New substance requirements for offshore companies
12 Dec 2018
Last month, the Treasury published a draft of the proposed Income Tax (Substance Requirements) Order 2018. If approved by Tynwald (in December 2018), this draft Order will have effect in respect of accounting periods commencing on or after 1 January 2019.
What this means is that from January 2019, companies engaged in business in relevant sectors will have to demonstrate that they meet specific substance requirements to avoid sanctions.
As many of you will be aware, this Order is in response to a comprehensive review that was carried out by the EU Code of Conduct Group on Business Taxation (COCG) in order to assess over 90 jurisdictions, including the IOM against standards of:
• Tax transparency
• Fair taxation
• Compliance with anti-BEPS (base-erosion profit shifting) measures
The review process took place in 2017 and although the
COCG were satisfied that the IOM met the standards for tax transparency and compliance with anti-BEPS measures, the COGC raised concerns that the IOM, and other Crown Dependencies did not have:
“A legal substance requirement for entities doing business in or through the jurisdiction”
And as a result, this “increases the risk that profits registered in a jurisdiction are not commensurate with economic activities and substantial economic presence”.
High level principles
The purpose of the proposed legislation is to address these concerns that companies in the IOM (and other Crown Dependencies) could be used to attract profits that are not commensurate with economic activities and substantial economic presence in the IOM. As such, the proposed legislation requires relevant sector companies to demonstrate they have substance in the Island by:
• 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.
We will discuss each of these requirements in further detail below.
The Isle of Man’s response
In late 2017, along with many other jurisdictions facing blacklisting, the IOM committed to address these concerns by the end of December 2018.
Due to identical concerns being raised in Guernsey and Jersey, the governments of the IOM, Guernsey and Jersey have been working closely together to develop proposals to meet their commitments.
As a result of the work published in Guernsey and Jersey, last month the Isle of Man published its legislation and limited guidance in draft. Please note further guidance will be forthcoming in due course.
Although the legislation is similar between all three jurisdictions, for the remainder of this article we will focus upon the IOM draft legislation.
The Income Tax (Substance Requirements) Order 2018
This Order will be made by Treasury and is an amendment to the Income Tax Act 1970.
This new legislation sets out to address EU Commission and COCG’s concerns by way of a three-stage process.
1. To identify companies in relevant sectors;
2. To impose substance requirements on those companies; and
3. To enforce the substance requirements
We will discuss each of these stages and their ramifications below.
STAGE 1: TO IDENTIFY RELEVANT SECTOR COMPANIES
The Order will apply to IOM tax resident companies engaged in relevant sectors. The relevant sectors are as follows:
b. insurance c. shipping
d. fund management (this does not include companies that are Collective Investment Vehicles)
e. financing and leasing f. headquartering
g. operation of a holding company h. holding intellectual property (IP) i. distribution and service centres
These are the sectors identified by the Organization for Economic Cooperation and Development’s (OECD) Forum on Harmful Tax Practices (FHTP) work on preferential regimes as the categories of geographically mobile income i.e. these are the sectors which are at risk of operating and deriving their income from jurisdictions other than those in which they are registered.
There is no de minimus in terms of income, the legislation will apply to all companies carrying on relevant activities where any level of income is received.
A key determinant here is tax residence and the Assessor has indicated that existing practice will prevail, i.e. the rules relating to residence set out in PN 144/07. Therefore where non-IOM incorporated companies are engaged in relevant sectors they will only be brought within the scope of the Order if they are IOM tax resident. This is clearly an important consideration: if tax resident elsewhere the rules relevant for the country of residence are likely to be relevant (note: companies could be dual resident, eg incorporated in the IOM but resident in Gibraltar or vice versa).
STAGE 2: TO IMPOSE SUBSTANCE REQUIREMENTS ON RELEVANT SECTOR COMPANIES
The specific substance requirements (Substance Criteria) vary by relevant sector. Broadly speaking, for a relevant sector company (other than a pure equity holding
company) to have adequate substance it must ensure that:
a. It is directed and managed in the Island
The Order specifies that the company is directed and managed* in the Island if the Island is the place where regular board meetings take place, there must be a quorum of directors physically present at the meeting, strategic decisions must be made at those meetings, the minutes of these board meetings must be kept on Island and that the directors present at these meetings have the necessary knowledge and expertise to discharge its’ duties as a board. In the case of an IP company, the legislation specifies that periodic decisions of non-resident board members are not to be taken into account.
* Note that the test for “directed and managed” is a separate test to the “management and control” test which is used to determine the tax residence of a company. The aim of the directed and managed test is to ensure that there are an adequate number of Board meetings held and attended in the Island.
b. There is an adequate number of qualified employees in the Island
This stipulation appears to be rather woolly as the legislation specifically states that the employees do not need to be employed by the company itself, this condition focuses on there being an adequate number of skilled workers present on Island, whether or not they are employed elsewhere does not appear to matter.
