Isle of Man Economic Substance Requirements
With effect from 1 January 2019 the Isle of Man (IOM) introduced its Economic Substance rules. These are now embodied in Part 6A Income Tax Act 1970.
This legislation was introduced in response to a comprehensive review that was carried out by the EU Code of Conduct Group on Business Taxation (COCG) in order to assess over 90 jurisdictions, including the IOM against standards of:
Compliance with anti-BEPS (base-erosion profit shifting) measures
The review process took place in 2017 and although the COCG were satisfied that the IOM met the standards for tax transparency and compliance with anti-BEPS measures, the COGC raised concerns that the IOM did not have:
“A legal substance requirement for entities doing business in or through the jurisdiction”
And as a result, this “increases the risk that profits registered in a jurisdiction are not commensurate with economic activities and substantial economic presence”.
High level principles
The purpose of the legislation is to address these concerns that companies in the IOM could be used to attract profits that are not commensurate with economic activities and substantial economic presence in the IOM. As such, the legislation requires relevant sector companies to demonstrate they have substance in the Island by:
Being directed and managed in the Island;
Conducting Core Income Generating Activities (CIGA) in the Island; and
Having adequate people, premises, and expenditure in the Island.
We will discuss each of these requirements in further detail below.
Part 6A The Income Tax ACT 1970
This new legislation sets out to address EU Commission and COCG’s concerns by way of a three-stage process.
To identify companies in relevant sectors;
To impose substance requirements on those companies; and
To enforce the substance requirements
We will discuss each of these stages and their ramifications below.
Stage 1: To identify relevant sector companies
The legislation will apply to IOM tax resident companies engaged in relevant sectors. The relevant sectors are as follows:
fund management (this does not include companies that are Collective Investment Vehicles)
financing and leasing
operation of a holding company
holding intellectual property (IP)
distribution and service centres
These are the sectors identified by the Organization for Economic Cooperation and Development’s (OECD) Forum on Harmful Tax Practices (FHTP) work on preferential regimes as the categories of geographically mobile income i.e. these are the sectors which are at risk of operating and deriving their income from jurisdictions other than those in which they are registered.
There is no de minimus in terms of income, the legislation will apply to all companies carrying on relevant activities where any level of income is received. However, if no income arises in any accounting period these rules do not apply.
A key determinant here is tax residence and the Assessor has indicated that existing practice will prevail, i.e. the rules relating to residence set out in PN 208/20. Therefore, where non-IOM incorporated companies are engaged in relevant sectors they will only be brought within the scope of the legislation if they are IOM tax resident. This is clearly an important consideration: if tax resident elsewhere the rules relevant for the country of residence are likely to be relevant (note: companies could be dual resident, e.g. incorporated in the IOM but resident in Gibraltar or vice versa).
Stage 2: To impose substance requirements on relevant sector companies
The specific substance requirements (Substance Criteria) vary by relevant sector. Broadly speaking, for a relevant sector company (other than a pure equity holding company) to have adequate substance it must ensure that:
It is directed and managed in the Island
The legislation specifies that the company is directed and managed* in the Island if the Island is the place where regular board meetings take place, there must be a quorum of directors physically present at the meeting, strategic decisions must be made at those meetings, the minutes of these board meetings must be kept on Island and that the directors present at these meetings have the necessary knowledge and expertise to discharge its’ duties as a board. In the case of an IP company, the legislation specifies that periodic decisions of non-resident board members are not to be taken into account.
* Note that the test for “directed and managed” is a separate test to the “management and control” test which is used to determine the tax residence of a company. The aim of the directed and managed test is to ensure that there are an adequate number of Board meetings held and attended in the Island.
There is an adequate number of qualified employees in the Island
This stipulation appears to be rather woolly as the legislation specifically states that the employees do not need to be employed by the company itself, this condition focuses on there being an adequate number of skilled workers present on Island, whether or not they are employed elsewhere does not appear to matter.
