Economic substance has become a major buzzword for companies doing business in other countries – but many South African companies have yet to make the necessary adjustments to their international structure to ensure compliance, more than 18 months after the regulations came into force.
This warning comes from Sovereign Trust’s Rone Silke, who says companies that do not comply with economic substance regulations face the risk of fines or even de-registration.
The economic substance requirements are a result of the European Union’s strategy to ensure effective taxation. This allows the EU to recognise and identify jurisdictions not practicing good tax governance, and which are seen as high-risk jurisdictions for tax avoidance. As a result, companies operating in certain jurisdictions must prove that they are operating legitimately, and not as a tax avoidance mechanism.
“At the core of economic substance is the actual activity and effective role that a company plays in a foreign country. The key question is this: does your foreign company have proper substance in the jurisdiction where it has been incorporated, or where the company is tax resident, or is it merely an empty shell to house a foreign business, from which you reap the benefits?” says Silke.
The process started in 2017, when the EU assessed 92 non-EU countries against three key factors: tax transparency, fair taxation, and compliance with the OECD’s anti-base erosion and profit shifting (BEPS) action plan. The aim was to determine if these jurisdictions were facilitating foreign structures or arrangements aimed at attracting profits that did not reflect real economic activity.
The countries listed included Guernsey, the Isle of Man, Jersey, the Turks & Caicos Islands, the United Arab Emirates, the British Virgin Islands, the Cayman Islands and the Bahamas. To move off the EU ‘grey list’, many of these jurisdictions committed to introduce substance legislation and regulations by December 2018, with the new EU regulations coming into effect in January 2019.
“Although each jurisdiction has its own variation of substance legislation, the core principles remain the same. Economic substance requirements apply to companies carrying out ‘relevant activities’ in these jurisdictions, including holding companies, intellectual property, distribution and service centres, banking, fund management, finance and leasing,” says Silke.
The three key stages of the EU requirements are:
- Is the company a tax resident company?
- Does it conduct a relevant activity?
- Does it pass the adequacy test?
“The test looks at whether the company is being directed and managed in the applicable jurisdiction, if its core income generating activities (CIGA) are conducted in the jurisdiction, and if the company has adequate personnel, premises and expenditure in the jurisdiction concerned,” says Silke.
Once substance is established in a certain jurisdiction, the company must then file an annual substance report with the relevant authority. The consequences of non-compliance with substance requirements differ from country to country, but include fines, removal from the register, or even imprisonment for failure to pay fines.
“If your company provides a relevant activity, but fails to create local substance, then it may be that the company would benefit from being tax resident in another jurisdiction,” she says.
Sovereign Trust (SA) Limited can assist with a ‘health check’ on your structure. If you would like more information, please contact Sovereign.