In addition, what is meant by ‘adequate’ in terms of numbers is very subjective and for the purpose of this proposed legislation, ‘adequate’ will take its ordinary meaning, as discussed below.
This raises a number of questions (see Verification of Substance Criteria below). Note: one would expect costs of employment to find their way into a company’s accounting records.
c. It has adequate expenditure proportionate to the level of activity carried on in the Island
Again, another subjective measure. Although it must be noted that it would be unrealistic to apply a specific formula across all businesses, as each business is unique in its own right and it is the responsibility of the board of directors to ensure that such conditions are met. This expenditure would be expected to cover employees and premises and other costs.
d. It has adequate physical presence in the Island
Although not defined, we understand that this would include owning or leasing an office, having ‘adequate’ number of staff, both administrative and specialist or qualified staff working in the office, computers, telephone and internet connection etc. The question of registered office costs or registered agent costs is an interesting one.
e. It conducts core income-generating activity in the
The Order attempts to specify what is meant by CIGA for each of the relevant sectors, the list of activities in each relevant sector is intended as a guide: not all companies will carry out all the activities specified, but they must carry out some in order to comply.
New substance requirements…
If an activity is not part of the CIGA, for example, back office IT functions, the company may outsource all or part of this activity (on or off island) without there being an effect upon the company’s ability to comply with the Substance Criteria. Likewise, the company may seek expert professional advice or engage specialists in other jurisdictions without effecting its compliance with the substance requirements.
In essence, CIGA ensures that the main operations of the business, i.e. the operations which produce the bulk of the income are carried out in the Island.
Further to that mentioned above, a company may outsource, i.e. contract or delegate to a third party or group company some or all of its activities. Outsourcing is only a potential issue if it is of its CIGA. If some or all of the CIGA are outsourced, the company must be able to demonstrate that there is adequate supervision of the outsourced activity and that the outsourcing is to an IOM businesses (which themselves have adequate resources to perform such
duties). Precise details of the outsourced activity, including for example, timesheets must be kept by the contracting company.
Whether this is an issue comes down to the value that the outsourced activities generate when compared to the expenditure incurred. In some instances, one might say outsourcing of say coding activities generates very little in terms of value but it could be design, marketing and other activities carried out locally that are integral to the value creation. Companies will need to look closely at where the value comes from, ie who and which activities generate it, to assess whether outsourced activities are an issue. “Adequate”
The term ‘adequate’ is intended to take its dictionary definition:
“Enough or satisfactory for a particular purpose” The Assessor has advised that:
“What is adequate for each company will be dependent upon the particular facts of the company and its business activity.”
This will vary for each relevant sector entity and the onus is on the relevant company to ensure that it maintains and retains sufficient records which demonstrate that it has adequate resources in the Island.
STAGE 3: TO ENFORCE THE SUBSTANCE CRITERIA
The Order provides the Assessor with the power to request any information required to satisfy her that a relevant sector company meets the Substance Criteria. Where the Assessor is not satisfied that the Substance Criteria have been met for a particular period, sanctions will apply.
Verification of Substance Criteria
The draft legislation provides the Assessor the power to request further information from a relevant sector company in order to satisfy herself that the substance requirements have been met.
Failure to comply with the request can result in a fine not exceeding £10,000. Where the Assessor is not satisfied that the Substance Criteria have been met, sanctions will apply.
Retaining and compiling evidence that a company has met the Substance Criteria is essential and there are as yet some unanswered questions in my mind surrounding the meaning of premises/employees. For example, OECD guidance refers to ‘full time employees’ yet it is understood that part time employees are also relevant, ie full time equivalents. Some companies of course will not need to have employees working 5 days a week for them to operate effectively to satisfy their CIGA or the need for people in the context of a pure equity holding company. There must therefore be some proportionality. The same is true of adequate premises: will payments for registered office facilities satisfy these requirements?
CSPs may need to think about their contractual arrangements for the provision of staff and premises to companies managed by them. One hopes that future guidance will be provided to cover such matters as these and the use of corporate directors, registered agent/office costs, the necessity or otherwise to have directors’ service contracts, whether it is necessary to register companies as employers (or otherwise) and for skilled workers to be actually employed. The current draft legislation does not require such specifics and is broad enough to allow employees to be employed by an entity other than the company itself (ie it permits local outsourcing provided the outsourced companies have suitable local qualified employees etc). The OECD guidance is also very limited and it worries me (perhaps unnecessarily) that reference to
‘full time employees’ in OECD guidance means just that
with all the associated trappings one would expect to see, eg registration as employer and employee, contracts, CVs and similar.
Note: the EU cannot barge in and demand information from companies. They must follow proper procedures as set out in relevant tax information exchange agreements. However, statistical information may be passed to the EU by the Government, ie number of companies per relevant
sector and number of companies sanctioned etc.
