Economic Substance Or Economic Warfare?

For every optimist there is a pessimist, but many are on the fence: hopeful but cautious about what this might mean for their country, their corporate service company, accounting or law firm, or indeed any business that relies directly or indirectly on the revenue generated by offshore business.

The objective of the EU is straightforward: to increase its tax base by reducing the ability of “geographically mobile” corporations to avoid tax through using so-called “shell companies” and other structures in offshore financial centres. To the casual observer, it must seem obvious that if the EU’s initiative is effective then it will benefit the EU at the expense of the offshore financial centres. If, as seems inevitable, large numbers of entities discontinue their offshore operations as a result, how can that be anything other than bad news for the offshore financial service industry?

Each of the keys British Overseas Territories (Bermuda, the Cayman Islands, and the British Virgin Islands) and the Crown Dependencies (Jersey, Guernsey, and the Isle of Man) has passed economic substance legislation.  They did not devise and pass this legislation voluntarily but in direct response to EU compulsion.  

These jurisdictions have grown accustomed to improving transparency and tightening anti-money laundering measures, including in response to international pressure. But the EU’s economic substance demands represent a dramatic escalation from ’pressure’: many view this as a form of economic warfare or imperialism whereby small, self-governing nations are subjected to explicit threats by a group of large nations and ordered to implement domestic legislation to the EU’s exacting requirements.  

Bermuda has experienced a taste of what may be still to come for the OFCs, having been placed on the EU’s list of non-cooperative tax jurisdictions or ’blacklisted’ on 13 March for failing to meet an EU-imposed deadline. If the Bermuda Government is to be believed (and the EU has not suggested otherwise), the blacklisting came about due to a drafting error (resulting, we are told, from a genuine and innocent misunderstanding) in Bermuda’s Economic Substance Regulations.

Although the error was apparently corrected before the meeting of the EU’s Economic and Financial Affairs Council (ECOFIN), at which the substance legislation passed by all the OFCs was to be reviewed, Bermuda’s mistake was seized upon and its mitigation effort ignored by ECOFIN. Even the UK – which has long been a voice of moderation amongst EU Members on issues involving the OFCs - was unwilling to expend its scarce political EU capital to block Bermuda’s inclusion on the blacklist. Bermuda must now wait, wonder and worry until the next ECOFIN meeting to find out whether it will be removed from the list, having purged its error and having spent two months on the EU’s ’naughty step’.

Less is more?

This all sounds pretty bleak.  But this is not how it is being portrayed to the general public by political and business leaders in the OFCs.  For example, when Bermuda’s Minister of Finance, Curtis Dickinson, announced the enactment of Bermuda’s Economic Substance Act at a press conference on 9 January, he portrayed the legislation as a positive development for Bermuda.  Flanked by business leaders, he explained that the Act would ensure that Bermuda “remains off any EU list of non-compliant jurisdictions and will continue to thrive as an international business centre”. The Minister went on to predict that the EU’s efforts to eliminate widespread business practices carried out through OFCs would, in fact, result in the “creation of new jobs and opportunities” for international business.   

We now know that the Minister was wrong about his first prediction but what about his second?

The view that OFCs stand to benefit from the EU’s economic substance requirements derives from the ’less is more’ theory that is being propounded by political leaders. The thrust of the OFCs’ substance legislation is that “in scope” entities – namely those in the banking, insurance, fund management, financing, and shipping sectors, as well as holding entities – must now have “adequate” substance within the jurisdiction, effectively outlawing so-called “shell companies”. The ‘less is more’ optimists reason that, although many business owners may choose to discontinue their offshore operations, others may conclude that the benefits of doing business offshore justify an increase in local substance. This, it is claimed (or hoped), will lead to a net increase in jobs and economic activity despite there being fewer registered companies overall.   

Indeed, Bermuda’s insurance and reinsurance industry is, for the most part, the epitome of ‘substance’ and is the model that many hope will be replicated in other business sectors. However, OFCs are also home to thousands (tens or hundreds of thousands) of other corporate entities operating across almost all business sectors. Some of these entities, like the insurers, do have a substantive presence but the majority have little or no substance with all activities being carried out through third party service companies.  These include holding entities for, or subsidiaries of, businesses with substantive operations elsewhere, including “geographically mobile” businesses such as Google. Unlike Bermuda’s highly visible insurance companies, most of these entities are virtually invisible, consisting of little more than a corporate record book and files maintained by the corporate registrar and third- party service providers.  