In addition, what is meant by ‘adequate’ in terms of numbers is very subjective and for the purpose of this proposed legislation, ‘adequate’ will take its ordinary meaning, as discussed below.
This raises a number of questions (see Verification of Substance Criteria below). Note: one would expect costs of employment to find their way into a company’s accounting records.
It has adequate expenditure proportionate to the level of activity carried on in the Island
Again, another subjective measure. Although it must be noted that it would be unrealistic to apply a specific formula across all businesses, as each business is unique in its own right and it is the responsibility of the board of directors to ensure that such conditions are met. This expenditure would be expected to cover employees and premises and other costs.
It has adequate physical presence in the Island
Although not defined, we understand that this would include owning or leasing an office, having ‘adequate’ number of staff, both administrative and specialist or qualified staff working in the office, computers, telephone, and internet connection etc. The presence of a registered office or registered agent and any associated costs may in certain circumstances be enough to satisfy the requirement (depending on the activity).
It conducts core income-generating activity in the Island
The legislation and guidance attempts to specify what is meant by CIGA for each of the relevant sectors, the list of activities in each relevant sector is intended as a guide: not all companies will carry out all the activities specified, but they must carry out some in order to comply.
If an activity is not part of the CIGA, for example, back office IT functions, the company may outsource all or part of this activity (on or off island) without there being an effect upon the company’s ability to comply with the Substance Criteria. Likewise, the company may seek expert professional advice or engage specialists in other jurisdictions without effecting its compliance with the substance requirements.
In essence, CIGA ensures that the main operations of the business, i.e. the operations which produce the bulk of the income are carried out in the Island.
Further to that mentioned above, a company may outsource, i.e. contract, or delegate to a third party or group company some or all of its activities. Outsourcing is only a potential issue if it is of its CIGA. If some or all of the CIGA are outsourced, the company must be able to demonstrate that there is adequate supervision of the outsourced activity and that the outsourcing is to an IOM business (which themselves have adequate resources to perform such duties). Precise details of the outsourced activity, including’ for example, timesheets must be kept by the contracting company.
The key here to whether this is an issue comes down to the value that the activities outsourced, if CIGA, generate when compared to the expenditure incurred. In some instances, one might say outsourcing of say coding activities generates very little in terms of value, but it could be design, marketing and other activities carried out locally that are integral to the value creation. Companies will need to look closely at where the value comes from, i.e. who and what activities generate it, to assess whether outsourced activities are an issue.
The term ‘adequate’ is intended to take its dictionary definition:
“Enough or satisfactory for a particular purpose”
The Assessor has advised that:
“What is adequate for each company will be dependent upon the particular facts of the company and its business activity.”
This will vary for each relevant sector entity and the onus is on the relevant company to ensure that it maintains and retains sufficient records which demonstrate that it has adequate resources in the Island.
Stage 3: To enforce the Substance Criteria
The legislation provides the Assessor with the power to request any information required to satisfy her that a relevant sector company meets the Substance Criteria. Where the Assessor is not satisfied that the Substance Criteria have been met for a particular period, sanctions will apply.
Verification of Substance Criteria
The legislation provides the Assessor the power to request further information from a relevant sector company in order to satisfy herself that the substance requirements have been met.
Failure to comply with the request can result in fines and where the Assessor is not satisfied that the Substance Criteria have been met, sanctions will apply.
Retaining and compiling evidence that a company has met the Substance Criteria is essential and there are as yet some unanswered questions in my mind surrounding the meaning of premises/employees. For example, OECD guidance refers to ‘full-time employees’ yet it is understood that part time employees are also relevant, i.e. full-time equivalents. Some companies of course will not need to have employees working 5 days a week for them to operate effectively to satisfy their CIGA or the need for people in the context of a pure equity holding company. There must therefore be some proportionality. The same is true of adequate premises.
The OECD guidance is very limited and it worries me (perhaps unnecessarily) that reference to ‘full time employees’ in OECD guidance means just that with all the associated trappings one would expect to see, e.g. registration as employer and employee, contracts, CVs and similar.
