Economic substance: what regulators now expect

For a long time, where a company was registered largely determined how it was taxed. That is no longer a safe assumption. The question regulators and tax authorities now ask is not where the entity sits, but where the work is actually done.

The shift did not happen suddenly. It came out of the OECD's base erosion and profit shifting programme, the European Union's screening of non-cooperative jurisdictions, and a series of substance regimes introduced across traditional offshore centres from 2019 onwards. The common thread is a single principle: profit should be recognised where the activity generating it takes place, and an entity claiming the benefits of a jurisdiction should have a real connection to it.

What "substance" is being measured against

Substance is not a single global standard. Each regime defines it differently, and the detail matters. But most share a similar architecture. They identify categories of relevant activity — typically including holding companies, financing and leasing, headquarters functions, shipping, insurance, fund management, distribution and service centres, and intellectual property. Entities carrying on those activities are then expected to demonstrate that the core income-generating activities occur in the jurisdiction.

In practice, assessment tends to turn on a recognisable set of factors:

• Direction and management. Are board meetings genuinely held in the jurisdiction, with directors who have the competence to make the decisions and a quorum physically present? Are minutes contemporaneous and substantive, or drafted afterwards to fit?
• People. Are there employees, of appropriate number and qualification, doing the work? Outsourcing is often permitted, but usually only to a provider in the same jurisdiction, and with the entity retaining genuine oversight.
• Premises. Is there physical presence proportionate to the activity, rather than a registered address shared with several thousand other entities?
• Expenditure. Is an adequate amount actually spent in the jurisdiction, in proportion to the income being booked there?

Intellectual property holding structures generally attract the strictest treatment, and in several regimes carry a presumption against adequate substance which the entity must rebut with evidence.

The useful test is not whether a structure satisfies a checklist, but whether the story it tells about where value is created would survive being read aloud to a tax authority.

Why it now bites harder

Two things changed the practical risk. The first is information exchange. Common Reporting Standard reporting and country-by-country reporting mean tax authorities increasingly receive, automatically, the information they once had to request. Structures that relied on opacity no longer have it.

The second is that substance failures are frequently reported onward. Several regimes require the local authority to notify the tax authority of the parent or ultimate owner's jurisdiction where an entity fails its substance test. The consequence is not confined to a local penalty; it can be an enquiry somewhere far more expensive.

Banks have absorbed the same logic. An account application from an entity with no demonstrable operations in its jurisdiction of registration now raises a question the relationship manager is obliged to resolve before proceeding.

Where territorial systems fit

Jurisdictions that tax on a territorial basis, Hong Kong among them, are sometimes treated as a way around all of this. They are not. A territorial system asks where profits arose, which is a substance question in a different vocabulary. Claiming that income was sourced outside the jurisdiction requires evidence about where the operations, contracts, decisions and personnel actually were.

Several territorial regimes have also been amended in recent years to add substance conditions to the exemption of particular categories of foreign-sourced income — typically dividends, interest, disposal gains and IP income — following engagement with the EU's review process. The direction of travel is consistent: exemptions increasingly come with conditions attached.

A practical way to assess a structure

Before assuming an existing arrangement is sound, work through the following:

1. Identify the relevant activity. Establish which category each entity falls into under the regime that applies to it. Requirements differ substantially between categories.
2. Locate the decisions. Document who actually decides what, where they are when they decide it, and what evidence exists. This is the most common point of failure.
3. Test proportionality. Compare income booked in the jurisdiction against people, premises and spending there. A large disparity is the pattern that draws attention.
4. Check the reporting obligations. Most regimes require an annual notification or return, with penalties for non-filing that apply irrespective of whether substance was met.
5. Ask whether the structure still serves its purpose. Arrangements designed under a previous set of rules are often maintained out of inertia, at a cost that now exceeds the benefit.

The last point is the one most often skipped. A structure that made sense a decade ago may now cost more in compliance than it saves in tax, while carrying risk it did not originally have. Winding down or simplifying is a legitimate answer, and sometimes the correct one.