Economic substance: how to prove that an offshore entity is legitimate?

In the context of international tax planning and cross-border business structuring, the concept of economic substance is of utmost importance. Both to ensure legal compliance and to avert risks associated with tax evasion and abusive practices.

But what does “economic substance” actually mean? And how can an international entity evidence effective management in the eyes of tax and regulatory authorities?

What is economic substance?

Economic substance refers to the actual and operational presence of a company in the country where it is legally registered. It goes beyond the simple act of formal incorporation. What this means is, that it implies the existence of genuine activity, adequate material and human resources, and effective management within the jurisdiction.

In short, is the company being run from the jurisdiction where it was incorporated, or is it being managed from abroad? Where do the most important board resolutions and directives originate?

This ultimately means that it is not enough to have a registration number and a post office box/registered addresses in tax efficient jurisdictions. The company must demonstrate that it operates in a concrete and relevant manner in the place where it is incorporated.

Why is it essential?

The economic substance requirement responds to growing concerns about tax transparency and the fight against artificial structures, namely those used solely to shift profits or hide real beneficiaries.

Consequences of non-compliance

Failure to prove substance may result in significant fines in the jurisdiction where the company was being managed from (in some jurisdictions up to hundreds of thousands of USD), loss of tax benefits or exemptions in the case of use of double taxation agreements, involuntary dissolution of the company by the local registry or tax authorities if there is an understanding that the company is operating illegally, or the shifting of tax residence of a company to the jurisdiction of the Beneficial owners and/or controllers. This means you may ultimately incorporate an entity abroad to benefit from low tax, and at some point, the country of your residence is asking you to pay taxes on your company profits.

So how do you evidence economic substance?

The legitimacy of an international company depends on its ability to prove, through consistent documentation and governance, that it has an operational and strategic presence in the country where it is based. Among the main elements of proof, some may include:

1. Physical presence: Own or rented office, with infrastructure consistent with the nature of the activity.

2. Human resources: Hiring of local or expatriate employees with clear roles.

3. Effective management: Strategic decisions made within the jurisdiction, with meeting minutes, records and formal appointments. Active participation of local or designated administrators.

4. Operational activity: Execution of real contracts with suppliers, customers or partners. Generation of revenue, commercial operations or effective provision of services in the territory.

5. Accounting and compliance: Audited accounts signed and presented locally, with tax reporting in accordance with the jurisdiction's standards. Compliance with legal, banking and regulatory obligations.

6. Having a locally appointed corporate director.

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Wrapping up…

Economic substance is now one of the main tools tax heavy jurisdictions are using to address the growing tendency for offshore tax domiciled companies. Showing you've got this substance is key to making sure your operation isn't seen as front, ultimately protecting your company, your partners, and your assets.

At Ancilia, we help our clients structure international businesses on a solid foundation,  ensuring not only the possible tax benefits, but above all full compliance with the principles of good governance and corporate integrity.