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Substance

19 Nov 2018

Written by Paul Hotchkiss

SUBSTANCE

REGISTERED OFFICE ONLY BUSINESS AND CORPORATE RESIDENCE

In my earlier document on substance I set out the basic parameters of the draft Income Tax (Substance Requirements) Order 2018 (the ‘Order’).  In this document I would like to highlight some particular issues but also (and more importantly) some opportunities for CSPs.

What we know

The Order applies to:

Isle of Man tax resident companies;

Which are in the receipt of income

from the performance of relevant activities,

in any accounting period.

What is a resident company?

Residence by incorporation

A resident company is defined in section 2N ITA 1970 as any company incorporated in the Isle of Man. This is a corporate taxpayer.

Residence by case law

Practice note PN 144/07 also sets out the Income Tax Division’s (ITD) position on non-IOM incorporated companies, which basically states that any non-IOM incorporated company will be IOM tax resident (and a corporate taxpayer) if its business activities are centrally managed and controlled on the Island. This is broadly a test based on UK case law and realistically means the place where strategic decisions are made with respect to the company’s business activities.  Loosely translated this is usually the place where the directors meet.

What might this mean for certain types of business?

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 below.

banking

insurance

shipping

fund management

financing and leasing

headquartering

operation of a pure equity holding company

holding intellectual property (IP) 

distribution and service centres

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 not, be directed and managed on island, have no local employees, have no premises (per se) and their core income generating activities will more often than not be carried outside the island. This means they will undoubtedly face sanctions and possible strike off (if they carry on relevant activities).

These companies often serve some sort of commercial or legal purpose and will certainly own assets so the prospect of being struck off or facing fines may result in severe consequences.  Some companies 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.

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. 

Putting this into context, section 2N(2) states ‘a company is not resident in the Isle of Man if it can be proven to the satisfaction of the Assessor that —

(a) its business is centrally managed and controlled in another country; and

(b) it is resident for tax purposes under the other country’s law; and

(c) either — 

(i) it is resident for tax purposes under the other country’s law under a double taxation agreement between the Isle of Man and the other country in which a tie–breaker clause applies; or

(ii) the highest rate at which any company may be charged to tax on any part of its profits in the other country is 15% or higher; and

(d) there is a bona fide commercial reason for its residence status in the other country, which status is not motivated by a wish to avoid or reduce Isle of Man income tax for any person.”

From this we can conclude.

A company could become resident (for example) in Malta, Estonia, UK, Bahrain because each country has a double treaty tie breaker clause (or will have in due course)

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 bona fide 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. 

However, as a matter of practice this is unlikely to be an issue.

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, it 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 – Redomicile

If a company cannot comply with the requirements of the Order and cannot cease to be Isle of Man 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.  A broad list of countries which have such laws is set out in Appendix 1.  As you can see there are very few countries on this list which are also not subject to similar rules, notable exceptions include Ireland, Luxembourg, Malta etc.

Generally when a re-domiciliation occurs the process results in no tax consequences in terms of the transition.

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.  Such restructuring may (in the simplest of terms and by way of example) involve:

establishing a company in the country where the most substance is already present, transferring some or all of the assets held by an Isle of Man company to that company and liquidating the Isle of Man entity or operating it on the basis that it may no longer carry out relevant activities;  or

A company transferring its business and assets (or some of them) to a subsidiary in another country.  Depending on the circumstances, the Isle of Man company may then cease to carry out one relevant activity and start to carry on a non-relevant activity or another relevant but with the ability to meet the necessary Substance Criteria, e.g. by selling IP to a related party and the appointment of a local board a company which was once RO business may cease to be a high risk IP company and become a pure equity holding company.

Much will depend on the circumstances of each case, the relevant activities and what is practically and commercially sensible. 

Clearly, this is perhaps the most costly in terms of legal fees and possibly may incur tax charges depending on the tax laws of the country concerned, the nature of the assets and the location and status of shareholders.  Also much depends on commercial and external constraints on the existing company.

What about foreign companies?

Many companies are ‘administered’ on the Isle of Man but are not currently treated as tax resident.  In theory, such companies engaged in relevant activities will not fall within the Order.  However, the question to be asked is this: where are such companies tax resident? 

These companies may be resident by incorporation in other jurisdictions and may not be able to satisfy the Substance Criteria in those jurisdictions.  They may therefore wish to locate themselves somewhere where they can satisfy the Substance Criteria and the Isle of Man may not only be a jurisdiction of choice but much activity may already be happening on island.  Often such companies will be already provided with local administration services, have local boards of directors and engage local professionals in the conduct of their business.  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 (see Appendix 1) and ‘beef up’ local substance (see Option 1 above) or making more of an effort to be considered Isle of Man tax resident. 

A perfect example of this would be a BVI company administered in the IOM.  If relevant activities are carried out then that company may not be able to meet the equivalent Substance Criteria in BVI and therefore something must be done to avoid sanctions in the BVI.  Clearly, there are other criteria to factor into any decision making including the incidence of VAT etc.

The above is intended to be a high level over view of the issues and opportunities and is no way intended to be a comprehensive review of the proposed changes.  No actions should be taken as a result of this note as each case needs to be considered on its own merits. If you wish to discuss these matters in more detail or any specific cases please contact Paul Hotchkiss (email: paul@hotchkiss.im or call 01624 872140).

Page Break

Appendix 1 – Countries that have re-domiciliation laws.

Andorra

Anguilla

Antigua and Barbuda

Aruba

Austria

Bahamas

Bahrain

Barbados

Belgium

Belize

Bermuda

British Virgin Islands

Brunei

Cayman Islands

Cook Islands

Costa Rica

Cyprus

Dominica

Gibraltar

Grenada

Guernsey

Hungary

Ireland

Isle of Man

Israel

Jersey

Latvia

Lebanon

Liberia

Liechtenstein

Luxembourg

Macao

Malaysia (Labuan) 

Maldives

Malta

Marshall Islands

Mauritius

Montserrat

Nauru

Netherlands Antilles

Panama

Philippines

Portugal (Madeira) 

Samoa

Seychelles

St Kitts and Nevis

St Lucia

St Vincent Grenadines

Switzerland

Turks and Caicos Islands

UAE (Dubai, RAK)

Uruguay

US Virgin Islands

USA (Delaware)

Vanuatu

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