High-risk IP companies
Generally speaking, the designation ‘high-risk IP companies’ refers to companies holding IP where (a) the IP has been transferred into the Island post-development and / or the main utilisation of the IP is off-Island or (b) where IP is held on Island but the CIGA are carried out off-island.
As the risks of profit shifting are considered to be greater, the legislation has taken a rather hard approach to high risk IP companies, it takes the position of ‘guilty unless proven otherwise’.
High-risk IP companies will have to prove for each period that the adequate Substance Criteria in respect of conducting core income-generating activity have been met in the Island. For each high risk IP company, the tax authorities of the IOM will exchange all of the information provided by the company with the relevant EU Member State authority where the immediate and/or ultimate parent and beneficial owner is/are resident. This will be in accordance with the existing international tax exchange agreements.
To rebut the presumption and not incur further sanctions, the high risk IP company will have to provide evidence explaining how the DEMPE (development, enhancement, maintenance, protection and exploitation) functions have been under its control and this had involved people who are highly skilled and perform their core activities in the Island.
The high evidential threshold includes detailed business plans, concrete evidence that decision making occurs in the Island and detailed information regarding their IOM employees.
In line with the tougher approach to IP companies detailed above, the sanctions are somewhat harsher for such companies.
Whether or not the substance requirements have been met, in accordance with international arrangement, the Assessor will disclose to a relevant EU tax official any relevant information concerning a high-risk IP company.
If a high-risk IP company is unable to rebut the presumption that it has failed to meet the substance requirements, the sanctions are as follows, (stated by the number of consecutive years of non-compliance):
• 1st year, a civil penalty of 50,000
• 2nd year, a civil penalty of £100,000 and may be struck off the company register
• 3rd year, strike the company off the company register
If the high-risk IP company is unable to provide to the Assessor any additional information requested, the company will be convicted to a fine not exceeding £10,000.
For all other companies engaged in relevant sectors (other than high risk IP), the sanctions are as follows, (stated by the number of consecutive years of non- compliance):
• 1st year, a civil penalty of £10,000
• 2nd year, a civil penalty of £50,000
• 3rd year, a civil penalty of £100,000 and may be struck off the company register
• 4th year, strike the company off the company register
For any year of non-compliance of a company operating in a relevant sector, the Assessor will disclose to an EU tax official any relevant information which relates to the company, this could represent a serious reputational risk to the company. This can include such an official in the country where a parent company exists or the beneficial owner is resident.
If the Assessor finds that in any accounting period a company has avoided or attempted to avoid the application of this Order, the Assessor may:
• Disclose information to a foreign tax official
• Issue to the company a civil penalty of £10,000
If a person (note that “a person” is not defined within this legislation) who has fraudulently avoided or seeks to avoid the application is liable to:
• On conviction: custody for a maximum of 7 years, a fine or both
• On summary conviction: custody for a maximum of
6 months, a fine not exceeding £10,000, or both
• Disclosure of information to a foreign tax official
Any appeals will lie with the Commissioners who may confirm, vary or reverse the Assessor’s decision.
Where does this leave us?
All companies must consider whether they fall within one or more of the relevant sectors, if not then there are no obligations falling upon them by this Order. However, if they are in a relevant sector then they will need to assess their position. It is possible to fall into several relevant sectors at once. If so the company needs to make sure it meets all the requirements for the CIGA relevant for each sector.
Many companies will easily be able to identify whether or not they fall within a relevant sector and companies managed by CSPs may need to assess whether they do indeed have the necessary substance.
What might change?
We are teetering on the brink of Brexit and so far much of the discussions have taken place with the EU commission and the draft legislation has been reviewed by them; however, the COCG will only meet to discuss such matters as blacklisting in January/February 2019. It therefore remains to be seen whether the COCG agrees that the proposals go far enough and we can but wait and see. Some commentators are already voicing views that such legislation is not in the spirit of the COCG and given
Brexit, one wonders whether it will have an influence on the COCG’s views. Having said that the legislation seems to fall very much in line with the OECD’s guidelines in BEPS Action point 5 so it would seem controversial if the COCG deviated from this global standard. What is clear is that
this legislation is here to stay in some shape or form so companies need to consider their positions early.
Earliest reporting date would be accounting period ended 31 December 2019 and therefore reporting by 1
Corporate tax returns will be amended to include sections which will gather the information in relation to the substance requirements for companies operating within relevant sector industries.
Registered office (RO) only business
Many CSPs provide only RO/Registered agent business for clients. In other words, the directors, business activities and administration are (in most cases) off-island. In fact, in some cases the directors may be in one or many different jurisdictions.
