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Economic Substance Laws and Impact on Offshore Companies

There is more and more interest in setting up offshore companies recently. One of the most frequently asked questions will be where is the best place to set up an offshore company. This is not an easy question to answer. We will always ask the client, are they ready to have economic substance in the particular offshore jurisdiction.

The leading offshore centers such as Cayman Island, Malaysia Labuan and British Virgin Islands (BVI) have already incorporated economic substance act to avoid potential blacklisting and reputation damage. The relevant entities are required to prove that any income earned from certain activities is derived from business that actually takes place in the Cayman or BVI. The motive behind is the global body's intention to clamp down on using offshore entities purely for tax avoidance as what they see as damaging tax-competition practices.

The offshore companies were attracted by many businessmen due to simple it’s simple-and-easy registration process, a flexible operating environment, minimal restrictions, a high degree of confidentiality, and tax exemptions and this has drawn the attention from international bodies, like EU and OECD.

In 2017, the EU released a list of jurisdictions with no or only nominal tax rates (“NOONS”) judged to be “non-cooperative jurisdictions for tax purposes”. It required them to enact legislation that aligned with the EU’s economic substance regulations – in other words, any profits declared must accurately reflect business activities in a territory – or face the prospect of sanctions, including a ban on access to capital from EU member states. The NOONS were assessed against several criteria, including transparency, fairness, and measures taken to counter profit shifting.

Both Cayman and BVI were in the list. By the end of 2018, both Cayman and BVI had introduced economic substance regulations for relevant entities, to meet the EU’s fair taxation standards.

What is the Economic Substance Requirement?

The scope of the economic-substance legislation is broadly the same in every territory. The “relevant entities” carrying out a “relevant activity” must satisfy reporting requirements regarding their actual level of economic substance in the jurisdiction. The rules lay down three tests that a relevant entity deemed to be operating within the scope of the economic-substance requirements must meet.

  • being directed and managed in the relevant jurisdiction,

A company has to be directed and managed in the jurisdiction, by conducting board meetings locally with the required number of board members to be presented. Besides, the directors must understand the business and their duties entail. This seeks to end the practise of appointing nominee directors with no knowledge of the company.

  • conducting its core income-generating activities in that jurisdiction,

The company must show that appropriate CIGA has taken place in the offshore territory. Rules were also put in place to stop entities outsourcing activity but claiming it as a core income generating activities

  • having adequate people, premises and expenditure in that jurisdiction.

It demands that the relevant entity to have an adequate number of people work for the company in that jurisdiction. Besides, the tools and environment required to do the job such as functioning office space is also required.

Reporting Requirement

Every company should be well aware of their obligations, the relevant entities should take two important steps: 1. Identify the status of company, whether “in-scope” or “out of scope” and establish economic substance requirements where applicable

2. Provide the registered agent of the company with relevant information and evidence for reporting purpose.

The consequences of non-compliance are significant, including both fines and imprisonment. Therefore, it is important to find out with your registered agent if you still not yet complete the reporting requirement.

What should I do?

Contact EWO to conduct a review of your structures. It is essential that all affected companies conduct a holistic review from commercial, legal and taxation perspectives before making any decision. Please bear in mind that any review should not be a one-off event. Management teams should regularly monitor the ongoing global efforts to combat tax avoidance so their businesses are prepared for further change.

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