Economic substance has been a current topic in the international wealth management industry since 2017. The EU Code of Conduct Group reviewed jurisdictions with zero or nominal taxation and determined that such places should not facilitate structures attracting profits which do not reflect real economic activity in the jurisdiction.
The relevant jurisdictions include most of the “offshore” international finance centres such as the Bahamas, Bermuda, British Virgin Islands (BVI), the Cayman Islands, Guernsey and Jersey.
Each of the jurisdictions brought in legislation and relevant guidance during 2018. There have been several revisions and extensions since that time – most notably extending to limited partnerships.
The rules apply to relevant entities[i] which carry out relevant activities. Each such relevant entity carrying out a relevant activity must satisfy the economic substance rules for that activity. There are certain exemptions particularly those entities which can establish that they are “tax resident” elsewhere[ii].
It is necessary therefore to briefly examine what kind of entities are covered by the rules and then the types of activity requiring substance. Thereafter we can examine the impact on private wealth.
This article will focus on the BVI. This has always been – and remains – a popular jurisdiction for private wealth.
In the BVI a “legal entity” means a company and a limited partnership[iii]. These are defined as one would expect but do not include entities resident for tax purposes outside the BVI[iv]. For the purposes of private wealth, the BVI business company is the main type of entity which is subject to the regime.
Obligation For All BVI Entities
All legal entities are required to make a notification regarding economic substance. This is done via the Beneficial Ownership Secure Search System (BOSS)[v] which is operated by the Registered Agent in the BVI. This relates to each financial period.
The entity needs to file basic details such as name, incorporation date, incorporation number and entity type followed by details of the financial period. Thereafter, there is a section about relevant activities. If the legal entity is “in-scope” then there is quite a lot of detailed information which needs to be provided to the Registered Agent and thereafter input into the BOSS[vi]. There are penalties for non-compliance.
These are listed as “banking business”, “insurance business”, “fund management business”, “finance and leasing business”, “headquarters business”, “shipping business”, “holding business”, “intellectual property (IP) business” and “distribution and service centre business” but “investment fund business” is expressly carved out.
The substance and enhanced regulation of investment fund business is dealt with separately by the BVI[vii] and other jurisdictions. Thus, legal entities which are investment funds (and underlying subsidiaries of investment funds are included in this definition) are not regarded as carrying on a relevant activity.
The definitions are set out in the ES Act. Most are self-explanatory and a number also relate to other areas of BVI regulation[viii]. Three points to set out at this stage. First, the definitions all include the term “business” or “the business of…”in the description. Second, for certain activities, to determine whether the activity is being carried out, it is also necessary to consider whether or not such activity earned income during the relevant financial period[ix]. Third, it is possible to carry out more than one relevant activity.
The more sophisticated private wealth structures will have entities falling within a number of such activities, but the vast majority of clients need only concern themselves with “holding business”.
In the BVI, “holding business” is defined as “the business of being a pure equity holding entity”. A “pure equity holding entity” is defined as “a legal entity that only holds equity participations in other entities and only earns dividends and capital gains”.
The BVI Guidance clarifies further: “the definition of pure equity holding company is deliberately framed in narrow terms. A legal entity will only fall within the definition if it holds nothing but equity participations, yielding dividends or capital gains. The ownership of any other form of investment (such as an interest-bearing bond) will take the legal entity outside this definition”.
Many BVI companies will in fact own (or can acquire) investments to take them outside of the definition (real estate and investment bonds being examples).
What Is Needed For “In-Scope” Entities?
In-scope entities need to comply with the relevant substance requirements. There are differing standards for holding business (reduced substance), IP business (enhanced substance), and the others (standard substance).
A pure equity holding entity has adequate substance if it: “(a) complies with its statutory obligations under the BVI Business Companies Act (BCA) … and (b) has, in the [British] Virgin Islands, adequate employees and premises for holding equity participations and, where it manages those equity participations, has, in the [British] Virgin Islands, adequate employees and premises for carrying out that management.”
Unlike reduced substance, standard and enhanced substance require the entity to be “controlled and managed” in the BVI and for what is defined as “core income generating activity” to take place in the BVI. Details of this are outside the scope of this article.
For those companies in-scope, there remains a number of minor issues[x]. The obligations are not clear for struck-off companies and clarification is to be welcomed. There is an apparent distinction in the rules between active and passive management but there is little commentary at this stage. Finally does income need to be earned?[xi] Again, there is a certain need for clarity. The author is aware of historic differences between the views of the service providers.
Fall-out From Economic Substance
Thus, it is the author’s experience that the vast majority of companies will be out of scope and the vast majority of those in scope will be carrying out holding business where the substance requirements are easily satisfied.
Here are some of my observations following the introduction of economic substance rules.
There was a certain amount of scaremongering from service providers representing certain jurisdictions predicting the demise of the BVI and that BVI companies were “doomed”. It was being suggested to close-down or move BVI companies to jurisdictions such as Hong Kong or Singapore. To the author this was somewhat disingenuous:
a) For most clients, the rules themselves are not that difficult to comply with. Of course, there could be amendments and revisions in future years.
b) Corporates in Hong Kong, Singapore, and other low tax jurisdictions were always likely to get on the EU radar at some point[xii].
c) In most cases, Hong Kong and Singapore do not in themselves offer any more “substance” than the BVI or other “offshore” jurisdictions. Yes, there is an audit requirement for companies but this does not add corporate substance. Singapore requires a local individual director but in the main this is marketed and sold as a “nominee” director- something which is not recognised in the BVI. A nominee director cannot be said to add substance- in fact the opposite could be argued.
