Substance requirements vs Harmful tax practices

Transcription

1 Substance requirements vs Harmful tax practices News Flash Hong Kong Tax January 2019 Issue 1 In brief The Organisation for Economic Co-operation and Development (OECD) Inclusive Framework on Base Erosion and Profit Shifting (BEPS) issued a document entitled Resumption of Application of Substantial Activities Factor to No or only Nominal Tax Jurisdictions 1 (the OECD document) in November The OECD document imposes a global standard that requires no or nominal tax jurisdictions to introduce substantial activities requirements in order for their tax regimes not to be considered harmful tax practices. A number of jurisdictions, including the British Virgin Islands (BVI) and Cayman Islands, have already enacted domestic substance legislation effective from 1 January The substance legislation mainly requires entities to (1) conduct specified core income generating activities (CIGA) in the jurisdictions; (2) have an adequate number of employees with appropriate qualifications who are physically present in the jurisdictions; (3) incur an adequate amount of operating expenditures and (4) have physical office or premises or equipment located in the jurisdictions. The substance requirements apply to the following mobile business activities: headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping, holding companies and the provision of intellectual property (IP). Under the legislation, the tax authorities of these jurisdictions will share information in respect of an entity which fails to meet the economic substance requirements with the tax authorities of the jurisdictions in which the parent company, ultimate parent and ultimate beneficial owner of the relevant entity are located. The new economic substance requirements in no or nominal tax jurisdictions may have significant impact on business groups with a BVI/Cayman Islands holding company in their corporate structures, as well as investment funds with a Cayman Islands fund manager. Business groups should take immediate actions to review their existing corporate structures, assess the implications of the economic substance requirements for their business models and identify possible remedial actions. In case they are unable to meet the economic substance requirements, they should evaluate the impact if the information of noncompliance is shared with the tax authorities of the jurisdiction where the parent company is located. They should also closely monitor any further developments in this area, such as further guidance on how the economic substance requirements can be met and the meaning of the words adequate or appropriate used in the legislation. In detail The substantial activities requirements for no or nominal tax jurisdictions The OECD Document was issued as follow-up work under BEPS Action 5 on countering harmful tax practices. The objective of introducing such substance requirements is to level the playing field and prevent shifting of profits derived from certain mobile business activities to no or nominal tax jurisdictions without corresponding local economic activities, as similar substance requirements have been introduced for preferential tax regimes in other tax jurisdictions. The OECD Document provides the following requirements:

2 Mobile business activities subject to substantial activities requirements The types of activities covered are: headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping, holding companies and the provision of IP. Substantial activities requirements for non-ip income No or nominal tax jurisdictions are required to have domestic legislation that (1) defines the CIGA for each relevant business activity; (2) ensures the CIGA relevant to the type of business activity is undertaken by the entity or is undertaken in the jurisdiction; (3) requires the entity to have an adequate number of full-time qualified employees and incur an adequate amount of operating expenditures and (4) provides a transparent mechanism to ensure compliance and an effective enforcement mechanism for non-compliance with the requirements. Substantial activities requirements for IP income The CIGA for income derived from a patent and similar assets is defined as conducting research and development whereas the CIGA for marketing intangibles (e.g. trademarks) is defined as "branding, marketing and distribution", though exceptions may apply in certain situations. There is also a rebuttable presumption that, in the absence of the CIGA mentioned above, the substantial activities requirements are not met in certain higher risk scenarios involving related parties (e.g. acquiring an IP asset from related parties or licensing/selling an IP asset to related parties). In addition, the following two scenarios are considered as insufficient to meet the substantial activities requirements for IP income: the entity only passively held an IP asset which had been created or exploited based on decisions made and activities performed outside the jurisdiction; and the only activities contributing to the income were the periodic decisions of non-resident board members in the jurisdiction. Mechanism for ensuring compliance Entities conducting mobile business activities in a no or nominal tax jurisdiction should be required to report detailed information in relation to the substantial activities requirements. A sanction mechanism should be in place so that actions can be taken for non-compliance with the substantial activities requirements. Finally, there should be an information exchange mechanism under which information filed with the jurisdiction will be spontaneously exchanged with the jurisdictions of residence of the immediate parent, ultimate parent and ultimate beneficial owner in cases of (1) noncompliance of the substantial activities requirements or (2) entities engaged in the higher-risk scenarios. Substance legislation in no or nominal tax jurisdictions A number of no or nominal tax jurisdictions 2 have already enacted their domestic substance legislation. There may be variations between the legislation of different jurisdictions, although they all generally follow the OECD requirements mentioned above. Among them are the BVI 3 and Cayman Islands 4, whose substance legislation became effective on 1 January Key features of their legislation are: Generally speaking, entities (companies and partnerships) incorporated in the BVI/Cayman Islands or incorporated in other jurisdictions but registered in the BVI/Cayman Islands will be subject to the economic substance requirements, unless they are a tax resident of another jurisdiction 5. The types of mobile business activities covered are the same as those stated in the OECD Document. The Cayman Islands legislation specifically states an investment fund is not a relevant entity and investment fund business is not a relevant activity, which means that they are not subject to the economic substance requirements. However, fund management business is listed as one of the relevant activities and will be subject to the economic substance requirements. The legislation defines what the CIGA for each type of mobile business activity is, including the holding company business. The economic substance requirements for mobile business activities other than holding company business basically require an entity to conduct the CIGA, have physical offices or premises or equipment, have an adequate number of employees with appropriate qualifications and incur an adequate amount of operating expenditure in the jurisdiction. For outsourced CIGA, the relevant entity must be able to monitor and control the carrying out of the CIGA by the other entity. The economic substance requirements for holding company business are less stringent and will be met if the holding company complies with the statutory obligations under the relevant Companies Act of the jurisdiction and has adequate human resources and premises for holding and managing the equity participation in other entities. Other key provisions include those dealing with sanctions for non-compliance (e.g. penalties and being struck off from the register of companies or partnerships), information reporting obligations and spontaneous exchange of information. 2 PwC

