The Economic Substance (Companies and Limited Partnerships) Act, 2018 (ESA) was enacted in the British Virgin Islands on 31 December 2018 and amended by the Economic Substance (Companies and Limited Partnerships) (Amendment) Act 2021 which received its assent on 28 June 2021 and was gazetted on 29 June 2021. Its purpose is to fulfil the BVI’s commitment to ensuring the highest standards of tax governance and to ensure that the BVI is not included in Annex 1 to the EU list of non-cooperative jurisdictions for tax purposes (List). All of the other key tax neutral jurisdictions (such as Bermuda, the Cayman Islands, Guernsey, Jersey, Isle of Man) have recently passed similar legislation.
The EU’s Code of Conduct Group is responsible for preparing the List, the latest version of which was adopted by the ECOFIN Council on 12 March 2019. The Code of Conduct Group also produces at Annex II to the List a document (State of Play) setting out the state of play of the cooperation with the EU with respect to commitments taken to implement tax good governance principles.
The BVI tax regime is currently included in the State of Play as one that facilitates offshore structures which attract profits without real economic activity. The BVI, mindful of the need to ensure tax good governance, made a commitment to address the EU’s concerns relating to economic substance in the area of collective investment funds by the end of 2019. The EU’s Code of Conduct Group is providing ongoing technical guidance to the British Virgin Islands on the economic substance requirements for collective investment schemes. Further communications and consultation with the BVI offshore funds industry is anticipated.
The British Virgin Islands International Tax Authority (ITA) issued on 9 October 2019 Rules on Economic Substance in the Virgin Islands which were updated on 10 February 2020 (Rules) to set out various rules and explanatory notes on ESA.
- Who does it apply to?
Companies and limited partnerships incorporated in BVI or registered as foreign companies or limited partnerships in BVI which are tax resident in BVI and carrying on Relevant Activities.
Essentially ESA provides that companies and limited partnerships which are tax resident in the BVI must, if they carry out a “Relevant Activity” (listed below) satisfy certain economic substance requirements. A company or limited partnership is tax resident in the BVI if it is not tax resident in another jurisdiction (other than a jurisdiction on Annex 1 of the List, as at 26 March 2019 American Samoa, Aruba, Barbados, Belize, Bermuda, Dominica, Fiji, Marshall Islands, Oman, United Arab Emirates, Vanuatu, Guam, Samoa, Trinidad and Tobago and the US Virgin Islands).
The explanatory notes in the Rules state that the ESA is aimed at BVI entities which carry on one or more relevant activities substantially outside the BVI but are unable or unwilling to establish tax residence outside of the BVI and take advantage of the BVI’s zero tax regime while carrying on their business substantially in another jurisdiction.
Rule 3 of the Rules provides that an entity which carries out a Relevant Activity and claims to be a non-resident company or limited partnership (i.e. tax resident outside the British Virgin Islands) must provide the following evidence:
- a letter or certificate from or issued by a competent authority stating that the entity is resident for tax purposes in that jurisdiction;
- an assessment to tax, confirmation of self-assessment, tax demand, evidence of payment of tax or other document issued by a competent authority.
Where tax is charged other than by reference to residence, the explanatory notes in the Rules state that what matters is that the competent tax authority accepts that the entity (or its participators) is/are chargeable to tax on its/ their worldwide income in that jurisdiction.
Rule 5 in the Rules states that:
“An entity (other than a pure equity holding entity) whose only sources of income from relevant activities are subject to tax in a jurisdiction outside the BVI will be regarded as resident for tax purposes in that jurisdiction.”
It would appear that a pure equity holding entity whose income and capital is taxed in an onshore jurisdiction will still be required to comply with the reduced economic substance requirements under the ES Act.
- Relevant Activities
The “Relevant Activities” are defined in ESA as: banking (defined as the business of providing credit facilities of any kind for consideration), insurance, fund management, finance and leasing, headquarters, shipping, holding business, intellectual property and distribution and service centre business. These are defined in more detail in ESA and certain “core income-generating activities” are specified in respect of each “relevant activity”.
Investment fund business excluded
Investment fund business is specifically excluded and is outside the scope of the economic substance requirements. An “investment fund” is defined as “an entity whose principal business is the issuing of investment interests to raise funds or pool investor funds with the aim of enabling a holder of such an investment interest to benefit from the profits or gains from the entity’s acquisition, holding, management or disposal of investments and includes any entity through which an investment fund directly or indirectly invests or operates (but not an entity that is itself the ultimate investment held), but does not include a person licenced under the Banks and Trust Companies Act, 1990 or the Insurance Act. 2008, or a person registered under the Cooperatives Societies Act 1979 or the Friendly Societies Act 1928;” and “investment fund business” is defined as “the business of operating an investment fund;”.