a) In certain jurisdictions, the concept of tax resident is not always black and white. For the ES Law, an entity needs to show and prove tax residence in another jurisdiction.[xiii]
b)Connected with this point (and also for Hong Kong’s economic benefit), there was a certain degree of lobbying for legislation to be able to “migrate” companies to Hong Kong.[xiv]
a) The corporate service providers have launched new business lines relating to economic substance solutions and offered to assist companies with their “classifications”.
b) There are obligations for the Registered Agents and thus Registered Agents’ fees have increased.
c) Furthermore, the requirements for preparing and maintaining beneficial ownership registers and complying with FATCA and CRS due diligence /reporting obligations have also increased the burden on service providers[xv].
d) It is now common to see extra line items of several hundred US dollars relating to economic substance and other matters.
e) It is apparent that several clients are now truly noticing the cost of maintaining companies. Many will determine that they are no longer needed. This is not directly due to economic substance, but economic substance could be the “straw that broke the camel’s back” or the “wafer-thin mint” of regulatory compliance.
What Is Happening On The Ground?
The BVI International Tax Authority does not have any publicly available current statistics. It is, however, beginning its programme of ES audits and will report in due course. The Cayman Islands recently had a “town hall” on ES matters and one area of feedback was that many entities were registering as carrying out holding company business but in fact were not!
The author carried out a very informal straw poll with three of the leading Registered Agents in the BVI. The results indicate that 80-90 per cent of BVI companies are out of scope; the vast majority of those in scope are pure equity holding companies and only around 1-2 per cent are caught by full (or enhanced in the case of IP) ES requirements. Of the 1-2 per cent, many may have already been fully compliant due to their regulated status as banks, fund managers or insurance companies. IP companies will have been the most impacted (and in some respects that is consistent with the EU’s original objectives).
The BVI’s accurate figures are awaited with interest.
What Do Other Numbers Suggest?
The BVI Financial Services Commission issues a quarterly statistical bulletin[xvi]. Here are the numbers of active BVI companies.
NUMBER OF ACTIVE COMPANIES
30 June 2021
31 December 2020
30 June 2020
31 December 2019
30 June 2019
31 December 2018
30 June 2018
31 December 2017
It is possible to detect a general downward trend but nothing out of the ordinary. These numbers do not suggest thousands of companies being closed down or migrated. In fact, in 2018, the numbers went up.
Other Trends Lending Toward A General Reduction In The Number Of Entities
Thus, it is true to say that there has been a certain level of reduction in the number of BVI companies. But certainly not serious and not all down to economic substance.
Much has been written about economic substance but the impact has to date been minimal. What is perhaps a potential trigger for future increase of substance has been the increased focus from a compliance perspective – not a tax perspective – on so-called “shell companies”. In that regard, as they say, watch this space!
[i] Or equivalent terms such as “legal entity” in the BVI
[ii] In BVI defined as a “non-resident company” or “non-resident limited partnership”.
[iii] See the Economic Substance (Companies and Limited Partnerships) Act 2018 (as amended) (the ES Act).
[iv] Provided the relevant jurisdiction is not on the EU list of non-cooperative jurisdictions for tax purposes.
[v] See the Beneficial Ownership Secure Search System Act (as amended)
[vi] See https://bviita.vg/wp-content/uploads/2020/06/BVI-ESS-Data-Model-Description-v1.1.pdf for more detail.
[vii] In the BVI, the Securities and Investment Business Act was revised together with the enactment of Private Investment Funds Regulations 2019.
[viii] Insurance, banking and fund management being obvious examples.
[xii] Hong Kong has been added to the EU “grey list” from 5 October 2021.
[xiii] See the author’s piece https://www.linkedin.com/pulse/choosing-subject-economic-substance-rules-richard-grasby-tep
[xiv] See https://www.hkcgi.org.hk/submission_details.php?menu_id=9&sub_menu_id=0&nid=2394
[xv] And real potential for liability.
Richard Grasby is a Partner in Appleby’s Hong Kong office, leading the Private Client, Trusts and Family Office practice. Richard advises trustees, ultra-high net worth individuals, private trust companies and family offices on the establishment, restructuring and administration of trusts, including special trusts i.e. BVI VISTA, Cayman STAR and Employee Benefit Trusts. He regularly assists in estate administration, succession planning and family governance. Private clients and family offices instruct Richard to advise on the use of corporate vehicles for asset holding and succession planning purposes. Richard is an expert in regulatory law including AML, AEOI, economic substance and licensing and risk management for trust companies. He also advises on collective investment funds, particularly unit trusts and private label funds. Richard has acted for many of the world’s leading trust companies, financial institutions, wealthy individuals and related structures. He has experience with dealing with clients and advisors across the globe. Richard has over 20 years’ post qualification experience with the majority spent in offshore firms. Richard has lived and worked in Jersey, London, the Cayman Islands and (since 2009) Hong Kong. He is admitted as a solicitor in England and Wales and the British Virgin Islands and is a Registered Foreign Lawyer in Hong Kong. He has also been admitted as an Attorney in the Cayman Islands. Richard is an active member of STEP. He has been on the local executive committee since 2012 and is a former chair. He is on the global steering committees for the Business Families and International Client Special Interest Groups. He is a member of the Academic Community. Richard is an elected Academician of the International Academy of Estate and Trust Law (the only such offshore practitioner in APAC). He is also a Certified Anti Money Laundering Specialist. Richard is a lecturer on trusts and family offices for the Hong Kong Securities and Investment Institute and for the Hong Kong University of Science and Technology. He is a member of the Hong Kong Trustee Association, the Family Firm Institute the International Bar Association and the Investment Migration Council. Richard is an active speaker at events across the world and a writer for many journals.