International: Economic Substance Requirements for MNE groups in Low-Tax/Zero-Tax Jurisdictions

Multinational companies with subsidiaries in low-tax or zero-tax jurisdictions must consider the economic substance they have in these jurisdictions.

• Ensure compliance with ESR (Economic Substance Regulations) rules enacted in 2019 and later. The UAE authorities introduced these laws to comply with the global standards (EU Code of Conduct Group) and the OECD (Organization of Economic Corporation and Development) Forum on Harmful Tax Practices.
• Ease the impact of the Pillar 2 rules that will come into effect from 1st January 2024. Multinational groups should consider substance for substance-based income exclusion.

ESR Legislation in Low-tax Jurisdictions

The authorities have fined companies for failing substance rules in jurisdictions with low or zero corporation tax. Many jurisdictions had to implement ESR rules to comply with the requirements of the OECD Forum on Harmful Tax Practices and the EU Code of Conduct Group. Most of these jurisdictions are in the Caribbean/Atlantic area or the Crown Dependencies.

These jurisdictions are popularly known as intermediate holding company jurisdictions to perform specific activities like intra-group financing or captive insurance.

ESR rules in the above-mentioned jurisdictions follow a similar model. The rules are mostly not a part of the tax system, but they aim to limit low-substance companies operating in the jurisdictions. As a result, the ESR laws can remove or prevent companies from conducting operations in these jurisdictions.

Lately, jurisdictions not taxing foreign source income (Hong Kong, Malaysia, Seychelles, St Lucia). Companies that fail to comply with the ESR rules in these jurisdictions will result in their relevant income being taxed by the authorities.

Even though many jurisdictions have issued extensive guidelines, companies are still unsure about their implementation.

The ESR rules make it compulsory for companies to meet the following conditions:

• A certain degree of expenditure
• Have an adequate workforce and premises
• Provide evidence of core income-generating activities in some sectors (applicable to sectors like financing and leasing, headquarters activities, banking, and insurance activities).

The rules are stricter for activities deriving income from intellectual property while being lenient for long-term equity-holding enterprises. Depending on the case, regulations determine whether the level of substance is adequate for a particular activity. Hence, the evaluation methods are quite subjective and open to interpretation in several matters.

For example, how many employees must work full-time to manage intra-group shareholdings or a loan portfolio, especially long-term and passive investments? Some cases require minimal formalities like holding regular board meetings. Others may require the employment of permanent employees in the jurisdiction.

Several groups will have to submit their mandatory substance returns. As a part of the ESR obligations, these groups must disclose company-specific information (on the levels of substance) to the authorities. Economic substance returns will allow authorities to develop unique assessment models that shed light on whether the firms meet the ESR tests.

The interpretation of adequate substance levels depends on the jurisdiction, local authorities, and taxpayers.

These interpretations can result in the following:

• Penalties.
• Opportunities for engagement with the authorities and appeal.
• In case No. 2 (above) fails, entities must implement rectification measures to avoid further penalties.

Many jurisdictions abide by the ESR rules to ensure compliance and end up in the good books of EU and OECD. Now, these jurisdictions must demonstrate what measures they have undertaken to implement these rules. What is the logic behind this requirement?

The EU and OECD have made it clear that implementing the rules is not enough. These regulatory agencies want to see proof that jurisdictions are taking the necessary actions and implementing steps to prevent abuse.

Groups can take the necessary steps to mitigate the risks of penalties and sanctions. Furthermore, they must conduct board meetings regularly and hire Emiratis in their workforce. When firms find it challenging to demonstrate substance or they do not understand what is expected of them, they can consider the following options.

• Restructuring
• Exiting the jurisdictions in question

Pillar Two Substance-Based Income Exclusion

A political agreement among EU member states in December 2022 provided a much-needed push to an implementation timeline. According to the timeline, the Pillar Two Rules or the global minimum tax will take effect across the EU and other major jurisdictions in less than a year’s time, starting 1 January 2024.

The Pillar Two Rules will enter the global corporate tax arena. As per these rules, multinational corporations with revenues over 750 million euros must pay a minimum of 15% corporate tax in their jurisdictions. How will the corporate tax be implemented?

Apparently, the authorities of the relevant jurisdictions will levy a top-up tax on the parent company of the multinational company on the difference between the local effective tax rate and the 15% minimum rate multiplied by the local profits.

The substance-based Income exclusion does not change the jurisdiction’s effective tax rate. The tax rate is locked as a percentage below 15%, but it slashes the net profit to the applied percentage.

Two metrics influencing the exclusion are as below:

• Employee payroll costs.
• Carrying value of tangible assets.

The exclusion constitutes a chunk out of the profits of 5% of all payroll costs or the carrying value of tangible assets (higher rates apply during a transitional period). Moreover, the exclusion has simplified rules (transitional relief) that may apply in the first two years if the exclusion amount exceeds a jurisdiction’s profit/loss before income tax.

Employee payroll costs will probably be a more relevant metric for finance-related activities and low/zero-tax jurisdictions. These activities require a few tangible assets while involving high-salaried and mobile employees. Most importantly, the substance rules will accentuate the benefits of moving employees into these jurisdictions.

Summing Up

Multinational companies with profits in zero/low-tax jurisdictions have a choice to increase substance to comply with the local economic substance tests and the Pillar Two substance-based income exclusion. Alternatively, they can restructure their businesses or quit these territories for good.

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