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Economic Presence in the Country of Incorporation, or What is Substance?

The concept of “economic presence”, or “substance” has been familiar to every businessman for the last 2-3 years – ever since the OECD and other international regulatory bodies came to a consensus on the need to increase tax and corporate transparency. The economic presence, which in some countries today is associated with the term “significant”, confirms the actual activity of the incorporated company in the state of incorporation. 

How important is economic substance to your business today? What are the advantages and disadvantages of substance for a non-resident company abroad? How important is it to organize the economic presence of your business in a timely manner? We will try to answer all these questions as completely as possible.

Economic presence (substance)

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Do you need to establish your company’s economic presence abroad? We are ready to take care of all the issues related to the economic substance of your business in a particular jurisdiction.  

What is Economic Substance and How Did this Definition Come About? 

The developments of the international community aimed at improving the fairness of international taxation and corporate cooperation have raised the issue of the corporate nature of business entities. The need for a modification of the international tax system has been formulated as part of the global struggle against tax evasion and money laundering. 

The first progressive step in this direction was the establishment of the automatic financial information exchange system, which was joined by a huge number of countries. Then, in 2013, the OECD created the BEPS plan, which involved a serious fight against shell companies and front businesses that had been illegally used for years to obtain tax benefits without doing real business. It was at the stage of implementation of the BEPS plan that the OECD, FATF and other international organizations for financial supervision and international taxation faced the need to introduce the concept of substance. 

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Economic substance is connected with the opportunities for the business to use the various state benefits and preferences provided to corporate tax residents.   

According to the OECD definition, there can be two types of substance:

  • physical; and
  • economic. 

The former means actual presence of the company in the country of incorporation (working in trade, production, etc.). The latter is about the actual activities within a certain jurisdiction, for example, generating income, having expenses in the country of incorporation of the company, mutual settlements with contractors, etc.

Economic presence for non-resident companies offers the following benefits:

  • exemption from local taxes (if provided by state laws);
  • reducing the risks of additional taxation for previous periods;
  • additional banking services (in many countries without an economic presence, companies cannot open an account);
  • improving the general reputation of a business (today, shell companies only raise suspicions);
  • serious opportunities to help your business grow and increase profitability. 

For example, in the EU, the economic presence of a non-resident company provides for conditions under which your business becomes resident. But in the world there are no uniform standards and rules regarding substance – the implementation of the BEPS and substance plan varies in each country and jurisdiction.

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Please note! Residency in more than one jurisdiction may result in unexpected tax liabilities and additional compliance costs. 

If you would like to register a company abroad and establish its economic substance, we recommend you to contact our experts. They have extensive experience in this area of business, and will be ready to deal with your specific situation and make individually-tailored suggestions just for you. Get in touch with us today!

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Why Does Your Company Need Economic Presence Abroad? 

Before the tax authorities of a state approve tax breaks for a foreign business, they must make sure that it is real, that it actually performs activities and does not make the impression of a shell company. The first thing that is looked at is the owner’s reason for setting up a business in another jurisdiction. Please note that tax officials are interested in the reality, not the products of active imagination of international tax planners.

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The company must demonstrate that it has economic presence in the tax jurisdiction where it plans to receive the requested tax regime. 

Economic substance is a general concept used in the field of business and taxation. Each country has its own legislation: one jurisdiction may require only an office with employees, another may request proof of a whole range of aspects, including regular filing of financial statements and declarations to prove tax residency. 

In general, economic substance requirements in many countries involve:

  • existence of office premises in the jurisdiction where the business is registered;
  • an active board of directors;
  • a certain number of employees required to perform the corresponding activity;
  • appropriate financing of the company. 

More and more often, some countries would refuse to consider a virtual office (a fairly popular service today) when determining the company’s substance. The same rules are being established in most states regarding hired personnel and general offices.

In any case, there is a need for a thorough analysis of the by-laws of the particular country in which you plan to create a business and establish its substance. Moreover, today the list of states that have implemented such requirements is very long, including regions and territories previously known as classic offshores with high level of privacy. You should be ready to face the requirements for corporate and tax transparency almost everywhere – from the EU and the BVI to the Isle of Man, Belize, and other attractive jurisdictions. These are the new realities of our time, to which we need to adapt as soon as possible. 

How Can You Demonstrate the Company’s Economic Substance? 

The required level of substance and overall content for a particular business can vary greatly from country to country, the peculiarities of the company itself, and the tax rules that may be applied in the implementation of the substance. The difficulty of establishing substance is made more difficult by the lack of its single definition around the world.

Since the rules of substance are extremely varied, any attempt to generalize can be not only risky, but also dangerous. However, we have put together a small list of the aspects that a business owner must consider when creating a company in a foreign jurisdiction.

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Please note! The list below indicates points that are important to consider, but it is not a dogma or a guide to action. We cannot take responsibility for the additional pitfalls an actual business may encounter in a particular country. 

