Shipshape for substance

Written by: Richard Willsher Posted: 11/03/2019

BL61_substanceNew tax rules on substance should enhance the Channel Islands’ reputation as a well-regulated international finance centre – and make the additional compliance burden worthwhile

Effective in Guernsey, Jersey and the Isle of Man from 1 January this year, the new substance tax legislation was prompted by the European Union’s Code of Conduct Group (Business Taxation) (COCG). Its aim is to ensure that businesses that choose to incorporate in low- or no-tax jurisdictions should not be able to avoid being taxed in countries where they actually do their business.

The corollary is that businesses that are tax domiciled in the islands should be able to demonstrate that they have real operations or ‘substance’ there.

Joint guidance put out by the three Crown Dependencies on 21 December 2018 explains that the activities that fall within the scope of the new tax rules are ‘geographically mobile financial and other service activities, identified by the OECD’s Forum on Harmful Tax Practices’ (see box).

If a business falls within scope, and is tax resident on one of the islands, it must be able to demonstrate that it has substance by being able to prove to the local tax authority that ‘it is being directed and managed in the island, conducting Core Income Generating Activities (CIGA) in the island, and having adequate people, premises and expenditure in the island’.

The term ‘adequate’ will be determined by the nature and activities of businesses. More guidance will emerge in due course, but, for the time being, a broad assumption can be made that, because the islands already have a rigorous regulatory regime in place for most of the categories of business that fall within scope, they are likely to be able to meet the substance requirements. 

John Riva, Senior Tax Partner at KPMG in Jersey, who was involved in drafting the legislation, is confident of this. He says: “This legislation, although some of it’s quite daunting when you first look at it, is actually quite good for the island. For the past 20-odd years, people like me have been screaming about trying to ensure that the profits you book in the island are justified. Now we have a specific legislation that says this is exactly what you have to do.”

Reporting deadline

Although the legislation took effect from 1 January 2019, the first tax return to incorporate the new reporting will be submitted in respect of tax year 2019/20. A business with a 31 December year-end, for example, would report at some stage in 2020, following the end of their tax period on 31 December 2019. 

An important point to note, however, is that reporting will need to demonstrate substance compliance throughout the reporting period, not just at its end. Riva points out: “This means it’s not a snapshot at any one point of time during the year as to whether you comply. You need to look at the whole business operation throughout the year and consider, on the balance of probabilities, whether that company complied with the law during that year.” 

In any case, as yet, the new tax forms are not available. They will be made available by the respective tax authorities in due course. The message is clear, however. Don’t wait to see the forms; businesses should start making sure that they are likely to be compliant straightaway. 

This note of caution is echoed by Guy Westmacott, a Partner in the Jersey office of law firm Bedell Cristin. “I think most regulated businesses on the islands are likely to be either compliant or largely compliant already. That being said, it’s going to be necessary for all companies that do or may fall within the scope of these laws to carefully consider whether they need to tweak anything in terms of their current governance arrangements, and particularly outsourcing.” 

He continues: “So, people can’t be blasé about it, because there are details here that require some analysis to ensure that companies are compliant.” 

Moreover, there are penalties for non-compliance that could be quite draconian. A first failure to comply will be subject to a fine of £10,000. A second breach will result in striking the company off the Companies Register – a ‘two strikes and you’re out’ approach. 

Given the length of time businesses will have had to prepare, there would seem to be little excuse for falling foul of such sanctions. The best course of action is to look at the Key Aspects document on tax authorities’ websites for a useful grounding. This will be supplemented in due course with additional guidance. 

BL61_substanceBusinesses that fall outside of regulated sectors should pay particular attention; this includes intellectual property (IP) businesses. The substance legislation is particularly levelled at companies that may domicile their businesses in low-tax or no-tax jurisdictions, drawing income from licensing sales in other geographies. It may be difficult for them to substantiate that their CIGA are located on the islands, as Chris Hutley-Hurst, Senior Associate at Carey Olsen in Guernsey, explains. 

“This is because IP is so highly mobile and certain big-name tech companies have used somewhat aggressive offshore structures to minimise the tax they pay in relation to their IP,” he says. “The substance requirements for IP are quite high and there’s an expectation that we will lose some IP business, but it’s difficult to think where that business would then go.” 

It’s worth noting that some 90 jurisdictions have been the subject of scrutiny by the EU’s COCG. They will all need to comply, so in the end the playing field will be level, and highly mobile IP companies will have nowhere to go to gain tax advantages.

While no business welcomes more compliance, as with all forms of regulation and legislation, the new substance legislation in the islands is a fait accompli. So, what will be its effect? On balance, the result could be positive and supportive of businesses across the islands, according to the experts. 

“It could drive some poorer quality businesses away,” says Mark Savage, a Tax Director in the Guernsey practice of accounting and advisory firm BDO. “The substance requirement ensures value is being added, so what we should get is better quality business. I’d say the effect of this legislation is neutral, tending towards good.”

The verdict

Carey Olsen’s Hutley-Hurst agrees. “Ultimately, it’s positive, because I don’t think it’s going to drive business away from the island. I think it shows that the island already has a high level of substance because of our regulatory laws and our regulator. So, I don’t think people are overly concerned about the rules.” 

Bedell Cristin’s Westmacott concludes with another, perhaps more pragmatic, view. “I think the laws as currently drafted, on balance, are positive, primarily on the basis that they are necessary to keep us off the EU blacklist. 

“If they can achieve that, and contribute to the reputation of the Channel Islands as well-regulated international finance centres, then I think that’s a good result.” 

In the final analysis, many on the islands will agree that this is a worthwhile outcome from the additional tax compliance that the substance legislation will require.

Who's affected?

Activities that fall within the scope of the new tax rules include:
• Banking
• Insurance
• Shipping
• Fund management (this does not include companies that are Collective Investment Vehicles) 
• Financing and leasing
• Headquarters
• Distribution and service centres
• Holding company (a pure equity holding company)
• Intellectual property (for which there are specific requirements in high-risk scenarios)


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