Economic substance - application to trust structures
The underlying purpose of the rules is to stop businesses moving profits to low tax jurisdictions where little activity takes place.
The rules were introduced with effect from 1 January 2019 for all entities in the Crown Dependencies and for new entities in Bermuda, the BVI and the Cayman Islands. In Bermuda and the BVI existing entities have until 30 June 2019 to comply (and in the Cayman Islands until 1 July 2019).
The rules in the various jurisdictions are wide reaching and trust structures are potentially caught in the cross-fire. Now that detailed guidance has been issued in most of the jurisdictions, we are able to identify aspects of the legislation that are most relevant to trust structures and should be a focus of trustees in the coming months. Guidance is still awaited in Bermuda but is expected to be published soon.
This note sets out fundamental principles of the economic substance legislation, how the rules may apply to trust structures in the different jurisdictions and important differences between the jurisdictions.
What does the legislation apply to?
The legislation for all of the jurisdictions mentioned above specifies that if an entity (broadly a company, partnership or a limited liability company) is carrying out a “relevant activity” it must be able to demonstrate substance in the jurisdiction in question.
The relevant activities are: insurance, fund management, finance and leasing, headquarters, shipping, intellectual property, distribution and service centres and holding entity. Of these, the most relevant to trust structures will most likely be "holding entity" and "finance and leasing". The relevant activities of "shipping" and "headquarters" may also be relevant.
If the legislation applies to an entity, the “full” economic substance requirements are having “adequate” employees located in the jurisdiction, “adequate” premises, demonstrating that the entity is managed and directed from the jurisdiction and that it performs “core income generating activities” in the jurisdiction. However, it should be noted that some entities qualify for “reduced” economic substance requirements (explained in detail below).
The following are key concepts common among the legislation in the various jurisdictions.
The concept of tax residence is important in the economic substance legislation. There are key differences between the different jurisdictions as to how this concept is utilised.
- BVI and Cayman Islands - Entities are only caught by the BVI and Cayman Islands legislation if they are incorporated there (or if they are a foreign company that is registered as such) and tax resident in the jurisdiction. If a BVI or Cayman Islands company is claiming to be tax resident in another jurisdiction it will need to provide evidence of this to the respective authorities (for example, a tax demand notice).
- Crown Dependencies - The legislation in the Crown Dependencies applies to all entities that are tax resident there, regardless of where they are incorporated. For example, a BVI incorporated company that is tax resident in Guernsey would need to comply with the Guernsey legislation (and not the BVI legislation).
- Bermuda - As originally drafted, the Bermuda legislation applied to all Bermuda incorporated entities (or overseas companies that require a permit to carry out a trade or business in Bermuda) regardless of where they are tax resident.
However, on 21 June legislation was passed in Bermuda to amend the relevant provisions so that entities that are tax resident in another jurisdiction will be outside the scope of the Bermuda legislation. Supporting evidence of the entity’s tax residence will need to be provided to the Bermuda authorities.
Whether a company is tax resident in a certain jurisdiction will depend on the relevant criteria in that jurisdiction. However, care should be taken if a company is incorporated in one jurisdiction and administered in another (which is a common occurrence). It may be that the company simply being administered in another jurisdiction is not sufficient to make it tax resident there, and instead it remains tax resident in its jurisdiction of incorporation (or elsewhere, depending on its other offshore activities). If so, because the company is having administration functions performed in a different location to where it is technically tax resident it may struggle to meet the economic substance requirements in that jurisdiction.
Carrying out a business as a holding company is a relevant activity in all of the jurisdictions. This is likely to be the most important category for trustees to consider.
Fortunately, the relevant legislation in all of the jurisdictions provides that “pure equity holding companies” (i.e. companies that only hold equity participations in other companies and only earn dividends or capital gains) qualify for “reduced” economic substance requirements.
These reduced requirements are that the entity:
- complies with the corporate governance requirements in the relevant jurisdiction; and
- has “adequate” employees and premises for holding and managing equity participations.
However, there are some important distinctions between the different rules.
- BVI and Cayman Islands - Only “pure equity holding companies” (as described above) are within scope and the guidance helpfully confirms that an underlying company in a trust structure which holds a broad investment portfolio including, for example, some shares in other companies but also bonds or cash, will be outside the scope of the legislation. In addition, a holding company which holds other assets (for example, an art collection or a property) will not need to comply.
If the entity is a “pure equity holding company”, maintaining a registered office in the BVI/Cayman Islands and the performance of services by a registered agent may be sufficient to satisfy the “reduced” economic substance requirements.
- Crown Dependencies - Only “pure equity holding companies” are within scope of the legislation. In addition, to be categorised as a “pure equity holding company” in the Crown Dependencies, the company must hold “controlling” stakes in its underlying companies.
Therefore, a typical holding company in a trust structure which is a sole shareholder of various other underlying companies would be within scope and will need to comply with the reduced requirements. However, an investment holding company which holds a normal portfolio of investments including some shares in other companies (none of which are controlling interests) would not be within scope. A holding company which holds other assets (for example, an art collection or a property) will also not need to comply.
Further guidance is to be published in the Crown Dependencies concerning the reduced requirements for pure equity holding companies.
