Substance Over Form

Of offshore investments

There is a clamor by countries and various tax authorities to pick into the minds of tax planners’ imaginations. They are looking for “substance.” Recent leaks, the Pandora Papers, the Panama Papers, etc have shown that businesses and individuals continue to rely on “offshore” or “non-resident” structures to reduce or defer taxes to improve returns for investors. These structures, and their management, seem to be changing course. For instance, a cursory look at the European Union (EU) case law seems to suggest that questions are being asked as to whether there is a business reason to set up a company in another jurisdiction. Or is it that taxpayers are simply following some abusive tax practices that rely on wholly artificial arrangements?

If there is a business reason, then the freedom of establishment rights should prevent tax authorities of one country, from imposing restrictions to entities properly established in another, e.g., imposing certain withholding taxes or denying certain tax reliefs. Brexit, and its aftereffects, have shown these pains. Tax authorities, however, are demanding more. They need justification. They need grounds. They need comfort. Before they can grant relief from local taxes. They want proof of substance and so are various other trading and economic blocs.

Global Phenomenon

This phenomenon has extended beyond the EU. It is now a global problem, and all tax authorities want in. Basically, they insist that a taxpayer must show that they have substance in that other tax jurisdiction before they can get the tax treatment, they claim they ought to legally enjoy. Unfortunately, the concept of “substance” in most cases, is as foreign as the investors themselves. It covers both material and economic sides and largely depends on who is making the interpretation at that point in time. The incorporation of a company is no longer sufficient to ensure that it will be a resident company in one jurisdiction and a “non-resident” in the other.

Some countries now require a demonstration of an active board of directors, employees, suitable financing, and even physical office facilities. This move towards having a physical presence (directly employed staff and designated office space, as well as dedicated telephone numbers, email addresses and office equipment) is generally becoming a prima facie test, at certain levels in a structure, to warrant interpretation, and justification, for substance. There are jurisdictions that have started ignoring subcontracted staff and general office space of an administration company when conducting their “substance” test.

It gets even more complicated when the jurisdiction is looking at the taxes involved. For instance, the French now insist that a more minimal substance for a holding company, not resident in France, would probably be acceptable from a French tax perspective to secure withholding tax exemption or reduction on dividends paid from France. However, more material substance would be recommended to support a claim for exemption from French tax on capital gains under certain double tax treaties.

What then?

The challenge facing investors is that there is no perfect answer as to what substance entails. It is often, proportional to the commercial needs of a company. Nevertheless, there are certain benchmarks that the tax authorities insist upon. More so where there are certain tax reliefs or gains sought. These include bank accounts, board meetings, composition of boards, employees, physical offices etc. Demonstrating the level of substance using these indicators is generally, not explicitly necessary, but can help one’s case. In other cases, and depending on the industry, seemingly minimal evidence has proved sufficient.

Granted, tax authorities are becoming more aggressive, governments are pushing for stiffer tax avoidance strategies, and everyone wants a piece of the pie, but nobody is willing to define the concept. It might be because of the fear that defining it may limit its scope. This fear notwithstanding, it is certain that substance will eventually find its way into tax legislation. Especially since there is already insistence that companies must demonstrate the non-tax related commercial rationale, for any specified transactions, or role, or purpose as a member of the group.

Investors therefore need to start considering if there is sufficient and proper motivation to invest offshore, and if at all, the only motivation is tax planning. Such decisions must be largely driven by the origin or location of the major investors and the amount of activity in the business structure vis-a-vis the corresponding country of investment. One thing that is certain though, is that there is a need to tread carefully going forward. Substance may not have strongly found its way into the tax legislation yet, but given the current responses, and public views and opinions, a substance requirement will soon become a mandatory requirement.

Original article by Varosa Alambo at Substance over Form

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