The Governments of the Crown Dependencies have published draft legislation that will require resident companies carrying on certain activities to have "adequate substance" in their jurisdictions. This will require most affected companies to be managed and directed, and to have adequate employees, expenditure and physical presence, in the jurisdiction and to conduct their core activities there.
The draft legislation includes robust sanctions for failure to comply with the substance requirements, including fines, information sharing and ultimately striking off the offending company.
This note analyses some of the main provisions by answering the key questions that we expect our clients to have on the new legislation.
The EU Code of Conduct Group (the Code Group) assessed the tax policies of various countries in 2017. The Code Group confirmed Jersey, Guernsey and the Isle of Man's status as cooperative jurisdictions but noted that the absence of a clear statutory "substance" requirement in those jurisdictions might increase the risk of profits registered in one of those jurisdictions not reflecting economic activities there.
The Government of each jurisdiction gave a commitment to address the Code Group's concerns by the end of 2018, and the Code Group included each of the Crown Dependencies in its list of jurisdictions that raised economic substance concerns but had made appropriate commitments to address them.
After 12 months of close engagement between the Crown Dependencies and various international bodies, including the Code Group and the OECD, the Governments of the Crown Dependencies have now published draft legislation (the Draft Legislation), namely:
- the Income Tax (Substance Requirements) Order 2018 in the Isle of Man;
- the Income Tax (Substance Requirements) (Implementation) Regulations, 2018 in Guernsey; and
- the Taxation (Companies - Economic Substance) (Jersey) Law 201- in Jersey.
Are All Corporate Taxpayers Subject to the Substance Requirements?
The substance requirements introduced by the Draft Legislation apply only to corporate taxpayers that are "resident companies".
In Jersey, residence is determined by reference to the Income Tax (Jersey) Law 1961 as amended and includes non-Jersey companies managed and controlled in Jersey. Residence in Guernsey is determined in similar fashion to Jersey with reference to the Income Tax (Guernsey) Law, 1975, as amended.
Unlike in Jersey and Guernsey, this term is not specifically defined in Isle of Man tax legislation.
Companies incorporated in the Isle of Man will have to comply with the substance requirements unless they meet the criteria in section 2N(2) of the Isle of Man Income Tax Act 1970 (the Act). A foreign company could also be Isle of Man tax resident if it is centrally managed and controlled in the Isle of Man, and any such company would also be subject to the substance requirements.
Certain types of entity will not be subject to the substance requirements, including partnerships and foundations.
Are All Resident Companies Subject to the Substance Requirements?
A resident company is not automatically subject to the substance requirements. The substance requirements apply only to resident companies that, in the case of the Isle of Man, derive income from a "relevant sector" or, in the case of Guernsey, derive income from carrying on "relevant activities" or, in the case of Jersey, carry out certain business in a relevant sector (relevant sector companies). Accordingly, companies resident in a Crown Dependency that do not derive income from, or carry on business in, a relevant sector do not need to comply with the substance requirements (although they will still be affected by some of the procedural changes that the Draft Legislation introduces to the tax filing process).
Companies should take care not to conclude too readily that they do not derive income from or carry out business in a "relevant sector". In particular, the relevant sector of holding intangible property is very broadly defined (see "Do Any Additional Requirements Apply to IP Holding Companies?" below).
What Is a Relevant Sector?
The Draft Legislation specifies the following relevant sectors:
- fund management;
- financing and leasing;
- operation of a holding company;
- holding intangible property; and
- distribution and service centre business.
In an apparent acknowledgement that collective investment vehicles differ from other companies with geographically mobile activities, the Governments of the three Crown Dependencies have clarified in a separate note that was published together with the Draft Legislation (the Key Aspects Note) that the fund management relevant sector does not include collective investment vehicles.
What Substance Requirements Apply to Relevant Sector Companies?
The Draft Legislation imposes three central requirements on all relevant sector companies (except pure equity holding companies in the Isle of Man and Guernsey, as discussed below).
