ranging to summarize in this article. Thus, I will focus mainly on the arm’s length principle which is the foundation of the rules. The new rules detail guidance that addresses the following matters related to transfer pricing:
“Issues related to transactions involving intangibles, such as intellectual property rights, since misallocation of the profits generated by valuable intangibles has contributed to BEPS [as argued by the OECD – this is covered in Action 8].

The contractual allocation of risks and the resulting allocation of profits to those risks which may not correspond with the activities actually carried out. This point also addressed the level of returns to funding provided by a capital rich MNE group member where those returns do not correspond to the level of activity undertaken by the funding [covered in Action 9].

Other high risk areas including the scope for addressing profit allocations resulting from transactions which are not commercially rational for the individual enterprises concerned, the scope for targeting the use of transfer pricing methods in a way which results in diverting profits from the most economically important activities of the MNE group, and neutralizing the use of certain types of payments between members of the MNE group (such as management fees and head office expenses) to erode the tax base in the absence of alignment with value creation.”(covered in Action 10)

The report contains revised guidance which addresses these issues and ensures that the transfer pricing rules secure outcomes that see operational profits allocated to the economic activities which generate them.

It calls for the revised guidance to “require careful delineation of the actual transaction between the associated enterprises by analyzing the contractual relations between the parties in combination with the conduct of the parties. The conduct will supplement or replace the contractual arrangements if the contracts are incomplete or are not supported by the conduct.” It notes that, “in combination with the proper application of pricing methods in a way that prevents the allocation of profits to locations where no contributions are made to these profits, this will lead to the allocation of profits to the enterprises that conduct the corresponding business activities.”

This would of course solve the BEPS issue on that point.

The report addresses circumstances where the transaction between associated enterprises lacks commercial rationality. The guidance continues to authorize the disregarding of these sorts of arrangements for transfer pricing purposes.

The revised guidance includes important clarifications relating to risks and intangibles. The report notes that: “the economic notion that higher risks warrant higher anticipated returns made MNE groups pursue tax planning strategies based on contractual re-allocations of risks, sometimes without any change in the business operations. In order to address this, the report determines that risks contractually assumed by a party that cannot in fact exercise meaningful and specifically defined control over the risks, or does not have the financial capacity to assume the risks, will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks.”

The report, with respect to intangibles like intellectual property rights, clarifies “that legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible. The group companies performing important functions, controlling economically significant risks and contributing assets, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return reflecting the value of their contributions.” This means that strategies like placing intellectual property rights in companies domiciled in low tax jurisdictions where no activity takes place will no longer work.

The report also provides that specific guidance will be given to ensure that the analysis of transfer pricing issues is “not weakened by information asymmetries between the tax administration and the taxpayer in relation to hard-to-value intangibles, or by using special contractual relationships, such as a cost contribution arrangement.”

The revised guidance addresses the situation where: “a capital-rich member of the group provides funding but performs few activities. If this associated enterprise does not in fact control the financial risks associated with its funding (for example because it just provides the money when it is asked to do so, without any assessment of whether the party receiving the money is creditworthy), then it will not be allocated the profits associated with the financial risks and will be entitled to no more than a risk-free return, or less if, for example, the transaction is not commercially rational and therefore the guidance on non-recognition applies.”

In other words, a capital-rich member of a group located in a low tax jurisdiction will not be able to fund other associated enterprises, take no risks, but then expect to have all the profits repatriated to it where said profits are not taxed. The new rules will demand that the companies which take the risks, irrespective of the jurisdiction in which they are domiciled, gain the profits which will not be able to be shifted to a low tax or other jurisdiction.

Finally, the guidance ensures that: “pricing methods will allocate profits to the most important economic activities. It will no longer be possible to allocate the synergistic benefits of operating as a group to members other than the ones contributing to such synergistic benefits.” The overall thrust of the guidance is to ensure that there is an alignment of transfer pricing outcomes “with value creation, including in the circumstances of integrated global value chains.”


This two-part article only addressed two of the fifteen reports designed to address the BEPS issue. The issues raised here cannot be understood in isolation however and the other action points mentioned above all work together to address the concerns of the OECD. However, from this discussion of the PE and Transfer Pricing points as well as the EU economic substance proposals, it is clear that substance is essential to the new regime.

Substance herein refers to not only to persons such as independent agents or physical locations which now qualify as PEs subject to what was said above but also the creation of economic value and the activities linked to such creation including where intangibles are concerned. It is these persons, locations and activities which will determine where taxing rights lie as opposed to where the corporate entities are domiciled. Tax advisors and others involved in planning and minimization need to understand then that if they are to take advantage of the zero or low rates in jurisdictions such as Anguilla and elsewhere that not only must the corporate domicile be located therein but economic activity, value creation and mind and management must also be located there also.

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Carlyle K Rogers

Carlyle K Rogers MBA, LLM is a barrister-at-law in Anguilla who practices in the areas of corporate and financial services law. He is also admitted in the BVI and New Zealand, owns and manages the Stafford Group of Companies.  He studied law in London at Queen Mary and Westfield College, University of London, where he obtained an LLB (Hons) degree in 2001 and with the University of London (International Programme) from which he obtained an LLM degree in Corporate and Commercial Law in 2005. He completed the Legal Education Certificate (LEC) at the Hugh Wooding Law School in Trinidad in March 2013 and was admitted as a barrister of the Eastern Caribbean Supreme Court in Anguilla and BVI in 2013. 

Carlyle K Rogers MBA, LLM
Stafford Group of Companies
201 The Rogers Office Building
Edwin Wallace Rey Drive
George Hill, Anguilla

T: 1 264 498 5858 + 1 264 498 5858 ; + 1 954 607 7239/7217
C: 1 264 476 5858 + 1 264 476 5858
F: + 1 264 497 5504
E: [email protected] 


Stafford Corporate Services

Stafford Group of Companies
201 The Rogers Office Building
Edwin Wallace Rey Drive
George Hill

T: 1 264 498 5858
T: + 1 264 498 5858
T: + 1 954 607 7239/7217
C: 1 264 476 5858
C: + 1 264 476 5858
F: + 1 264 497 5504 
E: [email protected]