Where the rules came from
For decades, many companies in international financial centres had a registered office and a registered agent, and very little else, in the place where they were incorporated. Their directors, staff and decision making sat elsewhere. International bodies, including the OECD through its work on harmful tax practices and the European Union through its listing process for non-cooperative tax jurisdictions, pressed low or no tax jurisdictions to make sure that companies earning certain types of income actually had a real presence there.
The response was a wave of economic substance legislation. The Cayman Islands and the British Virgin Islands both introduced economic substance laws in 2019. Other centres, including the Crown Dependencies of Jersey, Guernsey and the Isle of Man, as well as Bermuda, the Bahamas and several others, adopted similar rules around the same time. The laws differ in detail from one jurisdiction to the next, but they share a common structure.
The core idea
The basic idea is simple. If an entity registered in the jurisdiction carries on a relevant activity and earns income from it, the entity must show that it has adequate substance in the jurisdiction for that activity. Substance is measured by a series of tests, usually covering:
- Direction and management. Whether the entity is directed and managed in the jurisdiction, for example through board meetings held there with a quorum of directors physically present, and with minutes kept there.
- Core income generating activities. Whether the activities that actually produce the income are carried out in the jurisdiction.
- People. Whether there are adequate qualified employees in the jurisdiction, whether employed by the entity or provided by a local service provider.
- Premises. Whether there are adequate physical premises.
- Expenditure. Whether there is adequate operating expenditure in the jurisdiction, proportionate to the activity.
The word adequate appears again and again. The rules do not set a fixed number of staff or a minimum spend that applies to everyone. What is adequate depends on the nature and scale of the activity, and guidance issued in each jurisdiction explains how the authorities approach it.
Relevant activities in general terms
Each jurisdiction lists the activities that bring an entity within scope. The lists are similar across Cayman, the BVI and the Crown Dependencies, and commonly include:
- Banking business.
- Insurance business.
- Fund management business.
- Financing and leasing business.
- Headquarters business.
- Shipping business.
- Distribution and service centre business.
- Intellectual property business.
- Holding company business, often limited to pure equity holding.
Each term is defined in the legislation and guidance, and the definitions matter. For example, financing and leasing business generally covers providing credit for consideration, but there are carve-outs and nuances. Distribution and service centre business typically concerns buying goods from or providing services to group companies and reselling them. A company may carry on more than one relevant activity and must then meet the test for each.
Entities that do not carry on any relevant activity are generally outside the substantive tests, although they still usually have to file a notification saying so. Investment funds have typically been treated as outside the main requirements in Cayman and the BVI, though their managers may be in scope.
Pure equity holding and intellectual property
Two categories receive particular treatment.
Pure equity holding entities, meaning entities that only hold equity participations in other entities and earn only dividends and capital gains, usually face a reduced substance test. In broad terms, they must comply with their corporate filing obligations and have adequate people and premises for holding and managing their equity participations. Many holding companies meet this through their registered agent or corporate services provider. Once a holding company starts lending to subsidiaries, providing services or earning other income, it may move into a different category.
High risk intellectual property business attracts the strictest scrutiny. Where an entity holds intellectual property that was not developed in the jurisdiction and earns income from it, the rules may presume that it fails the test unless it can show a high degree of control and real activity locally. Authorities may also share information about such entities with the tax authorities of the countries where the parent and ultimate owners are resident.
Reporting and enforcement
Entities report on their substance position each year, usually through their registered agent or corporate services provider, to the competent authority in their jurisdiction. The report typically identifies whether the entity carries on a relevant activity, and if so provides information on its income, expenses, employees, premises and board meetings for the period.
An entity that claims to be tax resident in another jurisdiction may be able to show that instead of meeting the local test, with evidence such as a tax residence certificate. The details of what evidence is accepted vary.