A. Directed & Managed in the Jurisdiction
A relevant sector company (other than a pure equity holding company in the Isle of Man or Guernsey) must be directed and managed in the Crown Dependency in which it is tax resident. This is not the same as the "management and control" test for tax residence. For a company to be directed and managed in the relevant jurisdiction for this purpose:
- its board must meet in the jurisdiction at an adequate frequency given the level of decision-making required, and at each such meeting a quorum of directors must be physically present in the jurisdiction;
- strategic decisions must be taken at board meetings, and this must be reflected in the minutes;
- its directors must collectively have the necessary knowledge and expertise; and
- it must keep its company records (including board minutes) in the jurisdiction.
There is no one-size-fits-all answer to the question of what constitutes an adequate number of board meetings for this purpose. The Key Aspects Note states that relevant sector companies do not need to hold all of their board meetings in the jurisdiction, but they will be expected to hold at least a majority of such meetings in the jurisdiction. Bearing in mind the vagueness of this requirement, where practicable it would be advisable for relevant sector companies to hold all of their board meetings in the jurisdiction in view of the robust sanctions for non-compliance (discussed below).
B. Physical Substance
A relevant sector company (other than a pure equity holding company in the Isle of Man or Guernsey) must have:
- an adequate number of qualified employees in the jurisdiction (which can be employed by third parties);
- adequate expenditure incurred in the jurisdiction proportionate to the level of activity carried on in the jurisdiction; and
- adequate physical presence in the jurisdiction.
This is the most critical requirement introduced by the Draft Legislation. It is the central provision that will ensure that a company's activities in the jurisdiction reflect the amount of profits that it books there. As such, relevant sector companies will inevitably ask what would be "adequate" for this purpose. The Key Aspects Note makes clear that there is no one-size-fits-all answer to this question – what is adequate for a particular company will need to be considered on a case-by-case basis, taking into account the activities carried on by that company.
The Governments of the three Crown Dependencies have indicated that they are preparing guidance notes on the substance requirements. It would be helpful for this guidance to clarify from whose perspective the adequacy question will be considered: Will the Crown Dependencies' tax assessors defer to a relevant sector company's own determination of what is adequate, or will they make their own assessments and disregard the company's own judgment? Since there could be a wide range of reasonable views in any given case about what constitutes an adequate level of resources or expenses, if the adequacy assessment were to include an element of objectivity, this should only result in a company's own judgment being overturned if it was so unreasonable that no reasonable company carrying on the company's business could ever have considered the company's resources or expenses to be adequate.
From a practical perspective, relevant sector companies should actively consider the adequacy of their resources and expenditure at board level and keep clear records of the related discussions and conclusions. Going forward, they will need to maintain and preserve appropriate records to demonstrate the continued adequacy of their resources and expenditure.
C. Core-Income Generating Activities
The third requirement is that a relevant sector company (other than a pure equity holding company in the Isle of Man or Guernsey) will need to conduct core-income generating activity (CIGA) in the Crown Dependency in which it is tax resident. What this means in practice will vary from one relevant sector to another. The Draft Legislation sets out a non-exhaustive list of the potential CIGA for each relevant sector. However, the Key Aspects Note clarifies that a company will not need to carry on all of the CIGA listed for the relevant sector from which it derives income to demonstrate substance.
A relevant sector company will be able to outsource some or all of its CIGA, but the CIGA must still be undertaken in the relevant Crown Dependency and must be subject to adequate oversight by the company. In these circumstances, the service provider's resources in the relevant Crown Dependency will be taken into account when determining whether the relevant sector company has adequate resources in the jurisdiction.
Do Any Additional Requirements Apply to IP Holding Companies?
Any company that holds, exploits or receives income from an IP asset will be subject to the substance requirements (whether or not that is the company's main activity). IP assets are broadly defined and include patents, technical know-how, trademarks, brands and copyrights.
