The term ‘economic substance’ is not a new one. Indeed, many working in and around no and low tax jurisdictions will be very familiar with the term, but for the majority of those working in the superyacht industry, economic substance is either something they have heard of in passing, or an alien concept altogether.
So, what is economic substance, why does it exist and is it something to worry about? Well, read on and I will bring you up to speed.
What is economic substance and why does it matter?
Economic substance is the concept that the direction and management of economic activities should be sufficiently linked to the jurisdiction in which they are performed.
It forms part of the wider EU principle that the rules and laws of one member state should not give it an unfair advantage over others. While no and low tax environments are not, in themselves, incompatible with EU principles, their utilisation without adequate economic substance is considered potentially harmful to those principles.
In 2017, the EU Code of Conduct Group examined the taxation policies of international financial centres (IFCs) to establish compatibility with core EU principles relating to tax, in particular whether entities conducting economic activity from those IFCs maintained sufficient substance.
As a result of the investigation, concerns were raised that a number of jurisdictions lacked the legal substance requirements necessary to be compatible with EU principles.
A list of jurisdictions which were required to answer to the Code of Conduct Group’s concerns was drawn up – this included the Crown Dependencies (Jersey, Guernsey and the Isle of Man) and a number of the British Overseas Territories (BOTs), which many will be familiar with as Red Ensign Group Flag States.
So why is this relevant?
Economic substance rules apply to entities carrying out certain activities listed in the legislation relevant to each jurisdiction. While the details vary from jurisdiction to jurisdiction, common among the Crown Dependency and BOTs’ legislation is the inclusion of companies engaged in shipping and holding companies.
So, is a special purpose vehicle (SPV) established for the purpose of owning a yacht a shipping company for the purpose of economic substance? Well, it could be – here are a couple of examples which demonstrate the importance of the details.
Cayman Islands – in this jurisdiction the legislation and guidance is clear – the owning, operating, or chartering of a pleasure yacht is not considered to be “shipping business” for the purpose of economic substance. This covers yachts used both privately and commercially.
Jersey – economic substance rules for this jurisdiction are contained in the Taxation (Companies – Economic Substance) (Jersey) Law 2019 (the “2019 Law”). At a glance, shipping business appears to be treated in a very similar manner to the Cayman Islands, with the operation of pleasure vessels excluded. However, when we look at the detail (specifically the definitions of “ship” and “pleasure vessel”, a commercially operated superyacht could be interpreted as being “shipping business” under the 2019 Law depending on how it is used.
Understanding these nuances is vital to avoid falling foul of the legislation – expert advice should always be sought in the jurisdiction to ensure full compliance with the relevant laws.
Even if your SPV is not considered a shipping business in the relevant jurisdiction, it is important also to consider the ownership structure as a whole. Is there a holding company carrying out a relevant activity to which economic substance rules may apply?
In many instances, there will be.
What are the requirements for conducting a relevant activity?
If the operation of your superyacht is determined to be a relevant activity as described above, you will be required to comply with certain requirements to meet the economic substance test. These are set out in the legislation for each relevant jurisdiction, but generally these include measures to demonstrate that the business is sufficiently entrenched in the jurisdiction of incorporation and that the structure is not merely convenient from a tax perspective.
In the case of a holding company, these requirements are typically less strenuous than they are for other types of relevant activity such as shipping business (so much so that you may already meet them without trying), but care should be taken nonetheless to ensure compliance.
What are the consequences for failing to satisfy the requirements?
Again, the consequences vary from jurisdiction to jurisdiction, but using Jersey as an example a maximum fine of £10,000 may be payable for a first offender, however, if, following a determination that a company has failed to meet the economic substance test in one financial period, a company fails to meet the test in a following financial period, it may be subject to a maximum fine of £100,000.
There was a time not so long ago when businesses and individuals alike were able to shop around no and low tax environments to choose the most efficient location to house their business/investment/venture with relatively little interest from the regulators.
No and low tax jurisdictions aren’t going anywhere fast, but greater consideration must be given to whether their use is appropriate in all circumstances.
The superyacht industry is maturing, and we now live in a world where corporate and social responsibility are more important than ever. It is vital that we all keep up with the pace of change.
The industry is blessed with some excellent tax and legal advisors as well as experienced corporate service providers who can guide you through the establishment of a suitable structure for the ownership of your yacht to ensure that you don’t fall foul of economic substance requirements – and their fees are probably considerably less than the fine you may get if you fail to comply.