When I last wrote in this publication on economic substance, The Bahamas had recently issued draft legislation for consultation. Over the past year, The Bahamas, like many other financial centres around the globe. has passed legislation implementing economic substance requirements in line with the OECD’s Base Erosion and Profit Shifting (BEPS) Inclusive Framework (IF).
While there are variances in terminology, the effect of the legislation and guidance implementing economic substance is similar across jurisdictions: with some limited exceptions, entities organised in the relevant jurisdiction and engaged in specific activities identified by the OECD as geographically mobile preferential regimes are now required to demonstrate substantial economic presence. As of the beginning of 2020, over 120 jurisdictions in total have committed to the implementation of BEPS. The Bahamas was one of 18 international financial centres to join the Inclusive Framework (IF) on BEPS in 2017 and after passing the Commercial Entities (Substance Requirements) Act, 2018 (CESA) in December 2018, the Competent Authority (the Ministry of Finance) has now opened the jurisdiction’s electronic portal for CESA reporting.
The history of BEPs bears brief mention although it is not the focus of this article. In 2012, austerity measures implemented by the G-20 provided the backdrop for an unprecedented expansion of the G-20’s focus on international tax avoidance by multinational corporations. Base erosion and profit shifting were identified as extreme threats to the G-20’s fiscal stability. Although BEPs outlines 15 Action items, it is Action 5 which revamps the OECD’s work on harmful tax practices with a focus on improving transparency and requiring substantial activity for preferential regimes, such as IP regimes. In essence, BEPs addresses features of tax regimes of different countries that allow multinational corporations to shift income to low-tax or no-tax jurisdictions and expenses to high-tax jurisdictions, thereby eroding the corporate income tax base of higher-tax economies. A no-tax framework is not in itself harmful, it is the lack of real economic activity justifying the tax benefit accorded which is harmful.
In 2018, the OECD issued its guidance on the resumed application of the substantial activities factor to no or only nominal tax jurisdictions in the context of the 1998 Report on Harmful Tax Competition (the 1998 Report). The 1998 Report classified certain no or nominal tax jurisdictions as having “harmful tax practices” and built a framework for assessment which included the substantial activities factor as one of four criteria for assessing whether a jurisdiction was a “tax haven”. Although always a part of the assessment framework, when the OECD sought commitments in 2001 to address harmful tax practices, it did not seek a commitment on behalf of such jurisdictions to implement economic substance. Now, economic substance is once again a significant part of the OECD’s metric for the assessment of harmful regimes. Having already passed the enabling legislation, The Bahamas was positively assessed by the OECD in July 2019 to not be a harmful regime. The EU Code of Conduct Group on Business Taxation which has endorsed and adopted the BEPs guidance, has also noted the progress of jurisdictions like The Bahamas in implementing tax transparency and economic substance requirements. As a result, The Bahamas is not named by the OECD or by the EU as a non-cooperative jurisdiction for tax purposes.
CESA in Summary
Although economic substance requirements apply only to those entities termed “Included Entities”, The Bahamas has implemented reporting for all entities organised, continued or registered under certain enactments. In summary, these entities are International Business Companies (IBCs) organised, registered or continued under the International Business Companies Act, 2000 (IBCs); companies organised or registered pursuant to the Companies Act, 1992; partnerships, exempted limited partnerships; and limited liability partnerships. An Included Entity for CESA purposes is an entity which conducts relevant activities but is not tax resident and centrally managed outside of The Bahamas. Tax residency is demonstrated by providing to the Competent Authority one or more forms of evidence of tax residency, including but not limited to, a tax residency certificate.
The relevant activities are presently as follows:
a. Banking business;
b. Insurance business;
c. Fund management business;
d. Financing and leasing business;
e. Headquarters business;
f. Distribution and service centres business;
g. Shipping business;
h. Commercial use of intellectual property; or
i. Where a holding company engages, or where one or more of its subsidiaries is engaged, in one of the activities listed under paragraphs a- h.
Entities above which are resident-owned in The Bahamas and conducting core income generating activities in The Bahamas are considered non-included entities. Entities which are centrally managed and controlled outside of The Bahamas and which are tax resident in a jurisdiction outside of The Bahamas (even if conducting relevant activities) are also considered to be non-included entities. Entities claiming to be non-included due to being centrally managed and tax resident in another jurisdiction are still required to report that they are a non-included and provide evidence that they are compliant with the tax requirements of such jurisdiction. This tax residency point is central to CESA and it bears noting that further guidance will have to be issued to address the impact of foreign rules attributing income to a parent or otherwise disregarding the entity for foreign tax purposes. One would expect that in certain circumstances, i.e. where all of the entity’s income is taxed in another jurisdiction, that this would satisfy the Competent Authority that the intent of CESA is met i.e. that the entity’s income is actually taxed.
