Is Substance starting to bite?

Is Substance starting to bite?

KPMG Isle of Man's latest Substance update.


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For those who thought that Brexit might mean that the European Union (EU) would no longer focus on the tax regimes of the Crown Dependencies (i.e. the Isle of Man and the Channel Islands) and British Overseas Territories, they might wish to think again. If anything, the absence of the UK from the EU table could leave these territories more exposed, rather than less, to challenges from the EU. The latest challenge (ignoring such matters as public registers of beneficial ownership: that’s for another day) relates to a requirement for certain Isle of Man resident companies to have adequate “substance” in the island.


The workings of the EU, and indeed the Organisation for Economic Cooperation and Development (OECD), can at times be difficult to fully understand. The substance initiative, which is the subject of this article, started life with the work of the OECD’s Forum on Harmful Tax Practices (FHTP). In particular, one of the initial focusses of the OECD’s work was on requiring jurisdictions with preferential tax regimes (e.g. a regime that provides for a lower corporate tax rate for certain industry sectors, such as shipping or intellectual property) to ensure that such regimes only applied to those companies with a sufficient degree of relevant “substance” in that jurisdiction. This resulted in changes to the tax regimes of a significant number of jurisdictions. As our standard rate of corporate taxation is zero percent, by definition, the zero percent rate is not preferential to the standard rate.


In November 2016 the EU commenced work on a list of “non-cooperative jurisdictions” for tax purposes. Through 2017 the EU screened some 92 jurisdictions against criteria based upon transparency, fair taxation and the implementation of measures under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative. As we know, the Isle of Man has responded to a multitude of initiatives in the tax arena over recent years – not least in relation to automatic exchange of information measures and BEPS minimum standards. However, the one area of the screening process that was always going to be a challenge for the island relates to substance – the requirement that the jurisdiction should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction (which, according to the EU, zero rate regimes do, by their very nature).


In November 2017, against the threat of black-listing by the EU, the Isle of Man made a commitment to introduce legislation to deal with the EU’s concerns in this area. Roll forward 15 months and the legislation is in force and businesses across the island are in the midst of assessing the impact. First of all it must be appreciated that the legislation only impacts on certain sectors – these range from the regulated sectors of banking, insurance and fund management, through to shipping, distribution and service centre businesses, finance and leasing, “headquartering” companies, holding companies and last (but definitely not least) intellectual property (IP) companies.


An analysis of the substance requirements would not fit within this article, but it is fair to conclude that most Isle of Man companies probably fit into one of the following categories: (1) the legislation has no impact; (2) the company is within scope, but it clearly has the required “substance” and with relatively minor amendments to, for example, its record keeping it will be able to demonstrate that fact; (3) the company is within scope, but will need to make material changes to the manner in which it operates if it is to satisfy the requirements; and (4) the company is within scope and without fundamental change to its modus operandi will simply not be able to satisfy the requirements.


It is these final two categories where the legislation is really starting to bite. And it must be borne in mind that the consequences of non-compliance can be severe – for certain IP companies, those consequences can be a £50,000 penalty in the first year, and a £100,000 penalty combined with strike-off proceedings as early as the second year.


Some businesses will ultimately conclude that they cannot (or are unwilling to) satisfy the requirements and thus will, presumably, leave the island. In many ways that is exactly what the EU and the OECD are trying to achieve. On the other hand, there will be businesses located in other jurisdictions (e.g. the British Virgin Islands) that are equally struggling with the equivalent legislation and may conclude that the Isle of Man is exactly the place for them to cement their business going forward - after all, we are well placed in terms of people, expertise and space.


There is no doubt that there remain areas of uncertainty with the legislation – for example, how much is “enough” in terms of the level of substance that impacted companies must have on the island? Answers are likely to slowly emerge, with further guidance expected from the Income Tax Division and from the OECD as its own initiative in this area gathers speed. But for businesses that may have to make fundamental changes to their operations, if they wait too long they may not be able to avoid the legislation’s painful bite.

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