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Offshore structures swept up in ‘substance’ tide

South Africans may be forced to review their offshore structures.

Many high-net-worth South Africans with offshore assets make use of offshore companies, trusts or other entities to house their assets. They are likely now to be forced to review their offshore structures, including even the most standard ones, in light of a new rising tide in the form of the so-called EU Economic Substance Requirements, which have been translated into legislation with effect from 1 January 2019.

In 2016, the EU Finance Ministers instructed the EU Code of Conduct Group to undertake a screening process whereby non-EU jurisdictions, 92 in total, were assessed in respect of (i) tax transparency; (ii) fair taxation; and (iii) compliance with anti-base erosion and profit shifting measures.

Guernsey, Jersey, the Isle of Man, British Virgin Islands (BVI), Cayman, Bermuda and Vanuatu were found not to have a formal tax legal substance requirement for entities doing business in or through the respective jurisdictions and were put on an “EU grey list”. These jurisdictions all committed to adopting “Economic Substance Requirement” legislation by the end of 2018, in response to the threat of being blacklisted by the EU for not adhering to its proposals.

The proposals are aimed at addressing the EU’s concern that these jurisdictions’ tax systems facilitate artificial offshore structures without real economic activity. In other words, structures that attract profits which are not supported by sufficient economic activity or presence in the relevant jurisdiction.

Mauritius underwent a similar review, following which it committed to introducing relevant measures. The EU has however grouped Mauritius with jurisdictions required to “Improve Fair Taxation” and not with the aforementioned jurisdictions, which are required only to “Introduce Substance Requirements”. Malta does not feature in the list of reviewed jurisdictions by virtue of its being an EU Member State.

Guernsey, Jersey and the Isle of Man were the first to release draft “Economic Substance Requirement” legislation and worked closely together to ensure a uniform approach to implementation. The BVI, Cayman, Bermuda and Bahamas followed shortly after, each with their own legislative approach, with effect from January 1 2019.

Generally, a jurisdiction’s economic substance rules apply to entities that are tax resident in that jurisdiction. As there is no tax residence concept in the BVI, the tax residence requirement has been cast in the negative. Where an entity can show that it is tax resident elsewhere, it will not be caught under the BVI substance requirements.

In broad terms, the substance requirements target “relevant activities” that are deemed “high risk” from a lack of substance perspective, because they are geographically mobile. These are as follows:

  • Banking
  • Insurance
  • Fund management
  • Finance and leasing
  • Headquartering
  • Shipping
  • Distribution and service centre
  • Intellectual property holding
  • Holding company

In Guernsey, Jersey and the Isle of Man, carrying on a relevant activity is not enough for the economic substance test to kick in. The entity has to derive income from the relevant activity. The BVI legislation, in contrast, does not require there to be income from the relevant activity.  

Once an entity has been identified as undertaking a relevant activity and meets any other relevant criteria such as income and tax residence, it will be required to satisfy the economic substance test. In general, this test centres on the entity being directed and managed in the relevant jurisdiction, conducting its core income-generating activities in that jurisdiction and having adequate people, premises and expenditure in that jurisdiction. To the extent possible, depending on the relevant activities carried on, the test can be satisfied by engaging with a corporate service provider in the relevant jurisdiction.

Entities will have to report annually on their economic substance credentials and a formal hierarchy of sanctions for non-compliant entities will be enforced. Meeting the economic substance test, for example, may well imply certain additional expenses and regulatory filings in the relevant jurisdiction, directors resident in, or board meetings held in, the relevant jurisdiction.

The economic substance test thresholds are increased for intellectual property holding companies, which are seen as higher risk, and reduced for holding companies or pure equity holding companies, which are seen as lower risk.

The fact that pure equity holding companies are included in the list of relevant activities, indicates the breadth of the potential impact of the rapidly rising EU economic substance tide. Most offshore trusts, for a variety of reasons, have underlying companies (also known as a standard “trust-and-company” structure). Though the exact definition of a “holding company” and a “pure equity holding company” varies slightly from one jurisdiction to the next and guidance on certain matters of interpretation is still awaited, an underlying company in this context (trust-and-company structure) could qualify as a “holding company” or “pure equity holding company”, thereby triggering the substance requirements.

In practice, an entity should not be caught by more than one jurisdiction’s substance requirements. But it may have to comply with corporate requirements in its jurisdiction of incorporation and substance requirements in another jurisdiction if it is tax resident there.

It is furthermore expected that discrepancies in the Economic Substance Requirements legislation of the listed jurisdictions will be ironed out over time under the scrutiny of the EU Code of Conduct Group. Hence, it is unlikely that reliance on arbitrages created by such discrepancies would provide a long-term solution.

The safest and most cost-effective route, in the long run, might, therefore, be to consolidate one’s offshore structure to a single credible offshore jurisdiction – one where existing local regulations provide a strong economic substance framework that is likely to withstand the ebb and flow of the new EU substance tide for years to come.

Iris Harvey, Director, and Nel Schoeman, Assistant Director, Maitland

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1. Does Mauritius classify as “credible offshore jurisdiction” according to the criteria mentioned in the article?
2. Will the Mauritius trust structure and holding company still be recognized by SARS?

After all is said and done, a shack in Khayelitsha will be the only “tax-efficient structure” left on earth. A township dweller only claims benefits from SARS, and pays nothing. You even get free electricity if you set up your structure in Soweto.

South Africa is the only country in the world that offers financial rewards (grants) to their own citizens who set up “structures” in localized “tax-havens”. The ANC bribes people not to pay taxes, and harass the minority who do pay taxes. Then they wonder why the tax base is imploding…

End of comments.

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