To respond to the Organization for Economic Co-operation and Development (OECD) policies regarding fair taxation, Cayman Islands and other tax havens promulgated their economic substance laws, which came into force on or before January 1, 2019.
Because many Taiwan investors use offshore companies in the Cayman Islands, British Virgin Islands (BVI) or other tax havens for various tax, legal and historical reasons, these new developments in tax havens are particularly relevant for financial institutions and their Taiwan customers.
Under economic substance rules, zero tax itself is not a harmful tax practice, but paper companies are no longer tolerated. Specifically, economic substance is required to claim tax residency in a tax haven.
Returning to legal provisions, there are defined terms for economic substance requirements, where a “Relevant Entity” carrying on a “Relevant Activity” is required to satisfy the Economic Substance Test related to that Relevant Activity.
The Economic Substance Test could mean a Relevant Entity should have local management and board meetings, appropriate expenditures enough to produce and book profits, local core income-generating activities (CIGAs), an adequate number of employees and an adequate physical presence in order to pass the Economic Substance Test.
Due to the distance between Taiwan and Cayman/BVI, and the capacity of these tax havens, the economic substance requirement seems either difficult to achieve or is not worth the effort if, in the end, the profits are captured via the automatic exchange of information. See the economic substance rules using the Cayman Islands as an example.
What is a Relevant Entity?
Generally speaking, a company incorporated or registered under the Companies Law of the Cayman Islands will be considered a Relevant Entity. This also includes a limited liability company or a limited liability partnership registered under the Limited Liability Companies Law or the Limited Liability Partnership Law of the Cayman Islands. Although the law carves out three exemptions, for most Taiwanese clients using a Cayman company for foreign investments, none of these exemptions will apply.
What is a Relevant Activity?
There are nine types of Relevant Activities under the type of business: banking, distribution and service centers, financing and leasing, fund management, headquarters, holding companies, insurance, intellectual property, and shipping.
A relevant entity must satisfy the Economic Substance Test by conducting Cayman Islands CIGAs related to the relevant activity. These activities must be directed and managed in an appropriate manner for that relevant activity in the Islands. Also, an entity with a specific level of relevant income derived from the relevant activity carried out in the Cayman Islands must fulfill the requirements regarding operating expenditures, physical presence and personnel.
What Does Economic Substance Mean to Taiwan Investors?
Due to political and tax reasons Taiwan investors have for many years invested in the People’s Republic of China (PRC) through a tax haven, and kept most of the profits within the tax haven.
Although Taiwan has recently enacted legislation regarding controlled foreign companies (CFC) and Place of Effective Management (PEM), neither of these has become effective. Consequently, when Taiwan investors realize that they must either have economic substance in a tax haven or have all the profits taxed in a place where the economic substance occurs, they are shocked by the short time to react and eager to find solutions and next steps.
However, because the economic substance rules have intentionally left room for doubt to allow interpretations, Taiwan investors have become more confused about whether they could be caught up under these economic substance rules.
The most frequently asked questions include whether they are still subject to economic substance guidelines if they do not make a profit with the relevant activity, and whether a holding company which is not a pure equity holding company is subject to the Economic Substance Test.
Another fundamental question is whether another jurisdiction will replace the existing tax havens. The answer is very clear—the good days are over. However, meaningful corporate structure planning is still possible, but the structure will need to be legally compliant to deal with economic substance and succession planning objectives. Tax is still an important factor to consider on the assumption that the structure is fully transparent.
Compliant and Effective Corporate Restructuring—Factors
Several principles should be considered during corporate restructuring.
Firstly, multi-layer entities should be replaced with a flat structure with functional units to avoid unnecessary compliance costs, from either CRS or an economic substance perspective.
Second, it may not be necessary to engage in corporate restructuring for economic substance alone, but it is no doubt a good time to consider corporate restructuring to also achieve other purposes, such as family succession planning or pre-IPO planning purposes.
Finally, although a tax treaty is an important element to consider when choosing the ideal tax residency, compliance costs should also be taken into account.
What Does Economic Substance mean to Banks with Taiwan Customers?
The issues for banks are more complicated. Banks have abundant experience asking customers to declare their position under FATCA or CRS. However, these are built on clear standards and a given format, under which they know what questions their customers should be asked.
If banks intend to do the same exercise for economic substance, they do not have a ready declaration form, and they may not have the capacity and knowledge to perform effective customer due diligence. This is not because they are not sophisticated enough, but because they do not have clear guidance to follow.
Even the tax haven governments themselves are puzzled about what level of compliance will be satisfactory to the OECD.
If their customers fail to comply with the Economic Substance Test, the worst scenario is that the company registration may be revoked, which would lead to a default event. If banks are willing to take the risk, it may take until 2021 to compile responses from the tax haven authorities as to whether their customers conduct a Relevant Activity and pass the Economic Substance Test.
This means from July 1, 2019 to 2021, if the banks are doing nothing for their existing tax haven customers, they could be subject to unknown economic substance risks.
The question is whether the banks should do something now.
Fundamentally, this is more a risk assessment decision. Banks are recommended to review all the tax haven accounts and allocate a risk rating for different categories of customers. For instance, because by nature it is not hard for an equity holding company to comply with the Economic Substance Test, these companies, either under a trust or otherwise, may bear lower risk for banks.
Customer relationships are also a risk factor to consider because a pure deposit account, an investment account or a loan facility also bears different risks when the underlying entity is dissolved. If the banks really want to undertake the business but they believe the risk is high, they may wish to rely on outside professionals (such as a legal opinion) to minimize its risks.
Instead of providing clear guidance, the OECD asks each tax haven to stipulate its own economic substance rules. However, one reason an exempt company, as opposed to an onshore company, can be exempt is because it does not conduct business in the tax havens.
The idea to require an exempt company to have economic substance in the tax havens essentially defeats the purpose of an exempt company. Therefore, economic substance itself by nature cannot be easily understood logically in the context of tax haven company laws.
What Taiwan investors and banks who have Taiwan customers are struggling with is not simply how to comply with the economic substance rules, but how to deal with the risk of uncertainty and whether they have enough appetite to bear this risk.
Therefore, when determining the next steps, risk and time are always essential.
Taiwan investors who have time to wait and who are able to bear the risk, either because the risk is low or they have a large appetite, can choose to take a chance or wait for clearer guidance. For those who do not, they may choose to move or conduct corporate restructuring now in a way that minimizes the uncertainty.
Banks can also look at this development differently. For the more passive ones, the answer is to design ways to manage these risks, either by closing high-risk accounts or pushing customers to move.
For the banks who are more enterprising, however, this may be seen as a great opportunity to engage more closely with their customers and to pursue planning opportunities together with their customers, such as corporate restructuring.
Michael Wong is a Senior Executive Consultant and Peggy Chiu is an Associate Partner at Baker McKenzie, Taiwan