The OFCs acknowledge that many international businesses are unlikely to be able (or willing) to develop the required level of “adequate” substance at their offshore affiliates. As a result, these businesses will have to discontinue their offshore “shell companies” with a consequent substantial reduction in government fees and earnings by the lawyers, accountants, and other service providers who maintain and advise such entities.      

Conversely, other businesses may beef up local substance to satisfy the new laws.  This should, at least in part, reverse the trend whereby many offshore entities outsource administrative and other functions to onshore affiliates. It may also result in senior managers and other personnel relocating to OFCs.  If this happens to a material degree, job opportunities for locals with the expanding entities should also increase. It will also benefit commercial and residential landowners (who invariably are locals) and create new opportunities for those who service the needs of well-heeled expats, from landscapers to restaurateurs to yoga instructors to boat mechanics. 

Location, infrastructure and quality

As the concept of “shell companies” nears its demise, the OFCs have embarked on charm offensives to woo businesses from competitor jurisdictions.  With ‘virtual’ offshore entities no longer an option, considerations such as location, infrastructure, quality of service providers, and immigration policies have come to the fore. Bermuda and the Channel Islands, for example, may have the edge when it comes to proximity to Europe and North America. Likewise, the Cayman Islands has a strong reputation as a user-friendly jurisdiction for international businesses (particularly in the funds sector) and the BVI is well represented in the important Asian markets.

In the meantime, the OFCs are refining their guidance on what will satisfy the “adequate” substance requirements and lawyers and accountants are busy advising on the likely impact of the new legislation and whether their clients’ individual circumstances will bring them onto the right side of the substance line. In many cases, there is considerable uncertainty as to where that line is to be drawn.

With “in scope” entities in the tens of thousands (e.g. Bermuda) or even hundreds of thousands (e.g. BVI), corporate registries will need to multiply their personnel to cope with the avalanche of individualised, fact-specific substance returns that are due in 2020. They will also need to be equipped to enforce compliance with the substance requirements and to prosecute non-compliance.

When the time comes for the regulators to assess the adequacy of each entity’s substance, there will be a large number of marginal cases where the generic guidance will be of limited assistance and individual reviewers may be forced to take subjective (and no doubt inconsistent) decisions in determining whether the entity’s substance is considered “adequate”.  These marginal cases will need to be reviewed by the enforcement department and decisions taken as to whether to threaten or to impose sanctions. This review will be done in circumstances where there is no relevant legal precedent to guide the enforcement officers.  No doubt, guidelines will be tweaked as lacunae are identified and the courts will be busy considering appeals and creating legal precedent.

Overbearing Influence of the EU

As a result, for many businesses the current uncertainty will persist for years. It is possible that new formations in OFCs will drop off as the new landscape is formed and as OFCs attempt to move from economies supported, to varying extents, by “shell companies” and related services to economies (it is hoped) with substantive corporate industries.

But this uncertainty is greatly amplified by the watchful eye and overbearing influence of the EU.  Usually, a jurisdiction’s legislature and courts have the means to provide clarity and to reduce uncertainty and, between them, to ensure that policy objectives are achieved and enforced. No doubt Bermuda’s competitor jurisdictions experienced a wave of schadenfreude at Bermuda being placed on the EU’s blacklist, but this episode only serves to illustrate how the OFCs are not in control of their destiny: while governments and courts will no doubt issue endless guidance and court rulings, the ultimate decision-maker will be the EU who will retain the ability, through the threat and application of sanctions, to question a jurisdiction’s interpretations and decisions and to move the goalposts as it pleases. 

With the UK due to leave the EU (apparently), the OFCs will no longer enjoy the protection of ‘Mother Britain’ within the EU and, indeed, in a struggle for economic dominance in Europe post-Brexit, the EU may see the OFCs as fair and easy game and a means through which to undermine the City of London’s financial services industry.

It is therefore impossible, in these early days, to predict whether the imposition of the economic substance requirements will be a net positive or negative for OFCs and whether less will be more or whether less will be … well, just less.  

Mark Chudleigh
Mark Chudleigh is the managing partner of Kennedys Bermuda. Having practised in London for 20 years, he maintains an international practice for clients in Bermuda, London, the United States, Asia and elsewhere. His practice focuses on dispute resolution and commercial litigation involving the insurance and financial services sectors. Mark Chudleigh’s practice also includes commercial/corporate litigation, insurance and reinsurance claims and disputes, insolvency and restructuring and trust matters.