South African companies in so-called low- or no-tax jurisdictions should take heed to the economic substance rules that have been introduced to prevent the artificial shift of taxable profits away from where value is created.
Although the legislation has been around for more than a year, the reporting dates are only becoming due now. Indications are that a great number of companies, subject to the new rules have not fully dealt with it yet, says Charl du Toit, partner in the Tax Advisory practice of Stonehage Fleming.
“Failure to meet the requirements can result in the exchange of information between the relevant jurisdiction and other countries’ tax authorities, financial penalties and, ultimately, striking off the companies register.”
Du Toit explains that since the 2008 economic crisis, the Organisation for Economic Cooperation and Development (OECD) started a process of ‘reforming’ international tax. The main aim was to prevent base erosion and profit-shifting from high-tax jurisdictions to low-tax jurisdictions (tax havens).
With the introduction of economic substance rules the focus is on companies that are formed in countries where they are subject to low- or no tax, but have no presence in the form of staff or activities. “It is simply a name against the wall in some lawyer’s office.”
The countries where the economic substance requirements were implemented include Bermuda, the British Virgin Islands, Cayman Islands, Isle of Man, Jersey, Guernsey, Mauritius, Bahamas and Seychelles.
The international approach is that no one can be prevented from forming companies in these countries. However, when they do, there has to be substance in the form of staff, premises, expenses and activities, which must be determined in accordance with the nature of the company.
Du Toit says this is extremely relevant from a South African perspective. South African high net worth individuals “love” their offshore trusts (to which the legislation does not apply), and companies in places like Mauritius or the Bahamas.
He is aware of one South African group that has well over 100 such companies.
The new economic substance requirements do not apply to all companies, but are required for companies with income from “geographically mobile financial and other service activities”.
This include banking; insurance; shipping; fund management (except collective investment vehicles); financing and leasing; headquarters; distribution and service centres; holding companies; and intellectual property.
Du Toit says the legislation defines “core-income generating” activities of each of these industries. In the case of finance and leasing the activities include agreeing the funding terms, identifying and acquiring assets to be leased, setting the terms, monitoring, revising and managing risks.
In addition to the above, there must be an adequate number of employees working in the affected jurisdiction, as well as adequate expenditure and physical assets.
He explains that “adequate” means “enough or satisfactory for a particular purpose”. There must be board meetings at an “adequate” frequency and a quorum of directors must be physically present in the jurisdiction.
Companies need to establish their obligations on substance and reporting in terms of the rules and must ensure they meet the requirements by the due dates.
Time for implementation
“The legislation was introduced around 18 months ago, but companies were given time to get their house in order. The effective dates differ depending on various factors but is mostly around now,” says Du Toit.
Some countries have indicated that temporary “leniency and pragmatism” will be allowed to cater for the effect of the Covid-19 pandemic.
Du Toit says the economic substance rules add another layer of complexity to other rules applying to cross-border structures. These rules include determining the place of effective management, transfer pricing, source of income and withholding taxes.
It is becoming increasingly important to understand all the rules when choosing a country to use as an offshore centre.