Since the OECD presented their action plan on ‘Base Erosion and Profit Shifting (BEPS) the importance of the topic of ‘substance’ has significantly increased. Under the BEPS initiative the OECD counters harmful tax practices, not only of multinational companies, but also of small and medium sized firms that are internationally operational.
Some sophisticated tax jurisdictions, such as the United Kingdom, Switzerland and Austria, already had substance requirements as a pre-requisite to allowing companies to claim treaty benefits. Therefore, for the tax authorities in these jurisdictions, the mere fact that a company is incorporated in a specific jurisdiction does not mean than this company is automatically entitled to claim the favorable provisions of the relevant DTT.
Over the last few years, the global changes of as the CRS and FATCA driven by the OECD and the fact that the most of the foreign tax authorities tried to find ways to increase their tax income, countries are becoming more sophisticated in their approach when it comes to the double tax treaty interpretation related to the articles of dividends, interest and royalties that are paid to companies in other tax jurisdictions.
As part of this development, the mere fact that a company is incorporated in a jurisdiction and pays taxes in said jurisdiction on its worldwide income, is no longer sufficient for a business to guarantee that this company can access the full treaty benefits offered through the expanding and favorable DTT network that this jurisdiction has to offer.
The incorporation of a company is viewed as insufficient to ensure that it will be considered a tax resident company. To demonstrate substance, among others, an active board of directors (and, as appropriate, employees), suitable financing, and office facilities are needed.
The result of the above global changes is that, tax jurisdictions will examine whether a company established in a jurisdiction which claiming tax benefits has substance in that jurisdiction.
What is substance?
Substance can be defined as the various characteristics, notably resources, which demonstrate that the company does indeed have its activities based in the country where it is tax resident, and is not merely a “shell” company formed to avoid paying (usually much higher) tax in the country where the underlying business is based. A strong prove for a company in order to achieve that is managed and controlled in a jurisdiction, is to show that the majority of directors are residing in that jurisdiction and the board of directors is also holding meetings in that jurisdiction.
Minimal substance requirements for withholding tax, etc:
– bank accounts;
– properly held meetings;
– composition of the board;
– actively acting as a shareholder in lower tier subsidiaries;
– minor material substance.
More material substance requirements for beneficial double taxation treaty provisions, etc:
– appropriately qualified employees and payment of the relevant payroll taxes;
– full paper trail of reporting and basis for major decisions on investment;
– divestment, restructuring etc;
– preferably own offices with infrastructure etc;
– the holding company acting as platform for other investments;
– the registration of utilities such as water and electricity in the name of the company;
– the payment of local professional rates and taxes;
– existence of a telephone number, e-mail and fax in the name of the company;
– existence of a company website, company logo and company stationery;
– bank statements showing local expenditure (eg. for any of the above);
– the use of local professionals (IT support, courier services etc);
– accounting records and other records such as agreements, contracts, invoices etc being located in that jurisdiction.
Tax authorities have become more sensitive and do check substance requirements in order to grant treaty benefits. Proper advise from a professional consultancy firm is therefore needed in order to make the structure work.