As the European Union seeks tighter legislation over substance, funds businesses in the Channel Islands are already rising to the challenge
‘Substance’ is a word that’s been rattling around offshore jurisdictions for a fair few years now. But it’s been thrown into the spotlight most recently because of the tax activities of some of the world’s largest businesses – those that choose to incorporate in low- or no-tax jurisdictions to avoid being taxed in other countries where they conduct business.
Take the staggering case of 1209 North Orange Street in Wilmington, Delaware, an unassuming building that’s actually home – at least on paper – to some of the largest companies in the world. Apple, eBay, Walmart, Verizon, American Airlines, and more than 300,000 other business entities register their companies there, according to Business Insider.
But it appears the gig is up. International bodies are starting to clamp down on such nefarious activity – and the Channel Islands are being caught up as houses are cleaned.
Indeed, the Crown Dependencies (CDs) of Guernsey, Jersey and the Isle of Man are among 92 jurisdictions under review by the EU’s Code of Conduct Group (Business Taxation) – COCG – whose investigation mirrors the work of the Organisation for Economic Co-operation and Development’s (OECD’s) Forum on Harmful Tax Practices.
Businesses that fall within the scope of their work need to demonstrate that they have adequate levels of employees, expenditure, available premises or adequate outsourcing to service providers. This is what they mean by substance.
The types of businesses they are pursuing are those in banking, insurance, finance and leasing, headquarters’ activities, shipping, holding company activities, intellectual property (IP) and fund management.
Transfer pricing
Tim Clipstone, Partner in the Guernsey office of law firm Ogier, believes the move is in fact aimed at transfer pricing among companies that trade across borders. This is very much in line with the OECD’s Base Erosion and Profit Shifting (BEPS) project.
To that extent, funds and fund management activities are likely to be lightly affected compared with, for example, an internet sales operation that routes its sales through one jurisdiction, while the bulk of its sales are in others.
The good news is that the COCG recognises that collective investment vehicles – that is, investment funds, of which there are a large number in the islands – may collect funds from investors located in many different countries. This means reduced substance requirements should apply. The COCG is concerned, however, that there’s a general lack of local substance legislation in the islands.
The CDs have agreed to address these issues by the year end. A joint consultation exercise concluded on 31 August and it remains to be seen what will emerge.
Some, such as Richard Bray, Relationship Director at corporate governance and regulatory compliance specialist Active Offshore, are bullish about the possible outcomes. “I welcome this sort of legislation because it allows us to demonstrate how well placed we are in providing substance,” he says.
“When we look at the sorts of requirements being put forward as part of this consultation, they are requirements and rules we’ve been following, I think, pretty well since the Protection of Investors law came out in the 1980s.”
The new legislation could hit the statute books as early as 1 January next year. So who could be affected and how? “We expect the rules will be introduced through new provisions in the tax legislation,” explains Jo Huxtable, a Partner at Deloitte in Guernsey.
“It may require companies carrying on with relevant activities, to certify on their annual tax return that there’s ‘adequate’ direction and management of the company in Guernsey or Jersey and that there are ‘adequate’ numbers of directors and employees, expenditure and premises in the context of the specific activities carried on by that company.
“Companies that aren’t able to certify in this way will face sanctions, probably in the form of financial penalties, potential exchange of information with relevant EU tax authorities, and ultimately they may be struck off.”
Fund managers
While funds themselves are likely to be subject to lighter touch requirements, fund managers may have more to prove.
Andrew Weaver, a Partner at offshore law firm Appleby in Jersey, considers what this might mean. “There’s a thriving fund management sector in Jersey, and there’s been increasing and developing expertise here in Jersey in that sector,” he says. “I see no reason why, first of all, that trend shouldn’t continue.
"And second, it merely reinforces and demonstrates the substance that’s been developed here in response to increasing regulation. It’s not something we particularly need to be afraid of in this sense.”
Justin Woodhouse, a Tax Partner at PwC in Jersey, adds that the substance requirements for companies carrying on relevant activities, such as fund management, will be aimed at showing direction and management occurring in Jersey through board meetings. In addition, businesses will need to demonstrate the existence of core income-generating activities allied to the relevant activity.
“Proposed examples of core income-generating activities for fund managers are taking decisions on the holding and selling of investments, calculating risks and reserves, taking decisions on currency or interest rate fluctuations, and/or making other reports for government authorities and investors,” he says.
In practical terms, Deloitte’s Jo Huxtable believes that the COCG doesn’t expect a one-size-fits-all set of rules to be brought in. This should mean that “sensible judgements can be made about the required level of economic substance relative to the company in question”, she says.
“The guidance issued by the COCG indicates that the core income-generating activities of the company must be carried out locally,” she explains. “It’s common in the context of funds for the local fund manager to outsource investment advice to specialists in other jurisdictions.
“However, this doesn’t diminish the role of the manager, which is required to review, monitor, challenge investment decisions and set parameters in order to meet its own responsibilities as manager.
“This is a fundamental part of the Channel Islands’ investment management proposition. The expertise and governance available are arguably the primary reasons why the industry has developed here.”
Accounting issues
Other queries posed by Active Offshore’s Richard Bray relate to accounting and board meetings. He expects that firms that fall within the scope of the new legislation may need to make additional disclosures on their tax returns.
He thinks these are likely to relate to the business activities involved and the amount and type of gross income, as well as expenses matters, which he doesn’t see as being particularly onerous.
These issues won’t require a lot of new data or consume a great deal of time in order to comply, Bray says. “The first reporting won’t be required until November 2020, based on figures as at December 2019, so there’s a long lead-in period for us to get the figures ready.”
As for board meetings, the key principle is governance and that businesses are being properly run. Consequently, adds Bray: “The main difference to the way we would normally run a licensed entity in Guernsey – whether it’s an investment management company, a fund administration company or any others within the investment world – is the requirement of a quorum of directors to be physically present on the island for certain meetings.
“We do generally look to make sure that the whole board meets in person at least once a year, which is fairly standard,” he says. “It may just require a little bit more coordination to make sure that we do have people physically present in Guernsey for more meetings than maybe has happened in the past. I think that’s about the only one stipulation I can see that might create any particular extra work to normal activities.”
In summary then, although on the face of it, an approach from the EU’s COCG requiring new legislation to be put in place to prevent tax evasion and avoidance sounds like a rap across the knuckles, no one we spoke to for this article saw it in that way.
Rather, the islands have received consistently high ratings for their governance practices and tax cooperation from the OECD and the EU and have grown a global reputation for their expertise in fund formation and management services.
As we go to press, we don’t know what the result of the CD consultation will produce by way of amended legislation. What’s likely, however, is that the islands’ legislators will be able to demonstrate how nimble and quick they are to adapt to new regulatory requirements – seizing the opportunity to shine among the 92 jurisdictions the EU is examining.