20 June 2018 by Predrag Maletic
What exactly does it mean to have economic substance?
In this world of growing financial transparency, the OECD BEPS initiative and trends towards more economic substance for corporate entities, international mergers and acquisitions activity is becoming more heavily reliant on compliance.
The OECD recommendations have countries increasing regulation around what it means to have ‘economic substance’ in a country, and so companies and funds must review their substance to ensure they are in line with the new global requirements.
But what exactly does it mean to have economic substance?
In the past, it was possible to structure a holding company so that profits could pass through to countries that were more lenient with tax regulation. The company could be incorporated in a country without needing, for instance, personnel, its own offices or key employees, a sales function, and so on – basically, without those elements or transactions that prove it is a ‘true’ company, both in physical presence and activity.
The BEPS initiative, and those local regulations resulting from it, makes this ability a thing of the past. If a company is incorporated in a country, then real economic activity needs to be conducted by that company in that country.
The growing substance requirement does not mean that a multinational group setting up a company in a certain jurisdiction cannot avail itself of tax benefits; rather, the business set-up should be driven by real economic activity.
The Netherlands is one of the most stringent countries when it comes to complying with substance, so it’s worth taking a look at how it has handled these increasing needs from companies.
Here, when filing the Dutch corporate income tax return for certain types of companies, you must show that you’re meeting the minimum requirements for substance. This, amongst other needs, includes that at least 50% of board members with decision-making powers should be a resident of the Netherlands, and that these board members should be sufficiently qualified to perform their tasks. Their tasks should at least concern making decisions about the transactions the company will perform - such as strategic decisions related to acquisitions by the Dutch company - and also the proper completion of the transactions the company will perform.
However, it is anticipated that in 2019 new legislation will be implemented that will further expand the Dutch substance requirements. New legislation is under debate in Dutch parliament, and the world is watching to see what happens. Guernsey and Jersey, for example, who have politically committed to the EU to address the existence of ‘offshore business that attracts profits without real economic activity’, will likely use a lot of elements seen in Dutch legislation.
Missed our webinar on the proposed Dutch tax plan and staying compliant in the Netherlands? Watch the recording here.
We are now living in a world of transparency, be it financial transparency, tax transparency, or economic transparency. With Country by Country reporting (CbCr) becoming active, too, tax authorities of participant companies will be sharing information between themselves. Between transparency and free information exchange, authorities can easily pinpoint the absence of substance – which means when you’re looking into M&A, you should perform an extra step of due diligence.
When you acquire a multinational company, you inherit the structure and all group entities in that structure, and so you must now perform due diligence on all these group entities to see the extent to which they have relevant economic substance. In-depth corporate structure analysis has to be performed when acquiring organisations with multiple subsidiaries overseas.
Despite these global movements, each jurisdiction has different rules, and both globally and locally things are constantly changing. Consider first performing screening by evaluating your acquired entities. The next step, a review of your entities’ substance per each local requirement - or the global standard if there is no local requirement. This is a necessary but time-consuming and laborious process.
Working with a local partner that has competency for both international structures and in-depth knowledge of local requirements or new global standards can help to streamline the process. Third party providers can perform an initial health-check for your local economic substance, and support entities in all jurisdictions where the business operates.
That’s where a company such as TMF Group comes in. We can perform a substance health check and verify, using both local requirements and global interpretations and standards of substance, whether the specific group entity or entities meets those requirements and/or standards. We have qualified professionals in over 80 countries to support your regulatory compliance globally.
Get in touch to discover how we can help keep you compliant.