3 The takeaway The new economic substance requirements in no or nominal tax jurisdictions may have significant impact on a wide range of business entities and parties, including but not limited to: a Hong Kong listed group with a Cayman Islands listing vehicle or multi-level of intermediate BVI/Cayman Islands investment holding companies - although there is a less stringent economic substance requirements for holding company business, these investment holding companies will need to have adequate number of qualified employees and premises located in BVI/Cayman Islands for holding and managing the equity investment. Subject to further guidance to be issued by the relevant authorities of the BVI/Cayman Islands, it has yet to be seen whether the requirements on number of employees and physical premises can be met by sharing of resources within a group or through resources provided by a third party agent. Given that each of the holding companies within the group needs to have adequate substance, the costs of maintaining these BVI/Cayman Islands holding companies to be incurred by the listed group will inevitably be increased. a private business group or a family business/trust which uses multiple BVI/Cayman Islands companies for holding their equity investment or real estate property - the same issues as mentioned above apply to these parties. a business group which uses a BVI/Cayman Islands company to hold an IP and where the majority of profits derived from such IP is booked in such BVI/Cayman Islands company - under BEPS Actions 8 to 10 on aligning transfer pricing outcomes with value creation, the return derived by a company from exploitation of an IP asset should be commensurate with the DEMPE (i.e. development, enhancement, maintenance, protection and exploitation) functions performed by it. Under the new economic substance requirements, it is expected that the BVI/Cayman Island IP holding company will be required to have adequate substance/dempe functions in BVI/Cayman Islands that are commensurate with the profits derived by it. Failure to do so may not only lead to a strike-off of the BVI/Cayman Islands company but also possible challenges raised by the relevant tax authorities on the group's transfer pricing arrangement in relation to the IP asset. a Hong Kong parent company with a BVI subsidiary, where the BVI subsidiary is managed and operated from Hong Kong - if the BVI subsidiary is subject to, but fails to meet, the new economic substance requirements, the information of non-compliance of the BVI entity may be exchanged with the Inland Revenue Department in Hong Kong. This may lead to current as well as past tax and non-tax (e.g. non-compliance with the business registration requirement in Hong Kong) exposure of the BVI company in Hong Kong. the fund industry - although investment funds and investment fund business are not required to comply with the economic substance requirements under the Cayman Islands substance legislation, fund management business is within the scope, and therefore a licensed Cayman Islands investment fund manager is required to comply with the economic substance requirements. Business groups and individuals should take immediate actions to review their existing holding or operating structures, assess if any BVI/Cayman Islands entities in the structures are subject to the economic substance requirements, consider whether it is commercially desirable or feasible for these BVI/Cayman Islands companies to meet the economic substance requirements and, if not, identify the potential options that can be explored (e.g. to discontinue the companies or consider using a Hong Kong company to hold the equity investment or IP asset instead). In case they are unable to meet the economic substance requirements, they should evaluate the impact if the information of non-compliance is shared with the tax authority of the jurisdiction where the parent company is located (e.g. possible actions taken by the tax authority of the parent company jurisdiction to review the tax and regulatory compliance of the BVI/Cayman Islands company concerned in the jurisdiction or to review the group's transfer pricing arrangement). They should also closely monitor any further developments in this area, including further guidance on how the economic substance requirements can be met and the meaning of the words adequate and appropriate used in the legislation. Endnotes 1. The OECD document entitled Resumption of Application of Substantial Activities Factor to No or only Nominal Tax Jurisdictions can be accessed via this link: 2. Such no or nominal tax jurisdictions include: Barbados, Bermuda, BVI, Cayman Islands, Guernsey and Isle of Man. 3. The substance legislation of BVI can be accessed via this link: %20Economic%20Substance%20%28Companies%20and%20Limited%20Partnerships%29%20Act% %20Revised%2017%2012%202018%20%28clean%29%20%281%29_0.pdf 4. The substance legislation of Cayman Islands can be accessed via this link: 5. For BVI, there is a requirement that the jurisdiction where the entity resides is not on the blacklist of non-cooperative jurisdictions of the European Union. 3 PwC

4 For a deeper discussion of how this issue might affect your business, please contact: PwC s Corporate Tax Leaders based in Hong Kong Charles Lee China South and Hong Kong Tax Leader charles.lee@cn.pwc.com Rex Ho Financial Services rex.ho@hk.pwc.com Kenneth Wong Tax Controversy kenneth.wong@hk.pwc.com Jeremy Ngai China South Tax Leader jeremy.cm.ngai@hk.pwc.com Cecilia Lee Transfer Pricing cecilia.sk.lee@hk.pwc.com Jeremy Choi Industrial Products jeremy.choi@hk.pwc.com Jenny Tsao Corporate Tax and Consumer Markets jenny.np.tsao@hk.pwc.com PwC s International Tax Advisory Team Jeremy Ngai China South Tax Leader jeremy.cm.ngai@hk.pwc.com David Smith Senior Advisor International Tax david.g.smith@hk.pwc.com 4 PwC

5 In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 28 Jan 2019 and were based on the law enforceable and information available at that time. This China Tax and Business News Flash is issued by the PwC s National Tax Policy Services in China and Hong Kong, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.