The EU's goal to be the world leader on tax good governance and to dissuade "problematic third countries" from maintaining systems and legal structures considered to allow tax abuse and unfair tax competition, is well known. The political imposition of economic substance requirements on criterion 2.2 jurisdictions , including the BVI, is the latest step taken towards this goal. In response, the BVI has enacted the Economic Substance (Companies and Limited Partnerships) Act, 2018 (as amended, the ESA), adhering to its commitment to introduce an economic substance regime ahead of the EU's deadline of 31 December 2018.
However, at the time of writing, the BVI currently finds itself on Annex II to the EU's list of non-cooperative jurisdictions for tax purposes, or the ’greylist’, as a jurisdiction which is cooperative but requires further technical guidance, and which has been granted until the end of 2019 to adapt its legislation to address economic substance concerns. This article considers the current status of the BVI's economic substance regime and the practical impact of the substance developments on the Islands.
Current Status - The Greylist
What more the BVI must do to be moved off the greylist is currently unclear. In its conclusions of 12 March 2019, the EU Council acknowledged that further work is required to define acceptable economic substance requirements for collective investment funds (CIVs) under criterion 2.2 and invited the Code of Conduct Group (Business Taxation) of the EU ( COCG) to continue the dialogue and provide further technical guidance to the jurisdictions concerned by mid- 2019.
The scoping paper on criterion 2.2 correctly states that the usual substance requirements cannot automatically be applied to CIVs. CIVs are essentially established to facilitate international cross-border investment in a tax- neutral jurisdiction and are not intended to have economic substance in that jurisdiction; the substance remains onshore. The Council has recognised that reduced substance requirements should apply to CIVs but has not indicated what those requirements will be. This lack of information is unhelpful, given that the BVI's substance regime will likely be in full effect prior to any clarification being received and implemented.
This leads us to consider the current status and nature of BVI's economic substance regime, albeit that further change is inevitable.
Application Of The Substance Regime
The ESA came into force on 1 January 2019, with immediate application to in-scope entities formed on or after that date and, in relation to pre-existing in-scope vehicles, with effect from 30 June 2019. The ESA applies to vehicles with legal personality registered in the BVI, including companies and certain limited partnerships. The in-scope entities are referred to as “legal entities” and do not include trusts, partnership and limited partnership vehicles without legal personality, or entities which would otherwise be in-scope but are classified as "non-resident" due to their tax residence in a jurisdiction outside the BVI. Legal entities that can demonstrate, by supplying appropriate evidence, that they are tax- resident in another jurisdiction are exempt from the substance requirements.
A BVI vehicle which is a legal entity for the purposes of the ESA will be required to meet an economic substance test if it conducts one or more “relevant activities”. This term captures regulated activities such as banking business, fund management business, and insurance business, together with distribution and service centre business, finance and leasing business, headquarters business, holding business, intellectual property (IP) business, and shipping business. These activities reflect geographically-mobile activities typically embraced by the preferential tax regimes identified by the EU.
In summary, if a BVI vehicle is a legal entity, is conducting a relevant activity, and is not tax- resident outside the BVI, it will be required to meet the substance test imposed by the ESA.
The Substance Test
All in-scope legal entities carrying on a relevant activity must have an adequate number of suitably qualified employees physically present in the BVI and appropriate physical offices or premises in the BVI.
All in-scope legal entities , other than those carrying on holding business, must also conduct core income-generating activity (CIGA) in the BVI; incur adequate expenditure in the BVI; and direct and manage the relevant activity in the BVI. Additional requirements apply to IP business.
The BVI has published a draft Economic Substance Code to provide guidance on the practical application of the substance regime. Essentially, however, the substance test (including what is "adequate" and "appropriate") will require an analysis of the operations and circumstances of each legal entity, for an entity to assess whether the test is met and report accordingly. Those determinations should be made and documented very carefully.
Essentially, the aim is to ensure that BVI entities conducting relevant activities have real substance within the BVI. In turn, this evidences that those vehicles are not being used to enable artificial, intra-group transfer pricing or profit shifting from other jurisdictions imposing higher rates of taxation, thereby reducing the amount of income subject to taxation in those countries.
