OECD introduces minimum ‘substance’ requirements in low-tax jurisdictions

Overview

The Organisation for Economic Co-operation and Development (OECD) Inclusive Framework (IF), in follow-up work related to BEPS Action 5, has released new global standards that apply to ‘no or only nominal tax’ jurisdictions and that require ‘substantial activities’ in order for the tax regime not to be considered a ‘harmful tax practice.’  The objective is to prevent such low-tax jurisdictions from attracting profits from certain mobile activities without corresponding economic activity.  The types of mobile activities covered include headquarters, distribution centers, service centers, financing, leasing, fund management, banking, insurance, shipping, holding companies, and the provision of intangibles.

The standards are contained in a document entitled Resumption of Application of Substantial Activities Factor to No or only Nominal Tax Jurisdictions. This document sets out the background, rationale, and detailed information around reinstating the substantial activities factor. As discussed below, Barbados, Bermuda, and Cayman Islands have announced new domestic laws intended to meet the substance requirements.

The takeaway

Taxpayers should monitor how each relevant jurisdiction implements the new substance requirements (both law changes and future regulations), and be prepared to demonstrate that certain ‘core income generating activities’ are occurring within low-tax jurisdictions commensurate with the profits being reported in those jurisdictions.  

Failure to satisfy the substantial activities requirements may result in other countries taking certain ‘defensive measures’ in response, which could include denying deductions, imposing withholding taxes on payments to companies in such jurisdictions, or applying controlled foreign corporation rules to subsidiaries in such jurisdictions.

While awaiting final legislation in Bermuda and guidance on key terms (in each of these jurisdictions), taxpayers should review the level of activity undertaken at key decision points in a transaction in order to comply with the new legislation.