Substance Requirement

Basil Bielich

Our article in July highlighted the impending introduction of legislation pertaining to the substance requirements for tax resident companies.

The Isle of Man Government has recently released a piece of draft legislation in relation to new substance requirements, which will, subject to passage through Tynwald and will come into effect for accounting periods starting on or after 1 January 2019.

The new legislation has been drafted by the Isle of Man Government in consultation with industry professionals and following dialogue with the Code Group, individual EU Member States, the EU Commission and the OECD. Similar concerns on substance were raised by the Code Group in relation to the other Crown Dependencies so the Isle of Man has worked closely with Guernsey and Jersey in developing the new legislation.

The proposed legislation has been designed to address concerns that companies could be used to artificially attract profits that are not commensurate with economic activities and substantial economic presence in the Isle of Man.

The proposed legislation requires certain companies to demonstrate they have substance on the Island by way of a three part process:

  1. To identify if a company is carrying out a relevant activity;
  2. That the company is conducting Core Income Generating Activities (“CIGA”) on the Island; and
  3. To enforce the substance requirements.

Part 1 - To identify if a Company is Carrying Out a Relevant Activity

These substance requirements apply to the following categories of geographically mobile financial and other service activities, identified by the OECD’s Forum on Harmful Tax Practices:

  1. Banking;
  2. Insurance;
  3. Shipping;
  4. Fund Management (this does not include companies that are Collective Investment Vehicles);
  5. Financing & leasing;
  6. Headquarters;
  7. Distribution and service centres;
  8. Holding Company (a pure equity holding company); and
  9. Intellectual Property (for which there are specific requirements in high-risk scenarios and these are discussed in detail later).

These are referred to as the “geographically mobile business sectors” income i.e. these are the sectors which are at risk of operating and deriving their income from jurisdictions other than those in which they are registered.

Where non-IOM incorporated companies are engaged in relevant sectors they will only be brought within the scope of the Order if they are IOM tax resident.

Part 2 - Companies Undertaking Relevant Activities must conduct CIGA on the Isle of Man

1. Directed and Managed
The Order specifies that the company is directed and managed on the Island if the Island is where regular board meetings take place, and a quorum of directors are physically present at the meeting. Strategic decisions must be made at those meetings; the minutes of these board meetings must be kept on the Island and the directors present at these meetings, have the necessary knowledge and expertise to discharge its’ duties as a board. The directed and managed test is designed to ensure that there are an adequate number of board meetings held and attended in the Island (although it is not necessary for all of those meetings to be held in the Island).

The directed and managed test
The requirement to be directed and managed in the Island (“the directed and managed test”) is a separate test to the case law “management and control” test used in determining the tax residence of a company. It is designed to ensure that there are an adequate number of board meetings held and attended in the Island (although it is not necessary for all of those meetings to be held in the Island).

What constitutes an adequate number of meetings on the Island will be dependent on the relevant activities of the company. However, it is generally expected that the majority of Board meetings will be held in the Island. It is also expected that even for companies with a minimal level of activity there will be at least one meeting of its board of directors.

The test also looks to ensure that the associated minutes and records kept on the Island and the Board is a decision taking body with the necessary knowledge and experience. In the case where there are corporate directors, the requirements will apply to the individual(s) (officers of the corporate director) actually performing the duties.

2. Adequate Employees
This condition focuses on there being an adequate number of skilled workers present on Island. The legislation does not require the workers to be employed by the company; the work can be outsourced. There is no definition of what adequate is, this is open to interpretation, and it should be considered in conjunction with the other factors. For the purpose of this proposed legislation, ‘adequate’ will take its ordinary meaning.

3. Adequate Expenditure
The company should have expenditure, which is proportionate to the level of activity carried on in the Island. This is a subjective measure and each business must be considered on its own merits. Although it must be noted that it would be unrealistic to apply a specific formula across all businesses, as each business is unique in its own right and it is the responsibility of the board of directors to ensure that such conditions are met.

4. Core Income Generating Activities
The company must conduct its CIGA on the Island. The Order attempts to specify what is meant by CIGA for each of the relevant sectors. Not all companies will carry out all activities specified, but they must carry out some in order to comply. If an activity is not part of the CIGA, for example, back office IT functions, the company may outsource all or part of this activity without there being an effect upon the company’s ability to comply with the substance requirement. Likewise, the company may seek expert professional advice or engage specialists in other jurisdictions without effecting its compliance with the substance requirements. In essence, CIGA ensures that the main operations of the business, i.e. the operations that produce the bulk of the income are carried out in the Island.