Helpful clarification is given in the Code around outsourcing in that a legal entity may outsource CIGA to a third party (such as a BVI registered agent) and count this towards compliance with substance requirements if:
Amended Legislation For Reporting And Monitoring Compliance
The BVI established the Beneficial Ownership Secure Search System (BOSS System) in 2017 in order to enable the automatic exchange of beneficial ownership information, and it is this system which will be expanded in order to report and monitor compliance with the substance regime. Under the amended BOSS System legislation, all legal entities are responsible for providing accurate and complete substance-related information to their registered agent (RA) in the BVI in respect of each relevant financial period. For each legal entity, that information will include:
The substance information provided to the RA is then uploaded to the database (an RA database) maintained by each RA. The registered agent's responsibility in respect of the information is limited to taking reasonable steps to collect it and to enter the information in the RA database. The RA databases are not public but may be searched via the BOSS System upon lawful request by one or more designated persons, including the BVI's International Tax Authority ( ITA), and in response to requests from overseas law enforcement authorities. It is then a function of the ITA to determine whether a legal entity has complied with the economic substance requirements during any relevant financial period.
The amendments made to the BOSS System legislation also require the ITA to disclose economic substance information to relevant overseas competent authorities in certain circumstances; this includes where a legal entity is determined to be in breach of the substance requirements, and where a legal entity claims to be tax- resident outside the BVI.
Consequences Of Failure To Meet The Substance Test
In addition to the information sharing which will take place as noted above, failure to meet the substance test may lead to the imposition of an initial fine of up to US$20,000 (US$50,000 for certain IP related legal entities). Continued failure to meet the test in the following year could lead to an additional penalty of up to US$200,000 (US$400,000 for certain IP legal entities), and possibly to the legal entity being struck from the register of companies or limited partnerships, as applicable. A legal entity that has been served with a notice of non-compliance by the ITA has a right of appeal (to be filed within 30 days of such notice) to the BVI courts against both the determination of non-compliance and the amount of any penalty imposed, including where it is the minimum prescribed).
Economic Substance – Challenges And Opportunities
Although the substance regime was implemented on time, it does give rise to practical challenges. Whilst "in every challenge there is an opportunity", as noted by the BVI's Premier Orlando Smith, the current opportunities must be identified and realised in the short term.
The new substance regime demands that the BVI increase its financial services workforce, initially so that the BVI is able to meet the substance reporting and assessment obligations imposed by the EU, but also if the BVI is to be able to offer a deeper range of services, a wider pool of qualified individuals to provide those services, and innovative solutions to those entities seeking to create more substance in the jurisdiction.
The growth afforded by such an increase in capability will benefit the BVI as a whole and will require strong strategic leadership, targeted investment, and efficient harmonisation of government departments and business, covering such things as education, business-friendly policies, immigration, and infrastructure, amongst others. Most importantly, the people of the BVI need to support and drive this vital change with a clear, shared vision of how the Islands' economy should evolve. To gain that support, the BVI must further invest in its people and ensure that they have the understanding and skills required to take advantage of the significant opportunities this regime presents.
Further change and development of the substance framework can be expected in the future, whilst the regime itself may well stimulate development and transformation within the BVI, taking it to the next level as a major participant in the global financial services industry.
 See previous footnote.
 Provided that the relevant jurisdiction is not listed on Annex I to the revised EU list of non-cooperative jurisdictions for tax purposes, commonly referred to as the "blacklist". See footnote 3.
 The position is more complicated for legal entities conducting IP business, an area where the risk of artificial profit shifting is considered to pose higher risks. However, a discussion of the substance regime as it applies to IP business is outside the scope of this article.
 Currently, the sole designated overseas law enforcement authority is the National Crime Agency – Financial Intelligence Unit of the United Kingdom.
Sara Galletly Sara Galletly is Counsel at Mourant, Cayman Islands Finance and Corporate team based in the London office. She has significant experience with structured finance transactions, and specialises in investment funds, both hedge funds and private equity. She joined Mourant in 2016 as a Knowledge Lawyer in the London office, supporting the Cayman and BVI Corporate practices globally.
Rachel McDonald Rachel McDonald is Managing Partner of Mourant’s BVI office. She has extensive experience in corporate and banking and finance transactions. She advises on all aspects of finance transactions, including acquisition and leveraged finance, asset finance, debt repackaging, debt restructuring, insolvency and security enforcement, project finance, real estate finance and securitisation. Rachel regularly advises BVI companies, their directors and shareholders and international parties using BVI entities involved in corporate matters and investment transactions all over the world, in a multitude of industry sectors. Mourant BVI.
Mourant Ozannes British Virgin Islands, Cayman Islands, Guernsey, Hong Kong, Jersey and London.