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A Little Bit on Economic Substance

By Johannes Eulen

Everyone in the Bermudian business community is aware of the Government’s recently passed legislation on economic substance. It was essentially forced upon the Government by the European Union (EU), which has a seemingly visceral dislike of what it views as low, and no-tax jurisdictions.

So, it is worth thinking about some of the potential impact of the legislation, bearing in mind that it (and the related regulations) may well have to change further as the result of the EU’s response (expected late February) on whether, as enacted, it satisfies the EU’s requirements sufficiently to avoid “blacklisting” Bermuda – an outcome which would have serious negative consequences.

A few points should be made first:

  • As KPMG’s excellent and comprehensive recent presentation (see RG dated 14thJanuary 2019) on the whole issue emphasised: “we are not alone”. Those jurisdictions, which some may see (and see themselves) as Bermuda’s main potential competitors “offshore” (for example, Cayman Islands, British Virgin Islands, Guernsey, Jersey and the Isle of Man) are equally subject to the EU’s dictates.
  • Economic substance only affects 10 designated industries, including banking, insurance, fund management and shipping. Many local businesses will not be directly affected. Of course, insurance, in particular, is a critical business segment. However, the Bermuda Monetary Authority (BMA) is a highly-effective and widely-respected regulator, including by the EU. This should mean that BMA-regulated businesses will be deemed already compliant, even if they have to deal with reporting requirements (yet to be released), minimising the impact.
  • Intellectual Property (IP) is also “in scope”– particularly so-called “high-risk IP” – a term applicable to an entity that owns an IP asset acquired from an affiliate and is licensed to (or used by) a foreign affiliate.
  • Implementation is required to have been completed by July 1, which means that there will be a lot of “scrambling” to be done by Government, professional service firms, and businesses themselves to be ready. This is hardly helped by the fact that much uncertainty remains. There is no “grandfathering” mechanism.
  • The EU is likely to enforce a “level playing field” to prevent jurisdictional arbitrage. This should play to Bermuda’s strengths as a jurisdiction that models itself on best practice.
  • Further, the EU expects there to be real “pain” for any business that is deemed non-compliant, starting with escalating fines and ultimately (via a court process in Bermuda) to striking-off.

Therefore, while apprehension and concern are reasonable reactions to the current situation, fear and paralysis are not.

Of course, the management of any potentially affected business should already be thinking strategically and tactically about how to address alternative scenarios, and seeking advicefrom their accountants, lawyers and corporate service providers, as appropriate. As events in the UK surrounding Brexit demonstrate, wondering what Plan B may be, or whether there even is one, may not be a sensible approach.

One area of the legislation which is causing some angst is the frequent use of the word “adequate”

(“adequate physical presence”, “adequate full-time employees”, “adequate operating expenditure”, and so on); while those “adequate full-time employees” must be “suitably qualified”. No definitions or examples are provided of those terms, in the same way, that one is supposed to know what “prudent”, “proportionate” and “reasonable” mean. Terms of art are fine in the sense that they provide, in theory, for common sense and rational qualitative judgements. However, because they are open to interpretation, they are also open to abuse. So, it will be important for the Government to provide as much guidance as it can on how the terms should be interpreted. Expecting clarity from the EU is probably asking too much!

Similarly, entities “in scope” must be “managed and directed in Bermuda”. Brass plates and PO boxes will not do. The EU will expect the Registrar of Companies (which is tasked with monitoring compliance) to conduct examinations that ensure that compliance is real, and not a chimaera or work of fiction. And just to prove the point, “any person who knowingly provides false information to the Registrar shall be liable to a fine not exceeding $10,000 and/or to imprisonment for two years.”

The Government has realised that while “economic substance” is a potential threat (particularly if, despite best efforts, Bermuda is somehow “blacklisted” by the EU), it also offers the opportunity to attract high-paying jobs to the Island- including for Bermudians; and so, has announced initiatives to encourage inward migration of those who will meet the “suitably qualified” test.

To sum up, “economic substance” will become a fact. It is not going away; and the OECD, as well as the EU, will move towards making this a de facto global standard. One can fight it (and lose), or see it as an opportunity to create value and prosperity.

For any rational Bermudian, there is only one answer.

This article was originally published in the February 2019 edition of the RG Business Magazine.

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