Economic substance
Understanding economic substance
EU member states, like the UK, have reinforced their commitment to the Organisation for Economic Co-operation and Development (OECD) principles for improving global tax transparency by introducing specific rules of economic substance.
For example, companies resident in England for tax purposes that carry on certain activities will be required to comply with these new measures for their first accounting period beginning 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.
There is an innovative substance tool that can be used to identify the main risks of non-compliance with these rules. It can then help you develop and implement the necessary changes to your policies and procedures to mitigate the risk of failure to comply with these new legal provisions, help you prepare the necessary supporting documentation and prepare your companies’ tax returns.
The economic substance criterion
Case study: the UK
The UK Crown Dependencies, along with other UK jurisdictions, have introduced a legal substance requirement for entities doing business in or through their jurisdictions. The legal requirement takes the form of an economic substance test which will help entities to demonstrate that the profits they make in the UK are commensurate with their economic activities and substantial economic presence in the UK countries.
Each of these countries (England, Scotland, Wales and Northern Ireland) has introduced its own economic substance tests, which apply to accounting periods beginning on or after 1 January 2019. These tests are broadly similar to each other, but there are subtle differences.
The criteria of economic substance
All companies resident for tax purposes in England, which carry on a “relevant business”, must satisfy the appropriate economic substance test applicable to that jurisdiction.
The relevant activities are as follows:
- Banking activities
- Insurance business
- Fund management activities
- Financing and leasing activities
- Head office activities
- Holding activities
- Shipping
- Intellectual property holding business
- Distribution and service centre
- activities
- Sales of services and products
- Consultancy activities
- Transport
- Brokers, intermediaries
- … Non-exhaustive list
Where the economic substance test applies, companies must demonstrate that they have economic substance in England, by meeting the following conditions:
- physically and materially direct and manage in the said territory (tax residence of the company),
- carry out basic income-generating activities (CIGA); and
- have adequate staff, premises and expenditure.
Companies that are required to satisfy the economic substance test will also have to provide additional information on their annual tax returns. The directors of these companies will therefore have to self-assess whether they have met the economic substance test and report this in their company tax returns.
Failure to meet the economic substance test can result in a penalty of between £8,000 and £80,000, if the test is not met for consecutive financial years.
The tax authorities will also have the power to initiate proceedings to wind up businesses that fail to meet the economic substance test.
Failure to meet the economic substance test will also result in the tax authorities being obliged to exchange information with the relevant tax authorities (i.e. where permitted by a bilateral agreement or multilateral treaty).
Directors of companies that are resident in the Crown Dependencies for tax purposes must therefore review their portfolios to identify those companies that must meet 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 demonstrate that they have met the test.
The earlier this review is carried out, the more corrective action can be taken to avoid failing the economic substance test.
Find out more about economic substance: Understanding economic substance (pwc.com)