Authorities can impose penalties for failing to report or failing to meet the test, and repeated failures can lead to further sanctions, including striking off. Information may also be exchanged with foreign tax authorities. Because the penalties and processes are set out in each jurisdiction's legislation and change from time to time, they are not summarised here. Take local advice on your obligations.
Why banks and payments providers ask about substance
Economic substance laws are not anti money laundering laws, and a payments provider does not enforce them. Providers still ask about substance, for a few practical reasons.
- Consistency with the business description. If a company says it is a pure equity holding entity for substance purposes but its account shows regular trading income, either the substance filing or the business description is wrong. Either way, the provider needs to understand which.
- Understanding where the business is run. Substance answers tell the provider where the directors sit, where the staff are and where decisions are made. That shapes the provider's view of the company's real geographic risk.
- Regulatory standing. A company that has failed to file or has been penalised may be heading for strike off. The provider needs to know whether the company will still exist in a year.
- Tax transparency. Providers in many countries have international tax reporting obligations and want to understand where an entity is tax resident.
In short, a clear substance position makes a company easier to understand, and a company that is easy to understand is easier to service.
Answering substance questions at onboarding
A payments provider will usually ask a small number of questions about substance. Prepare short, factual answers to each.
- Whether the entity carries on a relevant activity under the law of its jurisdiction, and if so which one.
- If it does, how it meets the substance test. Name the local directors, the service provider supplying staff or premises, and where board meetings are held.
- If it is a pure equity holding entity, confirmation that it only holds equity and earns only dividends and gains.
- If it claims tax residence elsewhere, the country concerned and the tax residence certificate.
- Confirmation that the latest annual substance report or notification has been filed.
Keep the answers short. A provider is not asking for a legal opinion, and a long memorandum can raise more questions than it answers. One or two sentences per point, backed by a document where one exists, is usually right.
Supporting evidence can include a letter from the registered agent confirming filing, board minutes showing meetings in the jurisdiction, a service agreement with a local provider, or extracts from the substance report. Do not send more than is needed, but make sure what you send is consistent with the rest of the file.
Three short examples
A Cayman fund. The fund itself is an exempted company and is typically outside the main substance requirements as an investment fund. Its investment manager is a company in another country that is regulated there. The provider's questions focus on the fund's regulatory status and the manager's licence, with substance a minor point.
A BVI holding company. The company holds shares in three operating subsidiaries in Asia and earns only dividends. It reports as a pure equity holding entity through its registered agent, which provides the required premises and people. When it opens an account, it confirms this and supplies the agent's confirmation. Later it begins lending to a subsidiary, at which point it takes advice on whether its category has changed and updates its provider.
An Isle of Man service company. The company employs staff on the island who provide marketing and support services to group companies. It carries on a relevant activity and meets the test through its local office and employees. Its substance position is easy to explain, and the provider's attention turns to the group's wider business.
When the activities of an entity change
Substance is assessed on what an entity actually does in each financial period, so a change in activity can change the entity's obligations. Common triggers include a holding company starting to lend to subsidiaries, a dormant company beginning to trade, a group moving the ownership of brands or software into an existing entity, or a fund manager taking on new mandates.
When one of these happens, two things should follow. First, the group should take advice on whether the entity's category has changed and whether it now needs local directors, staff or premises. Second, it should tell its payments provider that the business has changed, with a short note of the new activity and the expected effect on payments. Providers monitor accounts against the profile given at onboarding. A holding company that suddenly starts receiving interest from subsidiaries, or royalties from third parties, will look different in the provider's monitoring, and an advance explanation avoids payments being held while questions are asked.
The same applies in reverse. If an entity winds down an activity and becomes a pure holding company, update the provider so that its risk profile reflects the simpler business.
General information only
This article gives general information about economic substance rules and their effect on banking and payments. It is not legal or tax advice. The rules differ by jurisdiction and change over time, so take advice from practitioners in the relevant jurisdiction. CCYFX does not advise on substance, but understanding your position helps when onboarding. See our international companies page for how CCYFX works with companies from international financial centres.