An "Included Entity" has to demonstrate economic substance in The Bahamas on a two pronged test: -
a) That its core income generating activities (CIGA) take place in The Bahamas (including if outsourced in The Bahamas) which presupposes adequate amounts of annual operating expenditure; levels of qualified full-time employees; physical offices and levels of board management and control within The Bahamas; and
b) Direction and management in The Bahamas which is fulfilled by demonstrating all of the following:
i) An adequate number of board meetings in The Bahamas given the level of decision making required;
ii) That a quorum of the Board of Directors is physically present in The Bahamas during the meetings;
iii) That strategic decisions made at such meetings are recorded in minutes;
iv) That the books and records of minutes are kept in The Bahamas; and,
v) That the Board of Directors has the necessary knowledge and expertise to discharge its duties.
Under CESA, “Pure equity holding companies” are subject to reduced economic substance requirements. An included entity that is in the business of being a pure equity holding company (i.e. it only earns dividends and capital gains or incidental income from the holding of equity participations in a subsidiary that is engaged in a relevant activity), is required to comply with all applicable laws and regulations of The Bahamas; and it shall have adequate human resources and adequate premises in The Bahamas for holding and managing equity participation in other entities.
A non-included entity that is a passive holding entity (i.e. it does not have subsidiaries conducting relevant activities, nor does it conduct a relevant activity) is required only to comply with all applicable laws and regulations in The Bahamas. The Bahamas was one of three jurisdictions (along with BVI and Cayman), identified by the EU Code of Conduct Group for continued assessment of its regime for collective investment vehicles. With the recent passage of the new Investment Funds Act, 2019 which creates registration requirements for key parties like the investment manager of Bahamas organised investment funds, The Bahamas regime meets the EU’s robust regulatory requirements for CIVs. Therefore, we are aware that proposed amendments to CESA confirm that CIVs will be considered Non-Included Entities for economic substance purposes.
The time period for compliance with CESA was six months from the date of commencement of CESA for entities incorporated prior to commencement. Newly incorporated entities were expected to comply with economic substance upon commencement of relevant activities. All commercial entities (included and non-included) must report on their status under CESA within nine months of the entity’s fiscal year end.
The Minister of Finance is the Competent Authority for CESA purposes and has authority to spontaneously exchange information with reportable jurisdictions of legal or beneficial owners of Included Entities in the following circumstances:
a) On the legal and beneficial owner of Included Entities engaged in high risk intellectual property activities;
b) On the legal and beneficial owner of Included Entities who do not comply with substance requirements; or
c) On the legal and beneficial owner of otherwise Included Entities that are non-included due to tax residence outside of The Bahamas.
The list of reportable jurisdictions contained in the schedule of CESA is aligned with The Bahamas’ Common Reporting Standard (CRS) reporting partners.
Amendments To CESA Expected
The Bahamas is expected to issue amendments to CESA within the first quarter of 2020 which will provide definitions of each relevant activity. Under the present version of CESA, while there are examples of what constitutes core income generating activities for each relevant activity, there is presently no definition of each relevant activity. The proposed amendments provide helpful definitions and provide much needed clarity.
The proposed amendments to CESA provide that:
i) CIVs are neither pure equity holding companies or passive holding entities and will be considered to be Non-Included Entities unless they are conducting some other relevant activity;
ii) Financing and leasing business involves extending credit for “any kind of consideration” to another person and includes intra-group financing; and the provision of credit for which a separate charge is made in connection with hire purchase, conditional sale or credit sales, the provision of secured financing where the risk and rewards are transferred to the lessee by the lessor; leasing. The leasing of land will not be considered financing and leasing business;
iii) Shipping business will not include the ownership, chartering and operation of a pleasure yacht where the chartering serves to defray the cost of owning and operating such yacht.
iv) Entities will be required to procure an Entity Identification Number or provide a Foreign Tax Identification Number for CESA reporting.
Of course, the proposed amendments are still in consultation and may be further amended prior to passage. As with most matters relating to economic substance, a minute analysis is required of the specific business activities, portfolio composition and income in order to properly classify an entity and determine the extent of economic substance likely to satisfy legislative requirements.
Aliya Allen Partner, Graham Thompson, Bahamas