INSIGHT: Economic Substance Requirements—What Should BVI Entities be Doing Now?

The British Virgin Islands (BVI), alongside the other U.K. Crown Dependencies and Overseas Territories and other major international financial centers, passed legislation in 2018 addressing the concerns of the EU’s Business Taxation Code of Conduct Group and the OECD’s Forum on Harmful Tax Practices (FHTP) regarding “economic substance.”

The implementation timetable, which was entirely imposed by the EU, was extremely short. However, on July 23, 2019, the FHTP published the results of its review of the BVI’s legislation, together with that of a number of other jurisdictions. For 11 of these jurisdictions (including the BVI and the Cayman Islands), the FHTP concluded that the domestic legal frameworks adopted are in line with their expected standard and are therefore deemed “not harmful.”

The BVI Legislation and Entity Classifications

The Economic Substance (Companies and Limited Partnerships) Act, 2018 (the Act) came into force on January 1, 2019. Key guidance on compliance and reporting requirements appear in economic substance rules and explanatory notes (the Rules), which were published by the BVI International Tax Authority (ITA) in draft on April 23, 2019 and finalized on October 9, 2019 to reflect comments from the EU and industry. The Rules comprise rules with statutory effect and also non-binding explanatory notes on the approach the ITA will generally take as the competent authority under the new regime.

The Act requires any “legal entity” which carries on any “relevant activity” during any “financial period” to comply with the “economic substance requirements” in relation to each such activity.

Initial Classification and ITA Approach

The ITA has stated that the basis of an entity’s classification should be formalized in sufficient detail to assist the ITA in determining compliance and, as part of its broad investigation and enforcement powers, it will expect that BVI registered agents will have the relevant details and documentation on file to ensure the timely provision of that information upon request.

Practice will undoubtedly vary but the BVI industry expectation is that this should either be in the form of a formal memorandum of advice or detailed resolutions or minutes, to be held by the BVI registered agent and readily disclosed to the ITA (subject to legal advice privilege, where applicable).

Except in clear-cut cases, we expect many BVI entities and their directors or other fiduciary service providers may want to rely on formal BVI legal advice, given the timeframe for compliance and the initial complexity involved.

With that in mind, let’s look at the key definitions in turn.

Relevant Legal Entities

The Act potentially applies to any BVI company or limited partnership with legal personality as well as any foreign company or foreign limited partnership with legal personality registered in the BVI.

The practical focus is on BVI companies, as the overwhelmingly most popular form of BVI corporate vehicle.

Financial Periods

Compliance with the Act will be measured over “financial periods” of not more than 12 months each, but the Act does include provisions designed to enable entities to shorten one of their periods to align it with their existing financial year for tax or accounting purposes.

Broadly:

• for incorporations in 2019, the first financial period commenced from the date of incorporation—although the ITA will only expect compliance from the point any “relevant activity” commenced, since many vehicles are set up some time before they begin to carry on business; and
• for entities incorporated in the BVI before January 1, 2019, the first financial period commenced on June 30, 2019.

All BVI companies and relevant entities are therefore in their first financial period for compliance purposes and will need to confirm in 2020 whether or not they carried on any relevant activity at any point during the financial period commencing in 2019. It is therefore immediately important to note that an entity will still need to make a “nil return” even if the Act does not impose any economic substance requirements upon it.

On that basis, all entities should have classified their current activities to determine how they are affected already and should monitor any changes to such activities during each financial period.

It must be highlighted that we anticipate that a large number of entities will not be subject to the economic substance requirements, whether that is because their business does not comprise any relevant activity or they qualify as exempt from such requirements as a “non-resident” (as described below). However, they must determine this formally in any event so that the ITA has the information easily to hand.

Relevant Activities

The nine relevant activities are defined in the Act and further clarified in the Rules. We will not go into the minutiae of each here, but in summary they are:

• holding business, as a “pure equity holding entity”;
• finance and leasing business;
• shipping business;
• headquarters business;
• distribution and service center business;
• banking business;
• insurance business;
• fund management business;
• intellectual property business.

Take into account that, whilst there is no express carve-out for investment funds under the Act, it is expected by both the ITA and the FHTP that regulated funds will not be carrying on a relevant activity (it should be noted that operating as a fund vehicle is distinct from the “fund management business”).

The EU has stated that it will provide further “technical guidance” in relation to collective investment vehicles generally later in 2019.

Non-residents

Even if an entity carries on a relevant activity, it will not be required to comply with the economic substance requirements for any financial period during which it qualifies as non-resident (for tax purposes), provided that is able to evidence such status.

Clients and their tax advisers should note that the evidence required and the concept of “residence” for these purposes is discussed in detail at Part 4 (Tax residence outside the BVI) of the Rules, which expands more traditional concepts of residence to include:

• certain transparent entities (for which residence must be demonstrated by reference to each of the participators or partners on whom the entity’s profits are taxable); and
• certain entities (other than “pure equity holding entities”) whose only sources of income from relevant activities are subject to tax in a jurisdiction outside the BVI (which will be regarded as resident in that other jurisdiction).

Non-resident status cannot be claimed if the entity is regarded as “resident” in a jurisdiction outside the BVI that appears on Annex I to the EU “blacklist” of non-cooperative jurisdictions for tax purposes. Any changes to the blacklist should therefore be monitored by any non-resident entity as it is revised periodically by the EU.

Economic Substance Requirements

The first point to highlight is that there is a reduced substance requirement for any entity that simply conducts holding business. It is highly feasible that, if the entity holds the relevant equity participations on a passive basis, it will have “adequate” substance if it complies with its statutory obligations under the applicable BVI company or limited partnership laws and has a registered agent in the BVI providing a registered office service.

If an entity conducts one of the other relevant activities, it must direct and manage the relevant activity, and conduct core income-generating activity (CIGA), in the BVI. It must also, taking into account the nature and scale of the relevant activity, have in the BVI an adequate level of suitably qualified employees and expenditure and appropriate physical premises for the CIGA.

Outsourcing of income-generating activity is permitted, subject to certain anti-avoidance restrictions.

The ITA has indicated that what is “adequate” or “suitable” will vary depending on the business and is therefore largely a commercial question and bespoke to each entity.

Entities carrying on IP business may wish to seek legal advice as the fines and penalties for non-compliance are potentially significant in the case of a “high risk IP legal entity” and the analysis can be quite complex.

Reporting Requirements

It is expected that:

• generally, reporting will commence in 2020 in respect of the first financial period within six months of the end of such period, via submitting prescribed information to the BVI registered agent which will be uploaded to an online portal; and
• the prescribed information will vary depending on the entity, the activities it conducts and whether it claims to be non-resident.

Entities and their advisers should be aware that, in certain circumstances (including where the ITA determines that an entity is non-compliant or where an entity claims non-resident status), the ITA may be required to exchange information automatically to certain overseas competent authorities (including tax authorities).

Planning Points

Get classified. This is the first and most important step. Once an entity has determined how the Act applies to it, the rest of the process logically flows from there.

Philip Graham is a Partner and Joshua Mangeot is a Senior Associate with Harneys.

The authors may be contacted at: philip.graham@harneys.com; joshua.mangeot@harneys.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.