These companies (if IOM incorporated) are within the scope of the Order IF (and ONLY IF) they carry on any of the relevant activities listed above. They are within scope of the Order because they are corporate taxpayers (by incorporation).
The consequence of this is that prima facie these companies will not meet the ‘Substance Criteria’ i.e. they will most likely not, be directed and managed on island, have no local employees, have no premises (per se) and their CIGA will more often than not be performed outside the island. This means they will undoubtedly face
New substance requirements…
sanctions and possible strike off (if they carry on relevant activities).
The notion of ‘registered office only’ services is looked upon with some degree of distain by many parties, but the reality is that a great number of CSPs have this type of business. These companies often serve some sort of commercial or legal purpose and will certainly own assets: the prospect of being struck off or facing fines may result
in severe consequences. Some companies in this category may have no choice but to choose other jurisdictions as business locations and the following sets out some options for consideration. Note: much will depend on the facts of each case but what is clear is that these companies cannot be ignored. What can they do?
Option 1 – ‘Beef up’ local substance
The companies can make sure they satisfy the Substance Criteria. For some companies this may prove impossible/impractical and will depend on the nature of the relevant activities and numerous other factors. Any such change will clearly cause a rethink as to the business model but may also have tax consequences if they are resident in another jurisdiction (see below). For example
an IOM incorporated company which is tax resident in the UK may have a deemed disposal of assets, if it shifts its tax residence back to the Island.
Option 2 – Opt out of IOM tax residence
If, as is often the case, such companies are in fact tax resident elsewhere (and registered as such), the board of directors could elect (within section 2N(2) ITA 1970) to be treated as non-IOM tax resident. This means they will cease to be IOM corporate taxpayers and the Order will not apply to those companies, although the company will still exist.
(1) A company could become resident (for example) in another country which has a double treaty tie breaker clause (or will have in due course)
(2) It could apply to a company wishing to become resident in any country where the highest rate of tax applicable to profits is greater than 15%, e.g. the UK (given the current treaty has no tie-breaker clause).
To satisfy this provision, there must be a bona fide reason for changing the company’s residence. It is mooted that such a cessation of residence ought to be treated as commercial for section 2N(2) purposes, i.e. especially when the downside is to be fined or struck off the companies register.
An anti-avoidance provision is also contained in the Order and once again, one would have thought that such steps would not be treated as avoidance for these purposes.
Of course, this option is only really open to those companies where it is clear that they are tax resident as a matter of foreign law in the other country but also that the business is centrally managed and controlled in that other country i.e. foreign tax residence is based upon the same or similar principles as central management control. This may of course not be the case, i.e. the two test may not technically coincide.
Furthermore, the option is not open to those companies resident in countries which fall outside the parameters in section 2N(2), e.g. Gibraltar or Bulgaria.
Therefore, if tax residence is as a matter of fact located in another country (or there is a desire to be tax resident there), the conditions in section 2N(2) need to be reviewed. If the outcome of this review is fruitless, other options
need to be considered.
Of course, if section 2N(2) were amended it may be possible to expand the list of jurisdictions where companies might find their natural home, even if legislation similar to the Order persists in those jurisdictions.
Option 3 – Re-domicile
If a company cannot comply with the requirements of the Order and cannot cease to be IOM tax resident within section 2N(2), it may be that re-domiciling the company to another jurisdiction is a viable possibility.
Much depends on which jurisdiction is beneficial to the company’s business and importantly whether the jurisdiction allows for re-domiciliation. Many
jurisdictions do not permit re-domiciliation and regretfully many of those that do are likely to have similar laws to the Order.
Option 4 – Restructure.
Restructuring may be the only course of action open to such entities if attainment of local substance, cessation of Manx residence or re-domiciliation are non-starters. This therefore may be the only sensible choice. Much will depend on the circumstances of each case, the relevant activities and what is practically and commercially sensible.
What about foreign companies?
Some companies have a place of business in a jurisdiction but are not actually tax resident, eg a BVI company may have activities being carried out in the IOM (but it is not be registered as tax resident) and it may be a relevant sector company. These companies may be resident by incorporation in other jurisdictions (and as a matter of that jurisdiction’s substance laws) but they may not be able to satisfy the Substance Criteria in those jurisdictions.
Such companies may therefore wish to locate themselves somewhere where they can satisfy the Substance Criteria eg the IOM or elsewhere. If these companies already have some presence on the IOM, a close examination of
PN144/07 may be warranted to assess whether they are in fact IOM centrally managed and controlled in Island. If they are, given that such companies are possibly some way towards meeting the Substance Criteria, it may make sense to look a little more closely at their activities and perhaps consider re-domiciling them to the Isle of Man.
How can we help?
If you think that your business may be affected by the new legislation, it is important that you begin to assess your business and taking appropriate action now.
Contact Paul Hotchkiss on (01624)872140 or email@example.com and we can discuss what we can do to help you.