Economic Substance for 2021

By Kelly Tadier, PwC Channel Islands

25 March, 2021

Moving Beyond ‘Year 1’ of Economic Substance

In many locations where tax resident companies have become subject to Economic Substance requirements, the first year submissions relating to accounting periods ending in 2019 have now been, or shortly will be, completed, bringing to a conclusion year 1 of the Economic Substance compliance obligations.

There is little opportunity for the dust to settle, however, as businesses should now not only be considering the 2020 compliance test, but also  whether there are any actions necessary to strengthen the position of the current substance year of 2021. Current year substance reviews will need to include some of the impact (if any) of the challenges presented by the global COVID-19 restrictions imposed. There will also be a need to consider whether the jurisdiction(s) have introduced any amendments or expansion of the substance rules, as well as whether any of the additional territories ‘coming online’ for substance determinations in 2020 and 2021 are of relevance to their operations.

What should be borne in mind when outlining the ongoing business approach to Economic Substance compliance is that the substance rules represent the ‘new normal’. We are now effectively in the early months of year 3 of substance for many companies. Whilst there will be elements of reflecting on the prior year evidence when completing the tax returns or substance filings, the business process should no longer be positioned as a retrospective annual review exercise, but rather a continuous live monitoring process, providing the business with the means to health check substance compliance in the current year, and remedy any weaknesses as they are identified on an ongoing basis. The paper forms completed by some during 2019 are already out of date, and companies only now reviewing their 2020 position may no longer be able to take the desirable action to improve their substance position for the second year, potentially attracting substantial financial penalties.

2020 revisions and challenges

Refreshing substance analysis

Companies resident in any one of the substance territories should be refreshing their first year analyses for 2020 and 2021 to ensure any change of activities or income streams are tested for whether a new substance obligation has been realised. If not already set out within formal policies and procedures, now is the time for businesses to put this documentation in place. This will help ensure that new analyses are conducted in a consistent manner, that trigger events are communicated and the end-to-end process from identification to reporting is clearly laid out. Not only will this provide the framework for lessons learned from first year projects to stick, but also will form one of the expectations of any tax office or regulator audit of Economic Substance assessment (which is anticipated in 2021).

In some cases, a company will not have needed to comply with the first year obligations owing only to its first relevant accounting period falling outside of the period under review. Care should be taken to make sure that these ‘late joiners’ to substance testing do not fall between the cracks, and are reported correctly in 2020 filings. This will however hopefully have provided room to strengthen those business practices tested ahead of the first period assessed.

COVID-19 concessions relating to impact of travel restrictions

Of particular note to a number of offshore companies will be the impact of COVID-19 restrictions on cross border travel. Certain jurisdictions have commented on the ongoing impact and how they anticipate businesses to have adapted their operating models to overcome these challenges, with recent clarifications in the Crown Dependencies making clear that any claims for a COVID-19 concession will provide relief only for the direction and management aspect of the test. As more jurisdictions provide guidance on whether and in what circumstances such a concession will be available, many could be left with areas of weakness (or failings) in wider aspects of their substance assessment, potentially struggling to meet the ‘people’ requirement, as well as issues with their ability to claim CIGA as having been conducted in their territory of relevance.

Those companies who are seeking to rely on a concession relating to the direction and management will be expected to declare their reliance on the COVID19 concessions within their filing (dependent on the jurisdiction in which they are resident), and may be asked to present detailed records maintained during the period setting out any adaptations that travel restrictions caused during periods of restricted travel. The jurisdiction may seek to have the company provide positive confirmation that any use of the concession was appropriate and necessary. This may also be a topic for future audit focus when the first audits of Economic Substance compliance are delivered across the various territories.

Companies which did rely on directors resident overseas may also need to consider whether they triggered tax residence outside of their jurisdiction during 2020 or 2021 from the changes to their business operations, as well as the potential adverse implications of creating tax residence elsewhere.

If these companies had previously failed the substance requirement of 2019, it may be more difficult to argue a reliance on the COVID-1919 concessions, and companies at risk may need to form their defence packs early to avoid triggering heavy second year failure penalties (or third year if the failure continued during 2021).

Self-managed funds joining list of companies subject to substance

When we look at changes to who is required to adhere to Economic Substance adequacy determination, we should bear in mind that with effect from 1st January 2021 (or with effect from 1st October 2020 in respect of Guernsey resident companies, and 16 December in respect of Isle of Man resident entities), self-managed funds will be asked to comply with the substance determinations based upon their fund management activities (performed on their own behalf) in their first accounting period commencing after the effective dates. This obligation will first attach to funds that are formed as companies, and for whom there is no separate fund manager appointed. This will bring into scope some companies that had previously relied on the exemption afforded to corporate fund vehicles under the substance rules, and has already been introduced by implementing legislation in the Crown Dependencies.