This relevant sector is broader than it might first appear. For example, manufacturing businesses would probably not consider themselves to be IP companies. However, they will almost certainly hold, exploit or receive income from patents or copyrights or from internal technical know-how, which means they would be IP companies for the purposes of the Act (and therefore subject to the substance requirements).
It would have been helpful for the Draft Legislation to clarify that a company will only be an IP company if its primary function is holding, exploiting or receiving income from an IP asset (as it does for pure equity holding companies in the Isle of Man and Guernsey, which are discussed below).
Certain IP companies are deemed to be "high-risk". This includes companies that own IP assets that have been acquired from related parties and are licensed back to (or otherwise monetised through the activities of) such related parties, as well as IP-owning companies that do not carry out R&D or marketing/branding activities in the jurisdiction.
A high-risk IP holding company will be presumed not to conduct its CIGA in the jurisdiction. This increases the evidential burden on these companies, particularly since they will, by definition, carry on some of their CIGA (i.e. R&D and marketing/branding activities) outside the jurisdiction. The Key Aspects Note provides guidance on what a high-risk IP holding company will need to do to rebut this presumption.
What Substance Requirements Apply to Holding Companies?
In Jersey, the requirements summarised above apply to all relevant sector companies.
In the Isle of Man and Guernsey, separate requirements apply to pure equity holding companies (i.e. companies that perform no commercial activity and that, as their primary function, hold controlling stakes in other companies).
In both the Isle of Man and Guernsey, the substance test for a pure equity holding company is three-fold and broadly aligned. First, it must be in compliance with its obligations as an Isle of Man or Guernsey company (as applicable). This part of the test will be easy to determine.
The other parts of the test are more problematic and require that the company has "adequate people and premises" for holding and managing the interests in its subsidiaries. The concerns expressed above about the meaning of the word "adequate" are equally relevant to this test. This test introduces further ambiguity for pure equity holding companies, which will hopefully be clarified in the guidance notes.
First, the test requires pure equity holding companies in the Isle of Man to have "adequate people" or in Guernsey to have an "adequate level of persons in Guernsey", which differs from the requirement for other relevant sector companies to have an adequate number of qualified employees in the relevant jurisdiction. It would be helpful for the guidance notes to explain the rationale for the different requirements. In particular:
- Why is there no express requirement for these "people" / "persons" to be physically present in the Isle of Man or Guernsey (as is the case for other relevant sector companies)?
- Must these people / persons hold any qualifications?
- Is the omission of the word "employees" intentional, so the adequate people could consist solely of directors (which would often be considered adequate for the needs of a pure holding company)?
- Can these people / persons be employed by a third party (as is the case for other relevant sector companies)?
Secondly, in the Isle of Man this test requires pure equity holding companies to have "adequate premises", which differs from the requirement for other relevant sector companies to have "adequate physical presence in the Island". It would be helpful for the guidance notes to explain the rationale for the different requirement, particularly since shares are commonly issued in registered form, which means it is often adequate for pure equity holding companies to have no physical premises.
Who Will Determine if a Company is a Relevant Sector Company?
The competent tax authority in each jurisdiction will determine whether a resident company has met the substance requirement and all corporate taxpayers across the Crown Dependencies will be required to provide additional information in their tax returns to enable them to make this determination.
What Are the Sanctions for Non-Compliance?
The sanctions are progressive and include financial penalties and spontaneous disclosure of information to foreign tax officials in the jurisdiction where the immediate parent company, ultimate parent company and/or ultimate beneficial owner is/are resident.
The ultimate sanction, for repeated non-compliance with the substance requirements, is for the relevant sector company to be struck off the register.
When Do the Requirements Become Effective?
We expect the final drafts of the Draft Legislation to be considered by the relevant Government before mid-December. If approved, the substance requirements would be effective across the Crown Dependencies for accounting periods starting on or after 1 January 2019.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.