Uncertainty remains despite new economic substance rules

Substance legislation passed by lawmakers in December 2018 has laid down the parameters for the way Cayman is responding to pressure by the European Union to reform its tax regime, but many questions remain about the economic impact of the new framework.

In response to the threat of an EU blacklisting, the new law requires companies and limited liability partnerships that are registered and managed locally and generate income in one of nine defined activities to demonstrate that they have enough economic activity on island to justify the profits they make.

In drawing up gray- and blacklists of countries and their cooperation in tax matters, the EU has taken aim at tax structures used by multinational companies to divert profits to jurisdictions with little or no corporate income tax, if the companies have no management, employees or offices there.

To ensure that profits are taxed where they are generated and economic activity is taking place, the new legislation imposes a substance test on banking, insurance, fund management and shipping companies, as well as entities functioning as headquarters or distribution and service centers, and businesses engaged in financing and leasing or holding intellectual property.

Resident companies that generate core income in these fields must pass the economic substance test from July 1.

They will do so, if they conduct core income-generating activities on island; incur an adequate amount of operating expenditure in Cayman; have a physical presence locally; and have an adequate number of full-time staff. In addition, the company must be directed and managed from Cayman with regular board meetings held and minutes of strategic decisions kept on island.

Holding companies will face a reduced test for economic substance. So-called high-risk intellectual property holding companies, on the other hand, are subject to more onerous requirements. The new rules effectively force these businesses to demonstrate that they had a high degree of control over the development and exploitation of the intellectual property asset they hold, even if they already have economic substance locally.

Relevant companies must file a report with the Tax Information Authority each year. If the authority deems that the company has not passed the substance test, it has the power to issue a penalty of $10,000. If the substance test is failed again in the subsequent year, the penalty increases to $100,000 and the company can be struck off.

What is the impact?

The economic impact of the measure is not clear. Some speculate the new rules would lead to an influx of workers hired by companies forced to demonstrate substance. Others predict an exodus of companies that do not want to bear the additional costs.

Paul Byles, director of FTS Consulting, says ultimately the impact will be determined by the extent to which other jurisdictions are implementing similar legislation, as well as the details of the guidance notes and regulations. These will give a better idea of the additional compliance costs associated with reporting.

“There is a potential positive economic impact locally, and this needs to be compared to the ultimate costs associated with implementation, which will be clearer later down the line,” he says. “Given what is expected to be widespread adoption of these changes as a global standard, the Cayman Islands will likely continue to do very well while adhering to the standard.”

Industry body Cayman Finance believes the additional compliance is just part of doing business and clients will take the changes in their stride, while some offshore law firms say they assume the substance legislation contains sufficient carve-outs and loopholes to have any significant impact. Several law firms advised that they expect few of their clients to be impacted in Cayman or any of the other territories that had to enact similar legislation.

Certain industries that already have a substantive presence in Cayman, like banking and insurance are also unperturbed. Erin Brosnihan, chair of the Insurance Managers Association of Cayman, says: “We have no significant concerns over our ability, as an industry, to meet the substance requirements.”

Premier Alden McLaughlin told fellow members of the Legislative Assembly in December, “Companies that are here in an attempt to circumvent tax obligations elsewhere will have a choice: They can go back to onshore jurisdictions with direct taxation or they can increase their level of substance in Cayman.”

According to Premier McLaughlin, exact data is not available but rough estimates suggest up to 20,000 companies could fall under the law.

If this number is correct, the worst-case scenario is a loss of tens of millions of dollars in annual fees to government and local service providers, should these companies decide to leave.

Part of the problem of quantifying the effect is that the legislation that forces companies to have enough economic activity in Cayman is left deliberately vague by including terms like “adequate” and “appropriate.”

The idea is that each company’s situation is unique, and the new rules must therefore be flexible. There would thus be no one-size-fits-all approach.

The unique circumstances of each business have of course never stopped tax systems from applying uniform tax rates to all companies with exceptions and deductions clearly spelled out.

The key question remains: what is adequate?

How much substance does a business need to have to justify a profit of, say, $1 million to be taxed, or rather not taxed, in the Cayman Islands? How much for $10 million?

In one of its reports, the OECD has given examples of how substantial activity factors could be applied. For relevant entities engaged in financing and leasing, a regime could, for instance, require “at least EUR 5 million in annual business spending.” For a company that serves as a headquarter, the report mentions a minimum business expense of “EUR 3 million.”

Although the amounts were only used for illustrative purposes and “not intended to set minimum standards,” they give an idea of what the OECD believes is realistic business activity.

If the regulations released by the Channel Islands in December for their own set of economic activity rules is anything to go by, Cayman’s as yet unpublished regulations are unlikely to provide more detail or set any minimum standards.

Even if they did, a conflict with the EU about what is or is not adequate economic substance appears to be almost inevitable.

This uncertainty is a significant threat to the optimistic scenario that companies without much economic activity would now invest in Cayman, open offices and hire new employees.

Much ambiguity stems from the fact that, until now, a substance test did not exist anywhere in common law or the corporate world, as Tony Travers, senior partner at Travers Thorpe Alberga, writes in the International Financial Review.

“All international transactions routed in and through the Cayman Islands involve the structuring of intangibles whether equity, debt, a hybrid or derivate,” he notes. Giving the example of a billion dollars transferred by a computer keystroke, Travers says, “Under no recognized system of law or accounting principle is the validity of that transfer measured or tested by reference to the size of the building in which the computer is housed, nor the number of employees required to effectuate the keystroke.”

If that were the test, many onshore and offshore financial centers would not meet it, he says.

