By Marie Barber and Dhara Soneji, Duff & Phelps
Published: 27 September 2019
The evolution to a truly global financial world has meant that tax policies and practices have also needed to be reviewed at a global level. The last 10 years have seen a shift in the global tax environment towards seeking to create a more level playing field across all jurisdictions. As part of this harmonisation project, there has been a revised focus by the Organisation for Economic Co-operation and Development (OECD) on local substance requirements and more specifically territorial substance. This has resulted in the introduction of several legislative measures within a short space of time. The outcome of this focus will be additional compliance and reporting costs. The purpose of this article is to discuss what these changes are and how they impact asset managers and their investment structures.
Background to the substance legislation
Following the 2008 financial crisis there has been an increased focus on tax avoidance and a desire to harmonise tax systems to try and minimise tax arbitrage.
The OECD sought to address this by the introduction of the Base Erosion and Profit Shifting (BEPS) measures. These provisions seek to create alignment between global tax regimes. Whilst these measures provided recommendations on how harmonisation may be achieved, adoption of the provisions was voluntary.
As a result, the EU made the adoption of a number of these measures mandatory for the 27 Member States. BEPS Action 5 focusses on addressing substance requirements. The focus on addressing substance stems from abusive structures that sought to take advantage of cross border tax arrangements.
Historically, profits in ‘onshore’ (i.e. EU, UK and U.S.) jurisdictions have been subject to higher tax rates. This led to the establishment of multi-jurisdictional structures to help achieve frictionless returns. For example, a holding company would be set up in a jurisdiction that operated a preferential tax regime (i.e. domestic exemption on investment yields - dividends and capital gains and low or nil withholding tax rates). Profits from these jurisdictions would then be repatriated to an entity in a country with a low or nil tax rate.
There was increasing concern at an EU level that such structures created economic arbitrage and did not reflect the true cost of commercial economic operations. The Forum of Harmful Tax Practice (FHTP) was set up in 1998 to conduct reviews of preferential regimes to determine if the regimes could be harmful to the tax base of other jurisdictions. Since the introduction of the BEPS initiatives and EU Commissioner's 2016 ‘External Strategy for Effective Taxation’ low or nil tax jurisdictions are required to implement legislation to address their economic substance requirements to ensure they were not blacklisted.
BEPS Action 5
BEPS Action 5 is one of the four minimum BEPS standards that the EU has made mandatory for all 27 Member States. Action 5 focuses on addressing arrangements that could erode the tax base of other jurisdictions. This is being addressed by this Action through three key parts.
Part I: Assessment of preferential tax regimes
The focus here is on beneficial tax provisions that operate in preferential tax regimes to ensure that treaty access is only granted where there is a true entitlement to income flows rather than an entity acting as an intermediary / conduit. We have recently seen challenges in this area by EU jurisdictions that have resulted in the denial of certain treaty benefits (such as reduced withholding tax rates).
Part II: Transparency framework
The existence of global business operations has necessitated the adoption of tax measures at a global level. The introduction of the Common Reporting Standard in 2016 (which followed FATCA) made it mandatory for financial institutions to report certain information about overseas beneficiaries to local tax authorities. Such information could then be shared globally. This was a major step towards combating tax evasion. This was taken a step further by the introduction of the EU Council Directive 2011/16 (DAC6) in 2018 that requires information about cross-border arrangements that display certain hallmarks, to be reported by the promotor / taxpayer.
Part III: Substantial activities requirements
The third part of the BEPS initiative focuses on addressing tax abuse in non-EU jurisdictions that operate no or only nominal tax rates. In order to address the abuse, the EU mandated that jurisdictions that operate such regimes implement legislation to address economic substance requirements by 31 December 2018 to apply from 1 January 2019. Non-compliance would result in that jurisdiction being added to the blacklist.
The legislation applies to ‘relevant entities’ performing ‘relevant activities. Where an entity falls within this definition, they will be required to complete annual reporting. This reporting includes confirmation of the performance of the relevant activity and the financial year end. In addition, to the extent any income from the relevant activity is generated outside of that jurisdiction, the entity must provide support of tax residence in that jurisdiction.
An entity will be deemed to be a relevant entity where it is tax resident in that jurisdiction. Where there is a relevant entity a determination needs to be made whether that entity performs a relevant activity. A relevant activity includes fund management businesses but does not include investment activities.
When the provisions were first implemented several jurisdictions were blacklisted. Most have undertaken remedial legislative action to remove themselves from the blacklist (e.g. Bermuda).
Consequences of being blacklisted
The new substance requirements need to be taken seriously. Where a country has not implemented the appropriate provisions, EU members states have agreed on sanctions including monitoring and audits, withholding taxes and additional documentation and reporting requirements.
Where an entity in a blacklisted jurisdiction is part of an EU group and would ordinarily receive payments from the EU entity gross due to a preferential tax regime, following the introduction of the economic substance provisions there is a risk that any payments made from the EU entity will be subject to a withholding tax. Therefore, non-compliance could have serious financial as well as reputational implications.
How will these new laws impact asset managers and what should they do next?
- The minimum requirements to be adopted by jurisdictions that operate in low or nil tax regimes mean that investment managers with entities in these jurisdictions should review their arrangements to determine if they meet the new economic substance requirements. This should involve reviewing and possibly amending investment management agreements and fund documentation. This may have an impact on the transfer pricing methodology currently being operated. Alternatively, these arrangements may no longer be considered fit for purpose and rationalisation might be a preferred course of action.
- To the extent that investment managers operate in jurisdictions that are caught by the provisions, they should ensure they understand their reporting requirements to meet the first 2020 deadline.
- Currently, investment funds are not caught by the provisions. However, it is important that a watchful eye is kept on any ongoing changes made to domestic legislation.
- Where part of an asset management structure includes entities in preferential EU jurisdictions (i.e. Luxembourg, Malta), it is vital that consideration is given to whether the substance requirements are being met. Following the introduction of the economic substance provisions, where an entity in the structure is in a jurisdiction that is on the blacklist (normally an entity in the structure which owns the shares of the EU country) returns that were previously made gross may now be subject to withholding tax. Even if this entity is in a jurisdiction that is not on the blacklist but operates in low or nil non-EU jurisdiction, they will need to consider if they meet the economic substance requirements imposed locally.
- It is important to note this exercise is likely to be extended to additional jurisdictions and therefore whilst entities may not currently be caught by the provisions imposed, they may be in the future. It is therefore important to keep a watchful eye on any developments.