British Virgin Islands: economic substance requirements
Economic substance (ES) is a perennially hot topic, and the concept arises in numerous contexts in the tax and accounting world. This article considers the ES regime introduced in the British Virgin Islands (BVI) in 2019 following the requirements of the Organisation for Economic Co-operation and Development's (OECD's) Forum on Harmful Tax Practices (FHTP) and the European Union's Code of Conduct Group for business taxation (COCG).
The BVI was not alone in adopting ES requirements – similar requirements are now applied across the world's other major zero and low-tax international financial centres.
The focus of the FHTP and COCG was on nine geographically mobile, income-generating "relevant activities". Each relevant jurisdiction would have to ensure that any entity carrying on any relevant activity and benefiting from the tax advantages offered by its regime would demonstrate ES (or be subject to enforcement action in the case of non-compliance).
At the international level, jurisdictions were required to introduce notification regimes whereby information required to assess profits booked in their jurisdiction as a whole from such activities could be made available to other jurisdictions with corporate income tax systems to allow them to calculate their own taxpayers' tax liabilities.
Where can I find the legislation and guidance?
In the BVI, the Economic Substance (Companies and Limited Partnerships) Act, 2018 (the Act) was introduced effective 1 January 2019, and potentially applied to all companies and limited partnerships with separate legal personality (PLPs) registered in the BVI. There was a six-month transitional period for companies and PLPs existing prior to that date. The Act was amended in 2021 to bring limited partnerships without separate legal personality (NPLPs) within the regime from 1 July 2021, again, subject to a six-month transitional period for pre-existing NPLPs.
For simplicity, we refer to all companies, PLPs and NPLPs (including foreign entities) registered in the BVI as entities.
The ES reporting regime was introduced via amendments to the Beneficial Ownership Secure Search System Act, 2017 (the BOSS Act). The BOSS Act was amended in 2019 and 2021 to allow the BOSSs' secure encrypted database to receive ES information via each entity's BVI registered agent (RA).
The guidance provided to jurisdictions by the COCG and FHTP was high-level, and the timetable allowed for implementation might be described as ambitious (at best); jurisdictions were effectively given six months to implement the requirements. As a result, the Act set out a framework with detailed guidance appearing in regulations and official explanatory notes.
Draft guidance was issued by the BVI International Tax Authority (ITA) in April 2019 on the interpretation of the Act and the ITA's approach. The final Rules and Explanatory Notes (the Rules) were published in October 2019, with minor amendments, and updated in February 2020 to reflect comments from BVI industry, and the COCG and FHTP.
Further additions will be made to the Rules in 2022 to reflect the amendments to the Act and the BOSS Act in 2021, in particular, to expand the scope of the ES reporting requirements in line with COCG and FHTP requirements, and provide additional guidance for limited partnerships.
How is compliance assessed?
Clients setting up BVI companies and limited partnerships (and their advisers) need to consider whether ES requirements apply to their business as every entity registered in the BVI is now required to submit an ES return (generally annually). In some cases, this can be complex and entities may need to seek qualified BVI advice. Business activities should be monitored on a continuing basis to ensure compliance with the Act.
Every entity must identify whether it carries on any "relevant activity" at any point in time. The Act specifies nine types of relevant activity, and expressly confirms that "investment fund business" is not relevant activity. Regulated open-ended and closed-ended funds generally fall within an exemption (although "fund management business" is a relevant activity).
Compliance is assessed by reference to an entity's activities during each "financial period" (FP). An entity's FP may not be the same as its fiscal or financial year, although it is possible to align the two by application.
By default, FPs run consecutively for 12 months each and:
- The first FP of a company or PLP incorporated in the BVI prior to 1 January 2019 commenced on 30 June 2019
- The first FP of a company or PLP incorporated in the BVI on or after 1 January 2019 commenced on its date of incorporation
- The first FP of an NPLP formed in the BVI prior to 1 July 2021 commenced on 1 January 2022
- The first FP of an NPLP formed in the BVI on or after 1 July 2021 commenced on its date of formation
Many entities are either not carrying on any relevant activity or qualify for exemption due to their tax status.
Entities that do not carry on any "relevant activity" during an FP are not subject to ES requirements, but must still file a "nil return" and should ensure that they are familiar with their reporting obligations under the BOSS Act.
Generally, an entity carrying on or receiving gross income from any relevant activity at any time during an FP is required to demonstrate adequate ES in the BVI for that activity.
Entities that are treated as tax resident in a jurisdiction outside the BVI (provided that jurisdiction is itself not on the EU's taxation "blacklist") are also not subject to ES requirements, but still need to determine whether they carry on any "relevant activities" and claim such an exemption with supporting evidence. Part 4 of the Rules expands the traditional concept of tax residence to include certain "transparent" entities and certain entities whose income from relevant activities is subject to tax. Broadly, a "non-resident" claim will result in a spontaneous exchange of all the information regarding the entity on the BOSS Act RA database with relevant overseas tax or other competent authorities.
