EU Sets New Substance Requirements for Offshore Companies

substance requirements

The European Union (EU) has added pressure to offshore centers such as the Isle of Man and Jersey to ensure that companies operating offshore demonstrate genuine tax substance. The new EU guidelines are targeted at re-looking at the way business taxation is implemented in zero tax territories such as the Isle of Man, Jersey, and Guernsey.

The targeted zero tax authorities have committed to complying with the new rules. In summary, a company operating in the zero tax territories will be required to meet tax substance requirements that are proportionate with activities and generated income, in the respective jurisdiction.  

Reporting and demonstrating economic substance

The new rule indicates that there will be reporting and tax audits to review tax substance of the companies in zero tax jurisdictions. If a company has insufficient substance, penalties ranging from fines to de-registration will be instituted. De-registration will be the option of last resort.

The EU management believes that the territories are likely to go for the option of regularly providing info (provision under EU Directive DAC6) to tax authorities in other jurisdictions where the companies are operating.

Already, Jersey and Guernsey have started consultations defining the proposed requirements while the Isle of Man has put the requirements under review. These consultations imply that offshore companies will be required to demonstrate how they do the core income generating events in the respective zero tax territories. Here are the specific things they need to demonstrate.

  • The adequate level of the company’s qualified staff in line with the activities of the company.
  • The company’s adequate annual expenditure incurred on operations in the zero tax jurisdictions.
  • The physical offices or premises that the company uses to run operations in the respective jurisdiction.

These tests can be done via outsourcing other firms, but only in the jurisdiction where the company has its operations. But, the companies that outsource activities from firms located outside the respective zero tax territory could come under scrutiny.

Here is an example. Many companies often register in the zero tax authorities but subcontract investment management from other EU countries. In such a case, if the profit achieved in local company surpassed the business substance in the tax free jurisdiction, enforcement would be required.

    Pricing parallels transfers

    The transfer pricing guidelines under the OECD were updated to help allocate profit within groups to businesses that are demonstrated to be in substance, controlling inherent risks, and managing the company’s business.

    To be specific, for intangibles, the business is required to recognize little or no profit from holding an IP (intangible property) except if it exercises control of the functions about the development, maintenance, protection and use of the IP assets.

    Though the crown dependencies (the three zero tax jurisdictions in the EU) and a few more countries have not operationalized the OECD model of price transfer, pricing requirements, and strict adherence to substance standards required in line with consultation documents, there is a likelihood that the same outcome will be achieved.

    The international info exchange arising from substance review is expected to make other jurisdictions start adopting transfer pricing audits. The penalties including striking off a company are considered more severe and are expected to force companies to focus on demonstrating substance. 

    The next step

    The new measures are expected to be ready by the close of 2018 and take effect from 2019. This implies that many companies will have a short period of complying with new regulations. Therefore, some might opt to start demonstrating substance of moving their operations elsewhere. The best thing for companies with businesses in the tax free territories is focusing on compliance as early as now.


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