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Economic Substance

Economic Substance

The Crown Dependencies have updated their economic substance guidance notes following further discussions with the Code of Conduct Group (Business Taxation) (“COCG”) regarding the application of elements of the economic substance rules (see attached). A summary of the key changes made in this version (v2.0) of the guidance notes is provided below:

Changes with general application

  • In a number of circumstances, it is the making of decisions that is the Core Income Generating Activity (“CIGA”) that the company needs to undertake. In light of this, there has been concern regarding the applicable analysis where a decision is made outside of the Island and whether this would be enough to result in the CIGA being undertaken outside the Island; it is welcome therefore that guidance notes v2.0 state: “The taking of decisions outside the Island would generally indicate performance of CIGA outside the Island. However, isolated decisions may be taken outside the Island provided that it can be evidenced that the decisions taken and the CIGA undertaken in the Island are of a quality and quantity to clearly outweigh the question that the CIGA involving the decisions is undertaken outside the Island.” (original emphasis)
  • Further information on the sanctions (penalties, exchange of information and company strike-off) available to the revenue authorities has been outlined – making it clear which competent authorities information will be exchanged with and that financial penalties will be increased in cases of repeated failure to meet the test.  Guidance notes v2.0 also makes it absolutely clear that information will always be exchanged with relevant competent authorities in respect of high-risk IP companies, irrespective of whether they have passed the test.
  • The treatment of Protected Cell Companies (“PCCs”) and Incorporated Cell Companies (“ICCs”) under the economic substance rules is clarified – PCCs being treated as a single company under the rules, whereas an ICC and each of its incorporated cells will be treated as individual companies.
  • Guidance notes v2.0 are silent on the issue of partnerships, on the basis that it appears that the COCG is preparing for a more detailed review of how economic substance rules might operate in the context of partnerships – further work on this issue by the COCG is expected in 2020. Under this approach partnerships are not within scope of the economic substance rules for 2019, whilst later years will need to be monitored.

Fund management relevant activity

  • Perhaps the most important element of guidance notes v2.0 in the context of fund management is the confirmation, outlined above, that a decision made outside the Island will not, in itself, necessarily cause that CIGA to be undertaken outside the Island.
  • In addition, guidance notes v2.0 put beyond doubt that where a company is itself a regulated collective investment vehicle it will be outside the scope of the economic substance tests – providing welcome confirmation for collective investment vehicles that undertake, for example, a financing and leasing activity. However, from 2020 this exclusion will not apply in the context of a self-managed fund (i.e. where the collective investment vehicle and the fund manager are part of the same legal entity), such companies remaining within the scope of the relevant activity of “fund management” – this change will require legislative amendment.

Pure equity holding company relevant activity

  • Somewhat surprisingly the definition of pure equity holding company is narrowed in the guidance notes to companies whose “sole function” is to acquire and hold shares – this being narrower than the legislative provisions (and the previous version of the guidance notes) which refer to the “primary function” of acquiring and holding shares.
  • Guidance notes v2.0 also utilise a sentence from the OECD’s Action 5 2017 update report – we understand that this sentence has been included to clarify the point that if a company is undertaking another relevant activity (in addition to the activity of being a pure equity holding company) it must meet the economic substance test in relation to that other relevant activity (i.e. a company which is a high-risk IP company cannot avoid the rules applicable to high-risk IP companies by claiming it is a pure equity holding company). We had always read the rules in this way and hence do not consider the inclusion of this sentence to reflect a change in policy by the revenue authorities.
  • It is noticeable that the sentence regarding the need to be the beneficial owner of the shares to be within scope of pure equity holding company has been removed from guidance notes v2.0 – however it is reassuring that the “Trust Services Ltd” example has been retained, which specifies that the company will not be a pure equity holding company because it holds shares in its capacity as a trustee.

Insurance relevant activity

  • Guidance in relation to the relevant activity of insurance has been provided in guidance notes v2.0. Further details of the insurance CIGAs have been provided – critically these focus on oversight of the determination of risk and strategic decisions in relation to the provision of client services. Four examples are provided which outline cases which both pass and fail the insurance CIGA tests.

Shipping relevant activity

  • Guidance in relation to the relevant activity of shipping has also been provided in guidance notes v2.0, the most interesting element of which is that to be within the scope of this relevant activity the company must operate one or more ships in international traffic. Therefore, the other shipping activities mentioned in the legislation (e.g. management of crew, sale of tickets) are only in scope where the company meets this gateway condition. As guidance notes v2.0 state: “A company which undertakes any of these other activities where the company does not also operate a ship, or ships, in international traffic is not within the shipping relevant sector.”

Distribution and service centre relevant activity

  • In the context of the relevant activity of “distribution and service centre” the sentence in the previous version of the guidance notes that the definition did not extend “to cases where [such] activities are not the main activity of a company” has been clarified with the inclusion of the following words: “…but only if that other activity is recharged at cost or less. (For example, where a company seconds staff for a limited period recharging at cost rather than for a profit.)”. The revenue authorities have then warned that they will take appropriate action where companies seek to manipulate their income to fall within this exclusion. This suggests that wherever a distribution and service centre activity creates a profit it will bring the company within scope of the test, irrespective of how minor those activities are in the context of the company overall. Companies which had concluded that they were outside scope of this relevant activity because their distribution and service centre activity was not their main activity should check their analysis in light of this extra information.

IP holding relevant activity

  • Guidance in relation to the relevant activity of IP holding has also been provided in guidance notes v2.0; although the specific guidance provided in respect of high-risk IP companies is a reproduction of the guidance previously provided in the “key aspects document”.
  • In terms of the general guidance on IP holding, guidance notes v2.0 provides a number of examples which seek to explain the different types of IP and the various forms of associated CIGA.
  • It is noticeable that the revenue authorities are focussed on companies trying to fall outside the scope of IP holding and hence there is a statement that where companies seek to manipulate their income to fall outside of scope this will be addressed and clarification is provided that where, for accounting purposes, IP assets are aggregated within “goodwill”, the company will still be regarding as undertaking IP holding.

In light of the challenges of agreeing the wording with the various stakeholders engaged in this process, we do not consider that further versions of the guidance notes are likely to be released in the near future and hence entities should progress on the basis that this is the maximum amount of guidance that is going to be released.

KPMG in the Channel Islands and Economic Substance

KPMG in the Channel Islands is ideally placed to assist entities with the impact of the economic substance rules; from classification of entities through to assistance with preparation of tax returns.

KPMG in the Channel Islands have also developed the KPMG Economic Substance Tool to help entities to understand and manage the challenges posed by the economic substance obligations. The Tool helps entities to identify their rules, assess the likelihood of compliance and collate relevant information in preparation for the submission of subsequent tax returns – housed within an environment that has management review and control processes built into its core.

Key contacts

Please contact us to discuss the above in more detail or to arrange a live demo of the KPMG Economic Substance Tool

Guernsey                            Jersey

Tony Mancini                      John Riva

Paul Beale                          Paul Eastwood

Nana Aboagye                   Chris Lowe

                                           Tomas T. Machado

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