Part 3 - To enforce the substance requirements

The Order provides the Assessor with the power to request any information required to satisfy them in that a relevant sector company meets the substance requirements. Where the Assessor is not satisfied that the substance requirements have been met for a particular period, sanctions will apply. The draft legislation provides the Assessor the power to request further information from a relevant sector company in order to satisfy themselves that the substance requirements have been met. Failure to comply with the request can result in a fine not exceeding £10,000. Sanctions will apply where the Assessor is not satisfied that the substance requirements have been met.

For companies engaged in relevant sectors (other than high risk IP), the sanctions are as follows, (stated by the number of consecutive years of non-compliance):

  • 1st year, a civil penalty of £10,000;
  • 2nd year, a civil penalty of £50,000;
  • 3rd year, a civil penalty of £100,000 and may be struck off the company register;
  • 4th year, strike the company off the company register.

For any year of non-compliance of a company operating in a relevant sector, the Assessor will disclose to an EU tax official any relevant information which relates to the company, this could represent a serious reputational risk to the company.

If the Assessor finds that in any accounting period a company has avoided or attempted to avoid the application of this Order, the Assessor may:

  • Disclose information to a foreign tax official; and
  • Issue to the company a civil penalty of £10,000.

If a person (note that “a person” is not defined within this legislation) who has fraudulently avoided or seeks to avoid the application is liable to:

  • On conviction: custody for a maximum of 7 years, a fine or both;
  • On summary conviction: custody for a maximum of 6 months, a fine not exceeding £10,000, or both; and
  • Disclosure of information to a foreign tax official.

High-risk IP Companies

Generally speaking, the designation ‘high-risk IP companies’ refers to companies holding IP where:

  • The IP has been transferred into the Island post-development and / or the main utilisation of the IP is off-Island; or
  • The IP is held on the Island but the CIGA is carried out off-Island.

As the risks of profit shifting are considered greater, the legislation has taken a rather hard approach to high-risk IP companies, it takes the position of ‘guilty unless proven otherwise’.

High-risk IP companies will have to prove for each period that the adequate substance requirements in respect of conducting core income-generating activity have been met on the Island. For each high risk IP company, the Isle of Man tax authorities will exchange all of the information provided by the company with the relevant EU Member State authority where the immediate and/or ultimate parent and beneficial owner is/are resident. This will be in accordance with the existing international tax exchange agreements.

“To rebut the presumption and not incur further sanctions, the high risk IP company will have to provide evidence explaining how the DEMPE (development, enhancement, maintenance, protection and exploitation) functions have been under its control and this had involved people who are highly skilled and perform their core activities on the Island”.

The high evidential threshold includes detailed business plans, concrete evidence that decision making occurs on the Island and detailed information regarding their Isle of Man employees.

In line with the tougher approach to IP companies detailed above, the sanctions are somewhat harsher for such companies.

Whether or not the substance requirements have been met, in accordance with international arrangement, the Assessor will disclose to a relevant EU tax official any relevant information concerning a high-risk IP company.

If a high-risk IP company is unable to rebut the presumption that it has failed to meet the substance requirements, the sanctions are as follows, (stated by the number of consecutive years of non-compliance):

  • 1st year, a civil penalty of 50,000;
  • 2nd year, a civil penalty of £100,000 and may be struck off the company register; and
  • 3rd year, strike the company off the company register.

If the high-risk IP company is unable to provide to the Assessor any additional information requested, the company will be convicted to a fine not exceeding £10,000.

Any appeals will lie with the Commissioners who may confirm, vary or reverse the Assessor’s decision.

This new legislation has been swift in its implementation and has put companies under pressure to ensure that they comply with the new legislation, which will commence at the start of 2019. This will have a significant affect upon many Isle of Man businesses who have only a short amount of time to demonstrate to the authorities that they are compliant. The potential penalties of non-compliance may cause detrimental reputational risk, fines of up to £100,000 and eventually struck off.

Peregrine Corporate Services is licensed by the Isle of Man Financial Services Authority.