Note: the EU cannot barge in and demand information from companies. They must follow proper procedures as set out in relevant tax information exchange agreements. However, statistical information may be passed to the EU by the Government, i.e. number of companies per relevant sector and number of companies sanctioned etc.
High-risk IP companies
Generally speaking, the designation ‘high-risk IP companies’ refers to companies holding IP where the IP has been transferred into the Island post-development from a related party or obtained through funding of overseas research and development activities and it is licenced to related parties or monetised through activities performed by foreign related parties.
As the risks of profit shifting are considered to be greater in this relevant sector, the legislation has taken a rather hard approach to high risk IP companies, it takes the position of ‘guilty unless proven otherwise’.
High-risk IP companies will have to prove for each accounting period that the adequate Substance Criteria in respect of conducting CIGA have been met in the Island. For each high risk IP company, the tax authorities of the IOM will exchange all of the information provided by the company with the relevant EU Member State authority where the immediate and/or ultimate parent and beneficial owner is/are resident. This will be in accordance with the existing international tax exchange agreements.
“To rebut the presumption and not incur further sanctions, the high risk IP company will have to provide evidence explaining how the DEMPE (development, enhancement, maintenance, protection and exploitation) functions have been under its control and this had involved people who are highly skilled and perform their core activities in the Island”.
The high evidential threshold includes detailed business plans, concrete evidence that decision making occurs in the Island and detailed information regarding their IOM employees.
In line with the tougher approach to IP companies detailed above, the sanctions are somewhat harsher for such companies. Whether or not the substance requirements have been met, in accordance with international arrangement, the Assessor will disclose to a relevant EU tax official or a jurisdiction where there is an international agreement in place any relevant information concerning a high-risk IP company. This applies if the parent company or beneficial owner is resident in those jurisdictions.
If a high-risk IP company is unable to rebut the presumption that it has failed to meet the substance requirements, the sanctions are as follows, (stated by the number of consecutive years of non-compliance):
1st year, a civil penalty of 50,000
2nd year, a civil penalty of £100,000 and may be struck off the company register
3rd year, strike the company off the company register
If the high-risk IP company is unable to provide to the Assessor any additional information requested, the company will be convicted with a fine applied not exceeding £10,000.
For all other companies engaged in relevant sectors (other than high risk IP), the sanctions are as follows, (stated by the number of consecutive years of non-compliance):
1st year, a civil penalty of £10,000
2nd year, a civil penalty of £50,000
3rd year, a civil penalty of £100,000 and may be struck off the company register
4th year, strike the company off the company register
If the Assessor finds that in any accounting period a company has avoided or attempted to avoid the application of this Order, the Assessor may:
Disclose information to a foreign tax official
Issue to the company a civil penalty of £10,000
If a person (note that “a person” is not defined within this legislation) who has fraudulently avoided or seeks to avoid the application is liable to:
On conviction: custody for a maximum of 7 years, a fine or both
On summary conviction: custody for a maximum of 6 months, a fine not exceeding £10,000, or both
Disclosure of information to a foreign tax official
Any appeals will lie with the Commissioners who may confirm, vary, or reverse the Assessor’s decision.
Where does this leave us?
All companies must consider whether they fall within one or more of the relevant sectors, if not then there are no obligations falling upon them by this legislation. However, if they are in a relevant sector then they will need to assess their position. It is possible to fall into several relevant sectors and if so, the requirements that must be met will be the highest level depending on which sectors are relevant.
Many companies will easily be able to identify whether or not they fall within a relevant sector and companies managed by CSPs may need to assess whether they do indeed have the necessary substance.
Earliest reporting period was for accounting periods starting one or after 1 January 2019. Therefore, for an accounting period commencing on 1 January 2019 and ending on 31 December 2019, t the first reporting must have been done on or before 1 January 2021 (i.e.one year and a day after the accounting periods ends).
Article courtesy of Paul Hotchkiss of Paul Hotckiss Associates Ltd