Economic substance: the beginning of the end or a new beginning for offshore financial centres?

The perception that the world’s leading offshore financial centres (OFCs) are harmful “tax havens” that facilitate the avoidance of tax in onshore jurisdictions has led to intense pressure for OFCs to adopt onshore-led transparency and tax intake measures.

The latest measures derive from difficulties onshore jurisdictions face in assessing corporation tax from large multinational companies who may manage their taxable profits through the use of structures in OFCs. The US was the first to address this issue in 2017 through the so-called Base Erosion and Anti-Abuse Tax.

EU requirements and the OFCs’ response

More recently, the EU has imposed “economic substance” requirements on OFCs, which must be adopted in order for those jurisdictions to avoid being placed on a blacklist of non-cooperative countries.

These requirements are intended to ensure that entities in OFCs have core-income generating activities in those jurisdictions and are not mere vehicles for shifting profits beyond the reach of onshore tax collectors. This has led to OFCs adopting economic substance legislation which will have a profound effect on OFCs and may dramatically alter the shape of their economies.

Substance legislation

The legislation adopted by each of the OFCs is similar, focusing on the nature and extent of entities’ “core income generating activities” within the jurisdiction and looks at factors such as the presence of physical offices, management and employees and local expenditure to determine if there is adequate substance. Entities affected include those engaged in the banking, insurance, fund management, financing, shipping sectors as well as holding entities.

Failure to comply with the substance requirements by 1 July 2019 will expose the entity and its directors and officers to criminal penalties and may lead to the entity’s activities being restricted or the entity struck off and terminated.

Whilst the OFCs are producing guidance on what is likely to satisfy the substance requirements, the outcome will depend on the particular features of each entity. Some cases will be clear: Bermuda’s “bricks and mortar” insurance companies will almost certainly satisfy the test, whereas a “paper company” holding a valuable patent for an onshore affiliate is unlikely to pass muster. However, many entities will find themselves in an area of uncertainty and will have to make difficult and speedy decisions on whether they are in scope and if not how they will respond.

The impact

The number of entities potentially affected is vast. For example, some 400,000 international companies are registered in the BVI alone.

Those companies that do not satisfy the requirements will have a choice: beef up local substance (e.g. by employing personnel locally) or discontinue or redomicile to an unaffected jurisdiction.

Many entities may choose to discontinue their operations in the OFCs, thereby causing a reduction in government fees and revenue for local service providers. However, it is likely that many entities will conclude that the benefits of doing business from the OFC justify increasing substance, which will lead to increased jobs and economic activity within the jurisdiction. For some businesses (e.g. those holding intellectual property) this may not be possible, but others (e.g. fund managers) may decide to set up offices and move personnel to OFCs to meet the requirements.

Entities that decide to add substance may also decide to relocate to another OFC, with considerations such as location, infrastructure, quality of service providers and immigration policies influencing the choice of domicile. Which OFCs will be the winners and losers remains to be seen but 2019 is likely to see OFCs embarking on charm offensives to woo new business from competitor jurisdictions.

Implications for the insurance industry

In the immediate term, offshore insurance entities will need to determine whether they meet the substance requirements and, if not, how they will react to avoid sanctions. For example, whilst Bermuda’s insurance industry is likely to be largely unaffected, there are a sizeable number of special purpose entities and numerous captive insurance companies where careful analysis of substance will be required.

For underwriters insuring or reinsuring offshore entities there may be lost accounts or altered risk profiles if the insured increases its operations and/or redomiciles. On the claims side, there might be increased regulatory enforcement and a spike in litigation as reorganisations expose latent corporate issues or crystallise disputes involving directors and shareholders of offshore entities.

The speed with which the substance legislation has been enacted, and the many uncertainties over the precise impact, make it difficult to predict the future landscape. But one thing is certain: interesting times lie ahead for the OFCs.

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