It should be noted that the definition of investment fund in the ESA is broader that the definition of both “mutual fund” and “private investment fund” in the Securities and Investment Business Act 2010 (“SIBA”) and may include funds that fall outside of those definitions.
FSC view followed on banking, insurance and SIBA license
The explanatory notes in the Rules state that the ITA will follow the Financial Services Commission’s interpretation of what does or does not fall within the definition of banking business, insurance business and investment business requiring a category 3 investment business license under the SIBA.
Finance and leasing business
The explanatory notes in the Rules clarify that the essence of finance and leasing business is the provision of credit facilities which must be a business in its own right and not incidental to a different sort of business. Entities operating a factoring business (where an entity purchases and then collects another’s book debts) will be treated as carrying on finance and leasing business but holding debt or debt instruments for investment purposes will not.
The explanatory notes in the Rules clarify that an entity’s position in at the apex of a group structure does not determine whether it is carrying out headquarters business but rather the services it provides to the group. If the senior management are employed by service company subsidiary it will be providing headquarters services.
The explanatory notes in the Rules state that the ITA will always consider whether activities which appear to fall within the definition of shipping business do in fact constitute shipping business, or whether they are merely incidental activities forming part of a different business e.g. a general travel agent will not be regarded as carrying on shipping business merely because it sells tickets for passenger cruises. Similarly a manufacturer will not be treated as carrying on shipping business only because it arranges for goods to be sent by sea.
Intellectual Property Business
The explanatory notes in the Rules clarify that intellectual property business applies to holding an intellectual property asset from which identifiable income accrues. A business that owns intellectual property which does not earn specific amounts of revenue and is merely an adjunct to its business would not fall within the definition. What is being targeted are entities which receive income from intellectual property rights which they have not developed themselves or are not actively exploiting.
Distribution and service centre business
The explanatory notes in the Rules clarify that for an entity to carry on distribution and service centre business it must have a business that consists of purchasing assets from other entities in the same group and or providing services to entities in the same group. The purpose is to prevent legal entities paying zero tax in the British Virgin Islands from extracting profits from entities in other jurisdictions which are subject to substantial taxes on profits. Occasional transactions which are ancillary to a different business will not constitute distribution and service centre business.
It is worth noting here that “Holding Business” is narrowly defined as “the business of being a pure equity holding entity”.
- Pure Equity Holding Entities
A pure equity holding entity which carries on no Relevant Activity other than Holding Business (i.e. just holding equity) will have “adequate substance” if it (a) complies with the BVI Business Companies Act, (Revised Edition 2020) as amended or the Limited Partnership Act, (Revised Edition 2020); and (b) has adequate employees and premises for holding equitable interests.
The explanatory notes in the Rules clarify that for an entity that only carries out holding business there is:
- no requirement that the entity is directed or managed in the British Virgin Islands;
- no requirement that the entity carries out its core income generating activities in the British Virgin Islands;
- no restrictions on the extent to which it may outsource its activities provided the outsourcing is to a person in the British Virgin Islands.
The explanatory notes in the Rules notes that “adequate” is not defined in ESA and must be given its ordinary English meaning. The explanatory notes go on to state that what constitutes adequate employees or premises:
“will be a fact sensitive question, dependent on the nature of the activity being carried on. At one extreme the requirement for being a pure equity holding entity is simply holding equity participations. If this is all the legal entity does during a given financial period, the relevant activity will be entirely passive in nature and the requirements for adequate and suitably qualified employees and for appropriate premises will be applied accordingly. Any legal entity will of course retain the services of a registered agent, and the performance of those services will be taken into account when assessing economic substance for pure equity holding entities.
On the other hand, the entity may actively manage its equity participations, in which case it should have adequate and suitably qualified employees, and appropriate premises, in the BVI to carry out this function.”
- What do you have to do if ESA applies to your company or limited partnership?
A company or limited partnership which does not carry out any Relevant Activities will be required to make an annual Economic Substance declaration to that effect.
A company or limited partnership which carries out Relevant Activities is required to (1) either provide evidence that it is tax resident in a jurisdiction other than the BVI and state what Relevant Activities it is carrying on; or (2) establish economic substance in the BVI. Any entity that intends to establish economic substance in the BVI will need to provide additional information evidencing this to its registered agent which will be entered into the Beneficial Ownership Secure Search (Economic Substance) System (BOSS(ES)S) (an extension of the system through which beneficial ownership information is centrally uploaded in the BVI).