Whatever your exact situation may be, it would not hurt to take care of the following in order to demonstrate the substance of the company abroad:

  • obtaining and collecting expert opinions of taxation specialists before organizing a major transaction or creating a new business structure;
  • appointing well-qualified directors who would understand the nature of your business (in many countries they have to be local residents) and would be capable of making decisions;
  • establishing office presence (real office premises designated specifically for your company);
  • maintaining business documentation, which is stored at the registered office;
  • signing direct contracts and agreements that do not require the use of powers of attorney for their execution;
  • demonstrating economic viability of your business throughout its life cycle.  

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Please note! If you are concerned about establishing substance, it is better to avoid creating a business, in which the directors of the foreign company are the same as the directors of the parent company.

How to Establish Economic Substance in the EU and Worldwide

We have already said that the requirements to substance differ greatly from jurisdiction to jurisdiction. In addition, the corresponding laws are being amended from time to time. In this connection, there is no single right answer to the question “What is a company’s substance?”. For example, apart from the aspects listed above, a British business must demonstrate the following:

  • minutes of the board meetings issued at an adequate frequency;
  • a sufficient number of qualified personnel in the enterprise;
  • a sufficient level of annual expenses (proportional to the amount that would cover the basic needs of a business conduct the full range of its activities);
  • adequate physical offices and/or premises located in the jurisdiction. 

If we talk about other countries, tax authorities may also take into account the location at which the meetings of the Board of Directors are held, the frequency such meetings, and the attendance of the directors in person. The authorities may go as far as requesting proof that the Board meeting was not a mere formality to approve decisions that had previously been made in other jurisdictions.

For example, the minutes of the Board of Directors of a company with an economic presence abroad should at the very least demonstrate that some key strategic decisions were made at the meeting held at the appropriate location. If in reality the Board does not make key decisions, the tax authorities will try their best to figure out, who does that and where. 

Establishing the Company’s Substance Abroad: Important First Steps 

Unlike physical presence, economic substance involves a thorough analysis of the economic essence of your business operations. And here it all comes down to two main indicators – people and assets. Both of those may be scattered across completely different companies in various jurisdictions. We understand that it is difficult to get a hang of all the details of business processes right away, even if one has vast experience in outsourcing. Especially nowadays, considering the ongoing digitalization of many business operations. But the OECD and the European Commission are more bureaucratic, so there is practically no way for you to avoid the need to plunge into this field and form a certain understanding.

Before ordering a service that would assist in establishing your company’s substance abroad, we recommend you to perform the following research of your business:

  • make a list of all non-resident companies in your business group;
  • make a detailed analysis of the involvement of personnel in particular operations;
  • study the requirements for economic presence of foreign companies in a particular country (almost all jurisdictions today have them, including classic offshore ones);
  • analyze which bilateral agreements are involved in your company making profit, and whether they are covered by the Multilateral Convention;
  • calculate the costs of servicing non-resident companies for 1 calendar year and compare the sum total with the benefits from applying the DTT. 

Our international tax planning experts are ready to help you go through all these steps and create the best-suited company structure for your business group.

Also, please keep in mind that as global corporate tax rates generally keep dropping, jurisdictions are likely to increase the pressure connected with business substance in order to prevent the loss of tax revenue. Therefore, the issue of corporate residency may become even more relevant, as countries seek to protect their tax base.

Another obviously significant aspect is the reputational risks of a business that does not have an economic presence abroad. Just imagine that you need to strike a big deal, say for EUR 20 million, with a company that has no employees, no office, does not file reports to the authorities, and generally exists only on paper. If we also throw in the thought that we are talking about an independent non-resident company with no substance, the conclusion suggests itself – a serious businessman would be unlikely to conclude such a contract. We know how to make sure that your potential partners and counterparties do not think the same way about your business. We know that protecting reputation is as important as the tax issues. Our practice and knowledge of international legislation allows our experts to create effective business structures with proper economic content in specific jurisdictions. To order a consultation and the comprehensive services of our experts, contact us today at [email protected]

Read more on a company’s economic substance in a foreign jurisdiction in the following articles: 

We are always ready to discuss any issues related to business, investment programs, bank accounts, asset protection and diversification, and so on. We offer you help and support in ensuring the most valuable thing – the safety of your family and assets. Contact us for more details at [email protected].

Why does my company need economic substance?

First of all, due to the availability or unavailability of tax benefits. The tax authorities of the jurisdiction, in which you organize your company, will thoroughly check the real existence and operations of your business before approving or denying the benefits you are requesting. Economic substance also means increased trust and a high reputation for a business.

How difficult is it to follow the substance rules and requirements in different countries?

There is no single unified definition of a foreign company’s economic substance in the world, since the BEPS plan is implemented individually according to the laws of different countries. However, in almost all jurisdictions with substance requirements, your company must become a tax resident and, consequently, pay taxes according to the laws of the country, taking into consideration the use of the DTT.

How can my business pass the EU economic substance test?

Depending on the region where the business is located, economic substance is confirmed by the presence of a real office, resident directors, relevant expenses for the company, and financial documentation. The full list of substance requirements depends on the national legislation of the countries where you plan to register a company.

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