What are the ES compliance requirements?
The ES requirements depend on the nature of the relevant activity and only apply if the entity is not able to claim exemption as a tax non-resident during the relevant FP.
There is a simplified regime for entities carrying on the business of being a "pure equity holding entity" (PEHE), which is defined as a "holding business". This should not automatically be conflated with being a holding company in the broader commercial sense. A PEHE is narrowly defined as an entity that only holds equity participations in other entities and only earns dividends and capital gains.
A PEHE meets its ES requirements if:
- It complies with its statutory obligations under the BVI Business Companies Act, 2004, or the Limited Partnerships Act, 2017 (as applicable)
- It has, in the BVI, adequate employees and premises for holding equity participations and, where it manages those equity participations, it has, in the BVI, adequate employees and premises for carrying out that management
The Rules acknowledge that the holding of equity participations can be (and, in many cases, is) entirely passive in nature and that, in such cases, the requirement for adequate employees and premises may be capable of being met by the BVI RA and the existing registered office.
An entity conducting any other relevant activity must demonstrate that:
- The relevant activity is directed and managed in the BVI (which, among other things, requires board meetings with a quorum of directors physically present in the BVI)
- Having regard to the nature and scale of the relevant activity, the entity:
- Has an adequate number of suitably qualified employees physically present in the BVI (employed directly or employed by another entity)
- Has adequate expenditure incurred in the BVI
- Has physical offices or premises as may be appropriate for the core-income generating activity (CIGA)
- Conducts CIGA in the BVI
Income from intellectual property was considered by the COCG and FHTP to be at higher risk of base erosion and profit shifting (BEPS) activity. Accordingly, an enhanced ES requirement applies to entities carrying on intellectual property business. Broadly, the general ES requirement (summarised above) is enhanced by requiring any relevant equipment to be physically located in the BVI, and creating various presumptions that the entity is not compliant, which may be rebutted in certain circumstances requiring a very high degree of ES in the BVI. However, in practice, those requirements may be extremely onerous. Any entity that may earn identifiable gross income or gains of any description from intellectual property rights in intangible assets should consider its position under the Act and may need to seek specialist advice.
How must entities report?
An entity must submit its prescribed ES information under the BOSS Act via its RA to be uploaded to the RA database within six months of the end of the relevant FP. The scope of the information to be reported varies widely in complexity, depending on the entity's business activities and tax status.
The BOSS Act was amended in 2021 to require entities to identify, and in some cases report on, any "immediate parent" and "ultimate parent" of the entity. The scope of ES information to be reported has also been extended for FPs commencing on or after 1 January 2022 and entities that have already reported for previous FPs should ensure that they are familiar with the revised BOSS Act requirements and Rules.
Although they are both set out in the same legislation, the ES and beneficial ownership reporting obligations under the BOSS Act run on different deadlines. Beneficial ownership information that is required to be reported under the BOSS Act must generally be notified to the entity's RA within 15 days of being identified (whether initially or in the case of any change to such matters).
What are the penalties for non-compliance?
Broadly, enforcement action may be taken by the ITA and other relevant BVI authorities in the case of:
- Any failure by an entity to:
- Identify or report the information required by the BOSS Act, which includes whether or not it carries on any relevant activity
- To comply with applicable ES requirements
- Any failure by any person (which potentially includes directors or partners and certain other individuals associated with the relevant entity) to provide information or the provision of inaccurate or misleading information to the ITA
Failure to identify or report information required by the BOSS Act or to provide information to the ITA without reasonable cause (or the intentional provision of false information) is a criminal offence carrying significant penalties.
Failure to comply with the ES requirements is not an offence. However, it may lead to fines and requirements to take remedial action and, in extreme cases, the entity may be struck off the relevant Corporate Register or liquidated via court order. The penalties are increased significantly for certain "high risk IP legal entities".
Entities that are determined to be non-compliant or carry on intellectual property business may be the subject of spontaneous information exchange of all the information regarding the entity on the BOSS Act RA database with certain relevant overseas competent authorities, including where a beneficial owner, immediate parent or ultimate parent of the entity resides.
All BVI companies and limited partnerships should consider:
- Whether the entity may carry on any relevant activity
- If so, whether the entity is treated as having a tax residence in another jurisdiction under the Rules (and whether that jurisdiction is, or is at risk of being, "blacklisted" by the EU for tax purposes)
- If the entity is subject to ES requirements, how it will meet its compliance and reporting requirements (and any potential reorganisational or restructuring options)
This article first appeared on the website of the Taxes Committee of the Legal Practice Division of the International Bar Association, and is reproduced by kind permission of the International Bar Association, London, UK. © International Bar Association.