- Economic substance requirements
The economic substance requirements for the Relevant Activities other than Holding Business are:
- the relevant activity is directed and managed in the BVI (not the legal entity which carries on the relevant activity);
- having regard to the scale and nature of the relevant activity:
- there are adequate, suitably qualified staff located in the BVI;
- there is adequate expenditure incurred in the BVI;
- there are physical offices or premises appropriate for the “core income-generating activities”;
- where an intellectual property business requires specific equipment, that equipment is in the BVI;
- the company or limited partnership conducts core income-generating activity (CIGA) in the BVI;
- if the income-generating activity is carried out by another entity it is done within the BVI and can be monitored and controlled by the original entity.
The explanatory notes in the Rules state that:
- where a legal entity’s only business is the Relevant Activity or Activities the entity itself must be directed and managed from the BVI.
- There must be an adequate number of board meetings held in the BVI having regard to the nature of the Relevant Activity and its importance to the overall business of the legal entity.
- For a board meeting to be held in the BVI there must be a quorum of directors physically present in the BVI and minutes of the meetings must be kept in the BVI.
- The directors attending the meeting must have adequate expertise to direct the Relevant Activity.
- “adequate”, “suitable” or “appropriate” are to be given their ordinary English meaning.
- The ITA will apply criteria such as the “adequacy” of expenditure and employment, the “suitability” of employee qualifications and the “appropriateness” of premises with regard to the usual way in which businesses carrying on the Relevant Activity on a commercial basis are structured and operate.
- What is adequate for a small business will not be for a large business. The amount of expenditure incurred and the number of employees (and their qualifications) employed globally in the Relevant Activity will be relevant to whether or not expenditure and employment in the BVI is adequate.
- Account will be taken of flexible working practices (provided the homes or premises from which employees work when not in the office are in the BVI) in determining what are appropriate premises in the BVI for the CIGA of a Relevant Activity.
- Premises may be rented or used under licence.
- CIGA and other activities may be outsourced to third parties in the BVI but in respect of economic substance account will only be taken of work done by the entity to whom the work is outsourced which actually relates to the outsourcing entity.
- The activities listed in the definition of CIGA are non-exhaustive and what constitutes CIGA of a Relevant Activity is fact sensitive and can vary from business to business. It may be possible to be carrying out a Relevant Activity without conducting all the activities listed in the definition of CIGA.
- The substance requirements are expected to be complied with during the time that a corporate and legal entity is in liquidation.
There are specific paragraphs in the Rules to clarify how the number of employees in the BVI will be calculated.
- New BOSS Information
Under the Boss Act BVI companies are required to provide information regarding the corporate and legal entity itself and its beneficial owners and registrable legal entities (BOSS Information). ESA has made various amendments to the BOSS Act so that each company and limited partnership carrying out one or more Relevant Activity is now required under the BOSS Act to provide additional information to the registered agent in the BVI, including: (i) confirmation as to whether or not it carries on any Relevant Activities and details of any Relevant Activities that it carries on; (ii) details of its parent, immediate parent and ultimate parent (iii) taxpayer identification number (“TIN”) or other identification reference number of the parent, immediate parent, ultimate parent and beneficial owners (iii) if non-resident in the BVI for tax purposes, details of where it is tax resident; (iv) if resident in the BVI for tax purposes, in respect of each Relevant Activity: TIN; type of mobile income, amount and type of gross income in relation to the Relevant Activity; amount and type of assets and premises held in the course of carrying out the Relevant Activity; the net book values of tangible assets held in the course of carrying out the Relevant Activity; expenditure incurred in relation to the Relevant Activity in BVI; the total amount of expenditure incurred on the Relevant Activity globally; total number of employees; number of employees in the BVI and globally involved in the Relevant Activity; details of the employees engaged in the Relevant Activity; the CIGA of the Relevant Activity; address[es] in the BVI; in the case of a legal entity which carries on an intellectual property business the equipment located in BVI; names of the persons responsible for the direction and management of the Relevant Activity; details of board meetings and directors and the name of any entity that carries out a core income-generating activity for the company or limited partnership (Additional Information).
ESA has also amended the BOSS Act so that limited partnerships now fall within the remit of that legislation, requiring beneficial ownership information to be provided by limited partnerships to the BVI registered agent. In addition, any exempt entity (under the BOSS Act), such as a listed company or a regulated fund, is required to provide beneficial ownership information to its registered agent (to be uploaded into BOSS) if such entity carries out a Relevant Activity.
- Intellectual Property Business.
ESA provides that there is a rebuttable presumption that any company or limited partnership which carries on an intellectual property business does not conduct core income-generating activities in the BVI (and therefore cannot comply with the economic substance requirements in ESA) if:
- the activities carried on in the BVI do not include – intellectual property business concerning intellectual property assets such as patents, research and development or non-trade, intangible assets such as brand, trademark and customer data, marketing, branding and distribution; or
- the company or limited partnership is a “high risk IP legal entity”.