- Bermuda - There are separate concepts of “holding entity” and “pure equity holding entity” in the Bermuda legislation.
- A “holding entity” is one that engages in activities including “holding or managing any assets or equity participations”. A holding entity will be subject to the “full” economic substance requirements.
- A “pure equity holding entity” is an entity that “holds or manages equity participations, and earns passive income from dividends, distributions, capital gains and other incidental income only”. Such an entity will be subject to the “reduced” requirements, as set out above.
We understand that the Bermuda legislation may be amended in the future so that only pure equity holding entities are within scope. However, in the meantime it appears that a company that owns an asset which is not an equity participation (for example, a property or artwork), or a company holding equity participations and other assets, will need to fulfil the “full” economic substance requirements. This is also the case if a company holds a broad investment portfolio that holds not only shares in other companies, but also for example bonds, cash or gold.
Finance and leasing
The relevant activity of “finance and leasing” should also be considered in relation to trust structures where an underlying company provides lending to other entities in the structure. The rules in the different jurisdictions can be summarised as follows:
- BVI and Cayman Islands - “Financing and leasing business” means the business of providing credit facilities for any kind of consideration (including interest) to another person. However, an entity that provides credit as an incidental part of a different sort of business will not be treated as carrying on a finance and leasing business. It is only when the provision of credit can be seen to be a business activity in its own right that the entity will be treated as a finance and leasing business.
Therefore, unless the provision of credit is the sole (or main) activity of an underlying company in a trust structure, it would not appear to be carrying on this relevant activity. So, if an underlying company made loan(s) to a beneficiary of the trust structure, we assume this would not be in scope unless such loans are the sole or main activity of the relevant company.
- Crown Dependencies - This encompasses any company which offers credit or financing of any kind “for consideration” (for example, interest is charged), including intra-group financing. It therefore appears that interest bearing loans to beneficiaries will be within scope. If the company is performing the activity of “financing and leasing”, the “full” economic substance requirements must be fulfilled (as set out above). If the loans are not for consideration (for example, they are interest free) the company would not be classed as a “finance and leasing” company.
- Bermuda - Financing means providing funds, other than by way of subscription for shares or other equity contributions, for the business activities of one or more other entities (whether or not affiliated). Until the publication of guidance in Bermuda, it is difficult to state whether this will apply to an underlying company providing funding to another entity in a trust structure, but it may do. We assume that loans to individual beneficiaries would not be in scope.
Other relevant activities
The relevant activities of headquarters and shipping should also be considered in the context of a trust structure:
- Headquarters - A holding company in a trust structure could be acting as a headquarters if it engages in the management and administration of its affiliates. The BVI, Cayman Islands and Crown Dependencies guidance all confirm that this would comprise providing the following services to an entity in the same group: the provision of senior management; the assumption or control of material risk for activities carried out by those entities; or the provision of substantial advice in connection with the assumption or control of risk. It may therefore be of relevance in certain trust structures, for example, those which hold trading companies.
- Shipping - This should be considered if an underlying entity in a trust structure holds yachts that are either chartered out or used by beneficiaries.
However, in the BVI and Cayman Islands holding a yacht is unlikely to bring an entity within scope. The BVI guidance confirms that pleasure vessels (as defined in the Merchant Shipping Act 2001) are not caught, and the Cayman Islands guidance confirms that a company owning a pleasure vehicle which is used for private use and occasionally chartered out to defray costs would not be within the scope of the legislation. Care should be taken, however, if the yacht is chartered out with a view to making profit.
Guidance on shipping is awaited in the Crown Dependencies and Bermuda.
Timing and filing requirements
As mentioned above, the rules were introduced with effect from 1 January 2019 for all entities in the Crown Dependencies and for new entities in Bermuda, the BVI and the Cayman Islands. In Bermuda and the BVI existing entities have until 30 June 2019 to comply (and in the Cayman Islands until 1 July 2019).
In some of the jurisdictions (such as Bermuda, BVI and the Cayman Islands) the guidance indicates that all companies incorporated in those jurisdictions must file economic substance information annually, even if it is to declare that the rules do not apply to the entity (either because it is not carrying out a relevant activity, or it is not tax resident in the jurisdiction). In the Crown Dependencies tax resident companies will need to give information on their activities as part of the normal corporate income tax returns to determine if economic substance requirements apply, and if they do whether they have been met.
Failure to comply results in automatic penalties (which differ across the jurisdictions), and potentially the striking off of the entity.
Given the potentially wide application of these rules trustees should be reviewing trust structures they manage. We would recommend that the following steps are taken.
- Identify underlying entities in trust structures that are either incorporated or tax resident in jurisdictions that have passed economic substance legislation. As noted above, it will be important to look carefully at entities which are incorporated in one jurisdiction but which are administered (but not tax resident) elsewhere.
- If the rules potentially apply, take advice from local advisers in relation to those entities and the requirements. It may well be that an entity’s existing arrangements are sufficient to meet the requirements but this should be checked.
- If entities that are potentially affected are dormant (or have minimal assets) consider liquidating these entities now in order to avoid filing requirements and potential automatic penalties (although the economic substance requirements will still need to be complied with during the liquidation process).