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Economy & Business

The awkward matter of substance

The regulatory noose is tightening further, and the implications stretch wider than we might think

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Earlier this year it became evident that, if Guernsey was going to thrive or even survive as an offshore finance centre, it would have to continue conforming to the ever-tougher governance and tax requirements imposed by the UK, the EU and the OECD.

In particular, we were told that our next “punishment” would be a requirement to demonstrate “substance” in the activities the island conducts in order to avoid being blacklisted (see earlier article here).  Though it is a bit of a weasel word, “substance” in this case means the “reality” or “essence” of those activities.

The EU has now come up with a list of the activities it deems relevant.  To be clear, it is the EU’s so-called Code of Conduct Group which is driving this, and it in turn is following in the steps of the OECD’s Forum on Harmful Tax Practices.  Given that the OECD is basically the G20 group of major nations, it is almost pointless for any outsider to argue about their intentions.

That said, it is important to understand that this assault is not aimed only at Guernsey, or at the kind of financial entities which dominate our economy.  Nor is it aimed specifically at the Crown Dependencies or Overseas Territories.  The main target is large multinational companies which, through careful and clever structuring, set up their businesses in a way which minimises the tax they pay.

This avoidance of tax is legitimate, but it comes at a cost to the exchequers of the rich countries, who have tagged the problem “Base Erosion and Profit Shifting,” or BEPS.  The European countries most involved in facilitating this are Ireland, the Netherlands and Luxembourg.  The main companies being targeted are Facebook, Amazon, Apple, and Google.  And “substance” is the weapon being used to deal with them – that is, wherever the economic activity which generates revenues and profits is located, that is where they want tax to be levied.

The OECD/EU actions are so far-reaching that jurisdictions like Guernsey are inevitably being caught in the maelstrom.  This is because the targeted economic sectors where the OECD/EU see the opportunity for profit-shifting include a number of finance-related activities which Guernsey happens to undertake – even though the island is scarcely hosting any multinational tax-driven businesses of the Amazon variety.

In the OECD/EU jargon, the common feature of the list is that the activities are “geographically mobile.”  They are named specifically as banking, insurance, fund management, financing/leasing, shipping, holding companies and intellectual property (IP).  Within these sectors, the target is any entity’s “core income generating activity.”

So much for the basics.  What observations can one make about all this which are of relevance to Guernsey?

  • The inclusion of fund management on the list is interesting because it is yet another imprecise label.  Do they mean investment advice?  Investment management?  Fund management?  Fund administration?  Where you draw the line dictates where the tax might be due.  One significant pointer:  at least one investment group, which already maintains its own staffed office in Guernsey, has decided to employ an investment specialist to demonstrate adequate substance.
  • The non-inclusion of fiduciary and trust business is a bit of a surprise.  While much of this business is driven by the preference for secrecy about assets and about the disposition of such assets among beneficiaries, some of it is widely suspected to be driven by tax minimisation.
  • The above two activities are currently the core businesses of Guernsey’s finance sector.  Banking has become a service business for local entities, insurance has reached a level of maturity in its offering.  So, if one of the two core businesses is outside the scope of the “substance” requirement, that is a plus for the island.
  • Nonetheless, the fact that Guernsey is a unique jurisdiction in one particular respect – entities managed in the fiduciary sector are not required to file tax returns – raises a couple of issues, because under the new regime all companies will be required to do so.  First, the local Tax Office’s responsibilities will grow, which means a requirement for better systems and more people.  Ahead of that it will also mean additional regulations, if not legislation, to allow it all to happen.  So watch out for the contents of the 2019 Budget, due to be presented in October.  The deadline for implementation is end-December.
  • Secondly, of the roughly 19,000 companies registered in Guernsey, it likely only some 5,000 will be caught in the “geographically mobile” net.  This gap will require some explaining.  More importantly, however, those who are caught will have to show they meet the “substance” requirement.  To do this, their board meetings must be held in Guernsey.  If board members are from outside the island, this means they will need convenient and reliable access.  It is not hard to see how this relates to the current controversy over our air links.
  • The “substance” question is also prompting a consultation on a more arcane aspect of company taxation.  Local businesses are being asked to give their view on the ticklish issue of what constitutes corporate tax residency in the island.  Currently, if the entity is incorporated in Guernsey or if shareholder control is in Guernsey, it is Guernsey tax resident.  The trouble is, every other respectable jurisdiction says an entity is tax resident locally if it is incorporated there or if it is managed and controlled from there.  This difference has already resulted in cases where some UK investment managers operating in Guernsey set up separate entities in Jersey to minimise their tax obligations – for example, stamp duty when an asset is sold. Some sort of reform seems inevitable on this front.
  • Interestingly, this saga has nothing specifically to do with the sensitive matter of public access to the beneficial ownership register which Guernsey maintains for all Guernsey entities.  This is a separate issue, and one which vexes certain politicians in London, but in the BEPS initiative there is no question of Guernsey being obliged to give real-time access to the OECD/EU to its register.  The existing position will remain unchanged – information exchange will occur through legitimate request from enforcement agencies in other jurisdictions.
  • It should be noted that, as far-reaching as all this is, Guernsey continues to attract attention – as do Jersey and the Isle of Man – because they are third parties offering a zero-tax regime for certain companies (in Guernsey’s case, most of its companies).   This is something the OECD/EU can’t quite cope with.  Yet if you ask them what is an acceptable rate of corporate tax (0.1%? 1%? 5%?), you receive no answer.

In fact this whole debate tells us an awkward truth about our 21st Century world.  Many of us still believe that all jurisdictions have the power to determine the domestic taxes they apply.  But every EU and OECD country, not just third parties outside these groupings, must nowadays conform to certain international rules in order to avoid being blacklisted and unable to do business.  In other words, their sovereignty in respect of a key power – tax-raising – is severely limited.  In this sense, “taking back control” has become a near-impossibility for any country.  Which means there is as much a lesson for Brexiteers in the UK as there is for little Guernsey.

One final point needs spelling out in relation to Guernsey.  We have successful funds and fiduciary sectors.  But as a result of globalisation, easy credit, more costly regulation and available business opportunities, many of our smaller fund administrators and fiduciary businesses have been taken over, had their names changed and are now part of a more widely consolidated (and leveraged) sector which is mostly headquartered elsewhere and which – crucially – can decide where to locate new business.

On the face of it this seems worrying for Guernsey, but some Guernsey entities have themselves initiated such changes, grown rapidly and kept their headquarters here.  More importantly, for Guernsey to keep winning funds and fiduciary work, its businesses will need to have the necessary skills, systems and competitive advantages so that, while we may become an even more regulated and costly jurisdiction, we would hope to have better quality work which earns the businesses and their employees higher incomes which contribute to overall economic growth.  That is the way things are now going.

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