Economic Substance for Offshore Companies

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A number of offshore jurisdictions offer legal opportunities to save on taxes by registering business entities on their territories. The fact that the opportunities are legal upsets various international organizations such as the EU, OECD, G20, and others. Consequently, they declare the tax practices applied in offshore zones ‘unfair'. What is legal? Whatever you make legal. What is fair or unfair? This is a more complicated question but the concept of fairness is a human invention anyway: fairness does not exist in the physical world.

Humans have morals of course but what is fair or unfair is often a matter of opinion. In the case of the international organizations dubbing offshore tax practices ‘unfair', this seems more like a convenient word rather than an attempt to give these practices a balanced reasonable assessment. They have a mercantile interest, as a matter of fact, when offering such a description of offshore tax practices. They feel bad about some of the tax money escaping the national budgets of large and economically strong states and ending up in the budgets of small insular jurisdictions instead. If the big and powerful could redirect the money flows from offshore zones to onshore countries, they could collect a few billion dollars more in fiscal revenues every year. Isn't the game worth the candle then? Obviously, it is.

One of the goals that the aggressive global de-offshorization campaign pursues is benign and praiseworthy indeed. Combating terrorism is an issue of utmost importance and one has to admit that offshore companies and offshore bank accounts have sometimes been used for illegal purposes including financing terrorists. These practices have to be stopped and there is no arguing about that. The other of the two central goals of the de-offshorization efforts is much less benign though. When large countries want to deprive small countries of the opportunities to earn some money from foreign entrepreneurs, they don't look very well in the eyes of an honest person, do they? Thus, the de-offshorization efforts may well look unfair from this perspective.

However, with their economic, military, and administrative power, the stronger countries do not really care what the governments of tiny island states might wish. And the former impose sanctions on the latter. They compile black and grey lists of ‘uncooperative' countries. The black list contains the names of the countries that refuse to submit to the international pressure and adapt their legislations to the global requirements. The grey list contains the names of the countries that have promised to bring their legislations in conformity with the international standards but they have not done so yet. Both lists are revised twice a year. Some countries may leave the black list while entering the grey one and some other countries may be scratched off both lists. Panama in Central America can serve as a bright example: the country has found itself on the black list, on the grey list, on none of the lists, then on the grey list again, and so on. (At the same time, many experts believe that Panama remains among the best countries where you can register an offshore company.) This means that if you are considering the opportunity to start an offshore company, you have to consult a professional to obtain the most up-to-date information concerning the sanctions currently applied to the particular jurisdiction that you are looking at.

What consequences does the country face if it finds itself on the black or the grey list? Its ability to offer lucrative conditions to foreign business people becomes limited. Companies registered in ‘white' jurisdictions may not desire (or may be disallowed) to enter business agreements with a company registered in a blacklisted country. International banks may refuse to take such a company onboard. This is probably the most important obstacle that you may face if you choose to set up a company in a blacklisted jurisdiction: opening a corporate bank account in another jurisdiction may prove a highly challenging task. It's not going to be impossible but it is going to be difficult.

What changes do the large countries want the small countries to introduce to their legislations? First and foremost, the former want the latter to stop their ‘unfair' tax practices. They want offshore jurisdictions to bring their tax rates to the international standards. The logic behind their thinking is quite clear: if you find the same tax rates no matter where you register your business company, at home or abroad, why should you bother traveling to a foreign country? Stay home and pay taxes to your own country!

The infamous BEPS initiative has been launched for this purpose. BEPS stands for ‘Base Erosion and Profit Shifting'. Thus, the global fiscal authorities want international business companies to do two things: a) to stop eroding their taxable bases and b) to stop shifting their profits from their home countries to some other countries. The first intention looks fair if you believe that taxing people and companies is fair. The second intention, on the other hand, may look a bit more questionable: why should you not shift your profit from one country to another, after all?

Raising their tax rates is the key obligation that offshore zones face if they want to leave the black and grey lists. There is an additional obligation that they have to meet, however. Namely, they have to introduce economic substance requirements for the companies registered in their territories. Previously, the offshore company owner had to have only the Incorporation Certificate and the company seal to enter business deals using his/ her offshore-registered company. These times are gone now: companies registered in a vast majority of offshore jurisdictions have to have some tangible assets in the country of the company incorporation.

What does the notion of economic substance refer to?

Today, you have to ascertain that your offshore-registered company has physical and economic presence in the country of its incorporation. This is referred to as ‘economic substance' or simply ‘substance'. Each jurisdiction will have its own list of items that count as economic substance. Normally, your offshore company has to have an office in the country where it is registered (in some places, having a virtual office is allowed). In addition to a brick-and-mortar office, the company may be obliged to have a telephone number, a website, corporate email, etc. Clearly, this means greater offshore company maintenance costs in comparison to the times gone by.

Moreover, many offshore jurisdictions now require that companies registered there by foreigners have some local personnel. Most often, you will have to hire a company secretary. Depending on the particular jurisdiction, you may also have to sign a job agreement with a local accountant or an accounting firm. In some places, you may have to have a registered agent to communicate with the local corporate and fiscal authorities on behalf of your company.

Hiring company personnel does not have to be a considerable item of expenditure, however. If you have to have a Company Secretary, it is going to be a ‘professional company secretary'. What does this mean? This means that the person acts as the secretary of multiple companies registered in his/ her country by foreign nationals. Consequently, the salary that each company owner has to pay to the secretary is going to be only a few hundred dollars per month. The same holds for the local accountant or the local registered agent.

As a rule, the scope of economic substance requirements will depend on the type of business activities that the offshore company is engaged in. Companies working in such industries as insurance, banking, financial services, shipping, distribution, and some others normally have to have economic substance in the country of their incorporation today. On the other hand, companies working in some other industries may be exempted from the economic substance requirements. For instance, if a company registered in the Cayman Islands is engaged in investment fund business, it does not have to comply with the economic substance rules. We must note, however, that the requirements can be different in different offshore jurisdictions. Besides, the requirements may change over time. Thus, you'd better consult an expert on the issue if you are planning to set up an offshore company.

The company ownership type is another factor that determines what economic substance requirements are applicable to the particular company. In most offshore jurisdictions, if the company is a separate legal entity, it is covered by the economic substance laws. In some cases, these laws are not applicable to companies of certain forms of ownership. A limited partnership in the Caymans, for example, is not considered to have a separate legal personality, and thus the substance requirements do not apply to such a company in that jurisdiction. Please note that there are other reasons to register an offshore company in the Cayman Islands too.

The company has to comply with the economic substance requirements in the jurisdiction where it is resident for tax purposes. In the normal case, the company is a tax resident in the jurisdiction where it is registered. If the company is registered in one offshore jurisdiction and it is tax resident in another jurisdiction, it does not have to have economic substance in the country of its incorporation, in most cases. There are exceptions from the general rule, however.

As you can see, setting up an offshore company has become a more intricate task these days and you certainly need professional guidance in the process.

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