An additional consideration when looking at self-managed funds that might be brought into scope is that the new requirements do not depend on any income having been generated from that activity for the substance obligation to be triggered. There will be subtle differences in the tests to be applied, owing to the presumptions surrounding direction and management, and the CIGA that will be undertaken by such entities.

Partnerships

Also due to be implemented in Summer of 2021 are the revisions to legislation and guidance relating to Economic Substance obligations attaching to partnerships. Again, the roll out of amending legislation will vary between jurisdictions, as some already included certain types of partnerships within their original domestic law. The November 2020 report from the EU Code of Conduct Group stated:

46. The Member States concluded that Anguilla, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man and Jersey should extend their Economic Substance requirements to all relevant partnerships which were identified to fall out of the scope of existing legislation.

47. It was also agreed that without this was already covered by the commitment of the jurisdictions concerned to comply with the scoping paper for criterion 2.2. and a new commitment was not required. The following timeline should apply to the relevant jurisdictions to adopt and put into effect the necessary amendments to their legal framework so that this could be taken into account in the October 2021 listing update:

a) by 30 June 2021 for the adoption of necessary amendments;

b) by 1 July 2021 for the entry into force with a maximum 6-month transition period for existing entities.

Whilst it can be expected that the partnership rules will not introduce any material difference in the types of activity included, the proposed extension does pose a number of practical issues surrounding the manner in which impacted partnerships would report. Given the impending deadline for the jurisdictions above to have enacted the necessary revisions to legislation, it is likely that only limited published guidance (if any) would be available before the rules take effect.

Expansion of Jurisdictions

The Crown Dependencies (Isle of Man, Jersey, Guernsey) together with Bermuda, Bahamas, the Cayman Island and the British Virgin Islands had already introduced substantial changes through legislation to implement the requirement to demonstrate adequate Economic Substance with effect from 1 January 2019, along with the limited scope of substance requirements for Mauritian companies, and implementation of similar rules for companies in the United Arab Emirates, Anguilla and Barbados.

The substance requirements for Mauritius are further expanded as we consider 2020 accounting years, and the filing systems for entities in the UAE and the Marshall Islands are now operational. The new substance rules for certain entities resident in Belize and Panama also replicate some of the key principles of the existing (established) substance regimes.

Key takeaways

With the Economic Substance rules requiring continual monitoring to identify change events, and increasing in their scope and complexity, having the ability to access information easily is more important than ever. With some companies now in the early months of year 3 of Economic Substance, certain of these projects are already out of date. Businesses should be challenging themselves on how flexible and future-proof their current substance monitoring process is. Where these substance projects have been completed manually, it may be more difficult in practice both to monitor the rate of completion of reviews, and to ensure the consistent interpretation of the rules.

Businesses should now focus on moving substance analysis away from centralised and time-intensive project teams, with an aim of embedding Economic Substance monitoring in their ‘business-as-usual’ processes. This not only empowers client facing administrators to proactively manage substance within the current year, asking themselves whether their operations have a substance consideration, and creating a ‘live’ audit trail of substance compliance across the year, but also frees up that technical resource to focus on legislative change.

Economic Substance determination as a business process lends itself well to automation, and we strongly encourage administrators or those businesses with more complex or high volume substance obligations to consider how the right approach to automation will provide them with the confidence around their ongoing compliance.

Finally, where Economic Substance business considerations and workflows have yet to be captured within formal policies and procedures, we strongly encourage businesses and administrators to begin to document their end-to-end processes, or to take stock of lessons learned and review their existing P&P documents to ensure they continue to reflect the agreed approach.

Contact us

Kelly Tadier

Kelly Tadier

Tax Senior Manager, PwC Channel Islands

Tel: +44 7797 784396

Chris van den Berg

Chris van den Berg

Partner, PwC Channel Islands

Tel: +44 7700 838308

David Waldron

David Waldron

Partner, PwC Channel Islands

Tel: +44 7781 138617

Aoife Furey

Aoife Furey

Tax Senior Manager, PwC Channel Islands

Tel: +44 7911 763718

Nana Aboagye

Nana Aboagye

Tax Senior Manager, PwC Channel Islands

Tel: +44 7911 732257

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