What is substance and why do foreign companies need it?

In today’s world, where business structures are becoming increasingly complex and global, the issue of tax fairness is of key importance. To prevent abuse and tax evasion, countries and international organizations regularly implement various standards, such as “substance” rules. These rules are designed to ensure fair taxation and encourage companies to engage in real business activities in the countries where they are registered.

In this article, we will look at what the concept of “substance” is, what criteria companies need to meet to comply with these rules, and what trends can be identified in the application of these rules in different jurisdictions.

What is “substance”?

“Substance” is a concept that describes the extent of a company’s activity and presence in a particular country. It includes elements such as having a physical office, hiring employees, conducting business transactions and performing other activities that indicate that the company actually operates in a given jurisdiction and is not just a “paper” enterprise created for tax and legal benefits.

Substance criteria

The “substance” (or actual presence) criteria may vary depending on the specific jurisdiction and its legislation. However, there are general criteria that are often used to determine the presence of “substance” of a company. These criteria usually include the following aspects:

• Physical presence – the presence of a physical office, warehouse or other commercial premises in the country where the company is registered.
• Employer function – the company must have permanent employees (some countries require resident workers).
• Active business activity, which consists of performing actual commercial operations related to the company’s core activities.
• Local financial management – the company must conduct its financial transactions and records locally and maintain bank accounts in the country.
• If a company provides services or products to customers, it should have local customer-centric service (website, delivery, local phone, local partners and agents).

In addition to these general criteria, each country can establish its own special rules of substance and their minimum level, so that it is considered that the company actually operates in the country of registration and can claim appropriate benefits.

What foreign companies need substance for?

One of the main reasons for creating “substance” is to comply with the tax laws of the country in which the company operates. Many countries have complex tax systems and require companies to pay income taxes, VAT and other taxes. It is through the creation of real activities in the country that companies can justify their presence and pay reduced taxes in accordance with the law, since they bear certain costs for maintaining the company and provide jobs. This is especially true among offshore jurisdictions, which one by one are introducing substance requirements for those who previously used tax-free jurisdictions as a tax haven and did not conduct any real activities.

In addition, having a real presence in the country, a company can gain access to local resources, subsidies and other benefits, which can significantly improve its competitiveness in the local market and have a higher and more reliable reputation among partners and contractors, as well as attract investment from outside. So in fact, with the help of the substance, a state brings business out of the shadows and forces it to either work at the local level or pay taxes in full.

Where is substance used?

Today, substance rules are no longer something new and unusual. Over the course of 5 years, these rules have spread to almost all popular offshore countries and those where taxation has raised questions in the context of combating tax evasion and ensuring fair taxation. Below we consider examples of countries and regions where the “substance” rules have been implemented or are in the process of being implemented:

• Tax-free jurisdictions: Some offshore territories such as Bermuda, the BVI, Seychelles, Panama, Bahamas, Nevis, Barbados, the UAE are implementing or even strengthening presence rules to prevent tax evasion and strengthen their tax base (for example, financial reporting requirements, keeping accounting records, having a real office and at least outsourced employees).
• British offshores: British offshore territories such as the Cayman Islands, Isle of Man and Jersey have announced and committed to implementing substance rules in accordance with international standards and requirements.
• Asian financial centers: Singapore and Hong Kong are also closely monitoring substance requirements and amending their legislation to ensure greater compliance with international standards.
• European Union: As part of its anti-tax avoidance initiative, the EU is also beginning to implement “substance” rules through various directives. In particular, ATAD 3 (Anti-Tax Avoidance Directive 3) has already been developed, which stipulates that companies must have a real physical presence and activity in the countries where they are registered at least according to the minimum criteria.

Europe substance standards

Let’s talk in more detail about substance in Europe. Thus, the above mentioned ATAD 3 is a European Union directive aimed at preventing the abuse of holding companies with limited or no economic presence.The directive was proposed by the European Parliament back in December 2021 and was planned to be applied by EU member states from December 31, 2023.

The main provisions and standards of the ATAD 3 Directive include the following:

• Minimum economic substance test – includes a number of indicators that must be met by a company to be considered to have sufficient economic substance. If a company fails the test, it may be denied certain tax benefits, such as tax deductions or income tax exemptions.
• Reporting obligations – oblige companies to submit reports on their economic presence to the tax authorities of the EU member states. The reports must include information about the company’s structure, operations and management.
• Fines – for failure to comply with the minimum economic substance test or reporting obligations, a company can be fined up to 5% of its annual turnover.

The scope of application of ATAD-3 includes all companies that can be considered tax residents of an EU member state and are entitled to receive a tax residence certificate (exceptions include subsidiaries, financial institutions, and listed companies).

The minimum level of substance (the so-called test) on which the company’s right to tax benefits will depend includes the presence of:

1) premises (office, warehouse) in an EU member state;

2) an active bank operating account of the company within the EU;

3) resident director or resident employees of the company with appropriate qualifications.

These rules are not yet in effect, because to begin with, the ATAD 3 Directive must be implemented by all EU member states. It is expected that it will be begun to apply in 2024, but this date may well be delayed or postponed, as countries may not have time to implement these standards so quickly.

But companies that fall within the scope of the Directive must take measures in advance to comply with its provisions and not fall under the concept of “shell entities” with the ensuing consequences of full taxation or even penalties.

Thus, “substance” is an important aspect for foreign companies that seek to further successful and transparent developing their business abroad. Establishing a real presence in a country helps companies comply with tax and legal requirements, strengthen business relationships and improve their reputation. At the same time, today it is important to follow the changing trends in substance rules in offshore and the EU in order not to fall into a disadvantageous tax position or restrictions.

Therefore, if you need advice on these issues or assistance with compliance with substance criteria in various jurisdictions, including offshores, please contact our specialists.