Understanding Economic Substance

The Crown Dependencies have enhanced their commitment to meet the Organisation of Economic Co-operation and Development’s (OECD) principles for improving global tax transparency by introducing an Economic Substance Test.

All companies’ tax resident in the Crown Dependencies that are undertaking certain activities will be required to comply with these new rules for their first accounting period commencing on or after 1 January 2019. Non-compliance could result in financial penalties. It is therefore important that companies consider the impact of these new rules as soon as possible.

PwC have developed an innovative Substance Tool that can be used to identify where the key risks of non-compliance under these rules lie. We can then aid you in developing and implementing any changes necessary to your policies and procedures to mitigate the risk of failing the test, and assist you with preparing necessary supporting documentation and in preparing your companies’ tax returns.

The Economic Substance Test
Relevant activities
Economic Substance
Failure to meet the Economic Substance Test
What must you do

The Economic Substance Test

The Crown Dependencies’, together with other offshore jurisdictions including the British Virgin Islands and the Cayman Islands, have introduced a legal substance requirement for entities doing business in, or through, their jurisdictions. The legal requirement is in the form of an Economic Substance Test that will help entities demonstrate that the profits they register in the Crown Dependencies are commensurate with their economic activities and substantial economic presence there.

Each of the Crown Dependencies have introduced their own Economic Substance Tests, which applies to accounting periods commencing on or after 1 January 2019. These tests are broadly similar to each other, but subtle differences do exist.

Relevant activities

Fundamentally, all companies that are tax resident in the Crown Dependencies and are also undertaking a ‘relevant activity’ must satisfy the appropriate Economic Substance Test applicable to that jurisdiction.

Relevant activities include:

Banking business
Insurance business
Fund management business
Finance and leasing business
Headquarters business
Holding company business
Shipping business
Intellectual property holding business
Distribution and service centre business

Economic Substance

Where the Economic Substance Test applies, companies must demonstrate that they have economic substance in that jurisdiction by satisfying all of the following:

being directed and managed there;
conducting Core Income Generating Activities (CIGA) there; and
having adequate people, premises and expenditure there.

Companies that are required to meet the Economic Substance Test will also be required to provide additional information on their annual tax filings. The directors of those companies will, therefore, need to self-assess as to whether they have satisfied the Economic Substance Test and make a declaration thereof on the companies’ tax returns.

Failure to meet the Economic Substance Test

Failure to meet the Economic Substance Test can result in a penalty of up to £10,000, increasing to £100,000 if the test is not met for consecutive financial periods.

The Crown Dependencies’ tax authorities will also have the authority to commence proceedings to wind up companies that fail to satisfy the Economic Substance Test.

Failing to meet the Economic Substance Test will also result in the Crown Dependencies’ tax authorities being obliged to exchange information with competent tax authorities (I.e. where a bilateral agreement or multilateral convention permits).

What must you do

Directors of companies that are tax resident in the Crown Dependencies must, therefore, review their portfolios to identify those companies that must satisfy the Economic Substance Test and subsequently that the test has been met. They will also need to put in place mechanisms to record the relevant supporting data for reporting purposes and to demonstrate that they have met the test.

The earlier this review is conducted, the greater the opportunity for any remedial action to be undertaken to avoid failing the Economic Substance Test.

We've developed an innovative tool that will enable you to identify whether the Crown Dependencies’ Economic Substance Test applies and aid your determination as to whether it has been met. The tool will produce a traffic light report so that you may identify any areas of concern and, if remedial action is necessary, provide you with the opportunity to implement any changes needed before the conclusion of the first financial year for which the Economic Substance Test applies.

We can provide you with tailored advice on the application of the Economic Substance Test to your business, whether the test is likely to be met, and what changes may be necessary to your policies and procedures to mitigate the risk of failing the test.

The introduction of this test will increase the level of detail required on your companies’ tax returns. We can use our innovative information technology solutions, which includes our Substance Tool, to prepare your tax returns efficiently and reduce your time spent on the increasing administrative burden that companies now face.

We can assist in resolving enquiries raised by the tax authorities. Particularly, should you use our Substance Tool, critical information will be collected and stored on your own servers that will aid with the preparation of defence packs to help support how you have satisfied the Economic Substance Test.