By Jo Huxtable, Deloitte LLP
New substance requirements will come into force in the Channel Islands (CI) and the Isle of Man from as early as 1 January 2019. The legislation has now been passed along with some high level guidance and so companies are now working through what these new rules may mean; firstly whether they are impacted at all and then, if so, what judgement may be needed to determine whether the level of substance in the company is adequate. The question of whether a company has adequate economic substance will be based on specific tests, largely borrowed from international tax principles, and consider what precise activities are carried on and by which people. Some companies will approach this work as part of a general review of the group’s transfer pricing policy where the focus is also on the location of key roles and functions. We are also supporting corporate service providers (“CSP”) to review their client portfolio to identify which structures may be impacted and what changes may be required by the CSP in delivering its services.
In response to concerns raised by the EU Code of Conduct (“the Code Group”) about profit shifting, Jersey, Guernsey and Isle of Man (the Crown Dependencies “CDs”), along with 10 other jurisdictions, committed to introduce new legislation by the end of 2018 requiring companies resident in their territory to demonstrate a link between the economic activity carried on there and the economic substance which supports that activity.
The CD governments have worked since then to develop their own new legislative framework to be in place by the end of 2018 and to take effect in respect of all companies resident in the CDs for accounting periods starting after 1 January 2019.
The Code Group published some guidance in a Scoping Paper dated 8 June 2018 which confirmed their focus is on so called geographically mobile businesses carrying on “relevant activities” which are perceived to be at risk of profit shifting: intellectual property, banking, insurance, headquartering, shipping, finance and leasing, distribution companies and service centres and fund management. In practice, holding companies should be subject to reduced substance requirements if they are passive and do not carry out any of the relevant activities. The timetable was tight but working closely together the governments of the three CDs have achieved their aim to each have their own legislation in place by the end of 2018. In addition to the three pieces of legislation, the three governments have published a joint document which provides additional explanation about the key aspects of the legislation and is to be followed by more comprehensive guidance notes on matters relevant to the individual industry sectors. This article considers what we know at this stage and the potential impact on the CI funds and investment management sector.
What will this mean for companies resident in the Channel Islands?
The rules have been introduced through new tax legislation requiring a company carrying on relevant activities to certify on its annual tax return that it is directed and managed in its place of tax residence (referred to below as territory), that it carries on its core income generating activity (CIGA) in that territory and that there is an “adequate” number of employees, expenditure and premises proportionate to the relevant activity carried on by that company in that territory. Companies which are not able to certify in this way will face sanctions in the form of financial penalties, potential exchange of information with relevant EU tax authorities and ultimately may be struck off.
Impact for fund managers
As regards the Channel Islands’ investment sector, there are a number of important points to note:
1. It appears that the Code Group do not expect “one size fits all” rules which should ensure that sensible judgements can be made about the required level of economic substance relative to the company in question.
2. The legislation applies to companies which are tax resident in Guernsey or Jersey but not to partnerships which are typically tax transparent.
3. In terms of the companies operating in this sector, there is a distinction between the (passive) collective investment vehicle (the CIV/fund) and the fund manager (covered as a relevant activity above). Based on comments made by the OECD on various occasions in relation to BEPS measures and also specific comments made by the Code Group in their June 2018 Scoping Paper, CIVs are not regarded as harmful and should not need to comply with these new substance requirements. After all, they are already subject to extensive corporate governance and other substance requirements set out within other company and regulatory laws.
4. Fund management is specifically listed as a “relevant activity” and hence companies with these activities, as defined in the legislation, will need to demonstrate substance. The definition does not cover investment advice.
5. The rules on adequate employees allow the company to outsource CIGA to a service provider based in the same territory which provides for the existing model of using a local outsourced service provider or administrator to continue.
6. It is not permissible to carry on CIGA outside the territory. Therefore where a fund manager (General Partner “GP”) appoints, say, a UK based manager who is authorised to buy and sell investments within parameters agreed by the Guernsey or Jersey based GP, this needs careful consideration. It may be possible for the GP to meet the substance requirements because it maintains supervision and oversight of the UK fund manager (i.e. it is making decisions on the holding and selling of investments which is one of the CIGA which much take place in the territory). However it will also be important to demonstrate that there are adequate employees and expenditure and this is where the services of specialist local service providers will be important to support this part of the analysis. This is a fundamental part of the CI’s investment management proposition and the expertise and governance available locally are arguably primary reasons why the industry has developed here.
7. As noted, the new requirements are based on existing international standards and so where fund managers have been part of a transfer pricing study, it may be able to meet the substance requirements. However it is worth noting that the rules and objectives of transfer pricing (profit attribution) are not aligned with those of the substance requirements (linking activity with substance) and so additional and specific work will be needed.