“This is then simply a ‘test,’ perniciously and transparently designed politically to advance the EU’s extraterritorial claims over global financial services at the expense of the legitimate offshore financial center; it is impossible to conclude otherwise,” Travers states.

Once established, he argues, the economic substance test “will surely be ratcheted up over time to the point where, as is intended, the compliance cost is unacceptable to the clients and the offshore financial center fails.”

Why do all substance legislations look the same?

Although there are subtle differences in the various newly introduced substance legislations in Cayman, Bermuda, the BVI and the Channel Islands – for instance, Cayman’s legislation applies only to companies and limited liability partnerships but not to funds and partnerships – the principles and defined activities are the same.

This is because Cayman and other territories based their legislation on the work of the OECD Forum on Harmful Tax Practices (FHTP) which seeks to eliminate harmful preferential tax regimes. These are regimes that apply tax incentives or concessions to taxpayers, who are engaged in operations that are purely tax-driven and involve no substantial activity.

For most of last year, the EU was not clear about the type of economic activity rules it wanted offshore centers like Cayman, the BVI, Bermuda or the Channel Islands to implement in their local legislation.

The EU claims this group of territories had failed one of its tax blacklist tests – criterion 2.2. It stipulated that jurisdictions “should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction.”

Then in a report by its Code of Conduct Group for business taxation, the EU endorsed the rules developed by the FHTP, for its own blacklist.

The report included a scoping paper in which the Code of Conduct Group states that the substance requirements in the “2.2 jurisdictions” should mirror those used by the FHTP in the context of specified preferential regimes.

This is significant because Cayman’s tax regime does not fulfil the OECD definition of “preferential.”

According to the OECD, a preferential tax regime “must be preferential in comparison with the general principles of taxation in the relevant country, and not in comparison with principles applied in other countries. For example, where the rate of corporate tax applied to all income in a particular country is 10 percent, the taxation of income from mobile activities at 10 percent is not preferential, even though it may be lower than the rate applied in other countries.”

This is clearly the case in the Cayman Islands where the same income tax rate of zero is applied universally.

The EU thereby forced Cayman and other “2.2 jurisdictions” to apply rules developed for a narrowly defined band of harmful preferential tax regimes to all relevant resident companies, even though they clearly do not fall within the scope of the FHTP.

In other words, the entire tax regimes of Cayman and other zero- or low-tax countries are treated as “harmful.”

The EU and the OECD justified this by stating that countries that used preferential tax regimes had complained that their business could move to low-tax jurisdictions.

“The need for this approach has been underlined by some members of the Inclusive Framework which are now adding substantial activity requirements to their preferential regimes and have expressed concern that they may be at a competitive disadvantage if taxpayers relocate to a zero-tax jurisdiction rather than comply with the new requirements,” the scoping paper said.

This is why, in May 2018, the OECD Base Erosion and Profit Shifting Project started to apply the substance requirements developed for harmful preferential tax regimes, the so-called BEPS Action 5, to all “no or nominal tax jurisdictions.”

This means that mobile business income cannot be parked in a zero-tax jurisdiction if no core business functions are undertaken there, the OECD said.

Is it going to be global?

The OECD, the Cayman Islands government and Cayman Finance say that because there are more than 120 members of the BEPS Inclusive Framework committed to implementing minimum standards to fight base erosion and profited shifting, this had elevated the substance rules to a global standard. The OECD is already conducting peer reviews and will potentially release its own blacklist on the matter.

Yet, there is some concern that not all members will implement substance legislation in the same way.

Hong Kong, as an associate of the BEPS Inclusive Framework, for instance, enacted transfer pricing legislation in July 2018 which will include greater requirements for substance.

It introduced a new provision that gives the Inland Revenue Department Commissioner the power to set substance thresholds for determining eligibility under certain profit tax concessions (i.e., for professional reinsurers, captive insurers, shipowners, aircraft lessors and aircraft leasing managers). A stakeholder consultation about the content of the substance thresholds is yet to take place.

It is important to note that most countries will apply the substance requirements only to preferential or concessionary tax regimes, i.e., relevant companies that are subject to very small parts of their tax systems. Nominal or no tax jurisdictions, however, must now apply it to all relevant resident entities within their tax regime.

There is no doubt that the resulting compliance burden is much greater in no- or low-tax jurisdictions.

What’s next?

Relevant companies without any substance will have a decision to make. Are they going to develop economic activity in Cayman, are they going to outsource operations to local service providers, or are they simply shutting down their Cayman business and moving elsewhere?

Effective tax rates are only a small part of this equation. Much will depend on the level of economic activity required and the ability to locate substance in Cayman.

In the debate of the legislation, both Financial Services Minister Tara Rivers and Premier McLaughlin warned that passing the substance legislation will not be the end but just the beginning of a continuous process.

Comments by German member of the European Parliament Sven Giegold show what the next regulatory target might be. The BBC reported in December that Giegold welcomed the introduction of substance laws in the Channel Islands but added that as long as they maintain zero percent tax rates, the Channel Islands will attract firms seeking to shift their profits.

The release of a tax blacklist by the Netherlands on Dec. 29 underlines that point. The Netherlands already applied substance requirements for withholding tax exemptions on dividend payments made by Dutch entities. Its new list goes much further than the EU blacklist by containing any jurisdiction, including Cayman, that has a corporation tax of less than 9 percent or no corporation tax at all.

It is the logical continuation of treating zero-tax jurisdictions in the same way as harmful preferential tax regimes.

Now that the substance legislation is in place, the danger is that it will be easier for the EU to demand ever greater substance requirements until it potentially becomes too costly or unfeasible to operate offshore. If that fails, the Dutch approach of imposing withholding taxes on specific cross-border transactions with entities in countries that have zero or low corporation tax rates could be the next step.