The impact of coronavirus on economic substance rules in low tax countries

Out-Law Analysis | 04 May 2020 | 12:18 pm | 3 min. read

Coronavirus travel restrictions may make it difficult for some companies incorporated in countries with zero or nominal corporate tax rates to comply with the economic substance rules that have been introduced over the last few years, a tax expert has said.

Economic substance rules require companies to use a minimum level of local human and technical resources. The rules were introduced to stop companies having only paper operations in a country so they can benefit from low-tax or no-tax regimes. They are designed to ensure that economic activity actually takes place in the country, and companies are typically required to file an annual return declaring that the rules have been met.

The economic substance rules are the flip-side of international tax rules – such as for 'permanent establishments' and 'transfer pricing' – which are used by one territory to tax the domestic activities of overseas companies. The economic substance rules make it harder for such companies to remain off the radar of the higher tax jurisdictions.

Compliance with these rules has been rendered problematic in some cases, because individuals are not able to travel and so may be stranded away from that territory or unable to travel there to work.

Jersey, Guernsey, the British Virgin Islands, the Cayman Islands and Bermuda have introduced temporary relaxations of the economic substance rules or have indicated that they will take a practical approach and take into account the circumstances where physical meetings cannot be held due to the pandemic.

In March Jersey announced that that where companies have had to adjust their operating practices to compensate for the coronavirus outbreak, the Jersey tax authorities will not determine that they have failed the economic substance test. The statement says that this treatment will only apply to adjustments to the normal operating practices, and to the extent required to mitigate the threats from this outbreak.

It gives the example of a company which would normally hold directors’ meetings in Jersey but, to avoid travel or because individuals are self-isolating, these meetings are temporarily held virtually. The statement says that in these circumstances the Jersey tax authorities would not regard this as failing to meet the economic substance test.

The Director of the Revenue Service in Guernsey has indicated that it will take a similar pragmatic approach in applying Guernsey’s economic substance legislation.

Higher tax jurisdictions have similarly taken steps to clarify that they won't use these rules to tax companies whose post-CV19 operating procedures mean that people are not where they are supposed to be.

Companies subject to the economic substance rules which have to adapt their procedures because of Covid-19, should keep careful records of why meetings were held remotely and the travel restrictions or company policies which prevented directors from attending in person.

These records will be needed to meet the relaxed requirements of the economic substance rules – but are also needed to prove that they are not liable to tax in higher tax jurisdictions in which their people are stranded or unable to travel from.

Economic substance rules have been introduced in a number of low tax jurisdictions in order to comply with international initiatives to combat harmful tax practices. In essence the rules require certain legal entities established in those countries to demonstrate that they carry out substantial economic activities there in order to be able eligible for a very low/zero corporate tax rate.

As well as Covid-19 making it impossible for directors to meet in one place, it is also affecting those people who might regularly commute from one country to another to work

Countries which the EU considers do not have sufficiently robust economic substance rules appear on its list of non-cooperative jurisdictions for tax purposes, the so-called 'blacklist'.

The Isle of Man, Jersey and Guernsey all introduced economic substance rules from 1 January 2019 and were removed from the EU's 'greylist' of countries which had committed to introduce rules to avoid being blacklisted.

The United Arab Emirates (UAE) was removed from the EU's list of non-cooperative jurisdictions for tax purposes in October 2019, after it implemented economic substance rules.

Businesses in the UAE have until 30 June this year to file an economic substance regulations notification, but there have not yet been any announcements as to how the rules will be applied in the light of the coronavirus pandemic. The filing deadlines have also been extended until 30 June in Bahrain.

The Cayman Islands was added to the EU blacklist in February on the basis that it does not have appropriate measures in place relating to economic substance in the area of collective investment vehicles.