A “high risk IP legal entity” is a legal entity which carries on an intellectual property business and which: (a) acquired the intellectual property asset (i) from an affiliate; or (ii) in consideration for funding research and development by another person situated in a country or territory other than the BVI; and (b) licences the intellectual property asset to one or more affiliates or otherwise generates income from the asset in consequence of activities (such as facilitating sale agreements) performed by foreign affiliates. The explanatory notes in the Rules provide that in determining if the presumption is rebutted there is a high evidential threshold and the ITA will need to be satisfied that the activity in the BVI is more than local staff passively holding intangible assets whose creation and exploitation is a function of decisions made and activities performed outside the BVI. The entity must employ local, permanent and qualified staff and show that they make active and ongoing decisions in relation to the generation of income in the BVI.
The explanatory notes in the Rules require that a legal entity wishing to rebut the presumption must:
- provide a detailed business plan explaining the commercial rationale of holding the IP asset in the BVI;
- provide concrete evidence that decision-making is taking place within the BVI e.g. detailed minutes of meeting which have taken place in the BVI;
- show a high degree of control over the development, exploitation, maintenance, enhancement and protection of the intellectual property asset is exercised by suitably qualified employees who are physically present and perform their functions from within the BVI and who are on long-term contracts (the “Requirements”); and
- demonstrate that the Requirements are satisfied not only when the high risk legal entity seeks to rebut the presumption but also during any historic periods when the high risk legal entity was carrying on the intellectual property business in question.
- When do you have to comply by?
ESA came into force on 1 January 2019 and applies to companies and limited partnerships which carry on a Relevant Activity during any financial period. “Financial Period” for companies and limited partnerships formed before 1 January 2019 is defined as a period of one year commencing on a date no later than 30 June 2019 and every following period of one year.
The Financial Period for companies and limited partnerships formed after 1 January 2019 will commence on the date of their incorporation or formation and will ordinarily terminate a year later. Entities formed after 1 January 2019 may give notice to the ITA that they wish to shorten their first Financial Period within three months of their incorporation or formation or, if later within three months of 30 June 2019.
Entities may apply to the ITA at any time to alter their Financial Period by shortening or where its Financial Period is less than 12 months by lengthening the Financial Period to 12 months.
The International Tax Authority of the BVI (ITA) may determine that a company or limited partnership has not complied with the economic substance requirements during any Financial Period of the relevant entity ending on or after 31 December 2019.
The explanatory notes in the Rules clarify that where an entity’s fiscal year or accounting year is different from its Financial Year for ESA purposes an entity may need to provide evidence from two accounting years to demonstrate ESA requirement in one Financial Period. The ITA may treat an entity as provisionally resident in a jurisdiction pending the issuance of suitable evidence by a local competent tax authority.
- How is it enforced?
The ITA can require a company or limited partnership to provide information to assist it in making its determination. This is in addition to the additional information requirements for BOSS.
The explanatory notes in the Rules state that:
“an entity which does not take steps either to take its relevant activity outside the scope of the legislation, or to bring it into compliance with the legislation, can expect to be the subject of enforcement proceedings.”
Where a legal entity notifies the ITA of its intention to re-locate a Relevant Activity out of the British Virgin Islands to comply the ESA, the ITA may agree a compliance plan setting out a timetable to ensure that the re-location happens as soon as practicable.
Exchange of information will take place between the ITA and the tax authority of any jurisdiction in which an entity claims to be tax resident as well as with the EU where the entity has one or more beneficial or legal owners resident in the EU.
- Offences and Penalties
On a first determination of failing to satisfy the economic substance requirements the ITA can impose a penalty of between $5,000 and $20,000 or $50,000 for certain high-risk intellectual property companies or limited partnerships. On a second determination the ITA can imposes a penalty of between $10,000 and $200,000 or $400,000 for certain high-risk intellectual property companies or limited partnerships.
ESA creates an offence of failing to provide or providing false information which is punishable on summary conviction with a fine of up to $40,000 or 2 years imprisonment and for a conviction on indictment of up to $70,000 and 5 years imprisonment.
The ITA can recommend to the BVI Financial Services Commission that the relevant company or limited partnership is wound up or in certain circumstances serve notice on the Commission requiring that the entity be wound up.
The explanatory notes in the Rules highlight that once the ITA has determined that an entity is in breach of the economic substance requirements, it has no discretion as to whether to impose a financial penalty but must at the least impose the minimum penalty.
- How can Forbes Hare help you?
We can advise you on applicability of and compliance with ESA and each of the above points.
- We can provide BVI based directors, secretaries and other officers to help you establish economic substance in the BVI.
- We can provide a BVI location for hosting board and general meetings.
This article is intended to be for the general information of the clients and professional contacts of Forbes Hare. It is not intended to be comprehensive and should not be relied on as a substitute for independent legal advice in any circumstances.