24 November 2020
A practical guide to substance in Guernsey for trust and corporate service providers
Like other offshore jurisdictions, Guernsey introduced economic substance requirements at the beginning of last year in order to address concerns by the EU Code of Conduct Group on Business Taxation that Guernsey's corporate tax system could facilitate offshore structures aimed at attracting profits which did not reflect real economic substance. Whilst the new substance regime is aimed at companies rather than trusts, where those companies form part of a trust structure, the trustees will seek reassurance that applicable substance requirements are being met.
Service providers often find themselves directly responsible for companies meeting compliance and reporting obligations in their capacity as trustees, shareholders, directors and/or trust and corporate administrators. For those working in this sector the introduction of the new substance regime has brought changes in the way they are expected to pitch for and then administer new and current business.
Here, Carey Olsen counsel Laila Arstall, a member of the firm's trusts and private wealth practice in Guernsey, considers economic substance from the point of view of a trusts and corporate services professional who has come to her for advice on substance requirements when taking on a new structure. In doing so, Laila summarises some of the key elements of Guernsey's economic substance legislation which impact different types of companies depending on their activities.
We're putting together a pitch for a new structure where we will act as trustees through our corporate trustee holding shares in a new Guernsey company that in turn will own a number of underlying subsidiaries around the world. These subsidiaries run a chain of hotels. Our proposal will cover the services that we offer as trustees and directors to support the new holding company's activities. As trustees and directors we will oversee the corporate administration, tax compliance and regulatory requirements of the structure in Guernsey. We will also be running the new company from Guernsey. As a result, I believe this possibly raises questions around economic substance. The first question is whether the corporate trustee itself will be subject to substance requirements because it will be holding all the shares in the new holding company?
Laila: If the corporate trustee is tax resident here, you are right to consider substance requirements but since the corporate trustee acts as trustee for a number of trusts on a commercial basis, it does not meet the criteria to be classified as a pure equity holding company for substance purposes. However, when we turn to the holding company, because its function is to hold shares in the underlying subsidiaries, Hold Co will be classified as a pure equity holding company for substance purposes, unless it carries on a commercial activity.
Well, the holding company will receive dividends from the subsidiaries, and invest those dividends in securities or otherwise hold them in a bank account. Would these count as commercial activities?
Laila: No, these are functions of being a holding company and do not take the company out of the classification of a pure equity holding company. Previously it had been suggested that if the company carries on an activity which is directly linked to the pursuit of profit, it would be regarded as carrying on a commercial activity. However, the most recent Guidance, published in November 2019, focusses on whether a company falls outside the classification of a pure equity holding company because it carries on a Relevant Activity.
So am I right to think that if the only thing the company does is hold the shares in its subsidiaries and receive dividends on those shares, which the company places, say, in a bank account, then it will be a pure equity holding company.
Laila: Yes, that's right. But if in any year Hold Co does not receive income from its share holdings then, although it will continue to be classified as a pure equity holding company, it will not have to demonstrate substance in Guernsey for that reporting period.
In practice I will only know whether Hold Co has received dividends during the year once the year is over.
Laila: Yes. So as the year unfolds, you will have to keep monitoring whether it receives dividends, even on the last day of the accounting period, as that would trigger the requirement to file data demonstrating that the company meets its Guernsey substance requirements. For these purposes you need only look at the company's activities. Whatever happens at trust level is irrelevant for substance purposes. However, the trustees will at all times have a duty to exercise professional oversight of any company owned by the trust. This is in accordance with regulatory requirements.
What are the substance requirements for a pure equity holding company in Guernsey?
Laila: Substance applies across a spectrum. At one end of the spectrum you have pure equity holding companies that are subject to reduced levels of substance. In the middle you have Relevant Activity companies that are subject to a higher level of requirements. And at the other end you have IP companies that are subject to the most onerous levels of substance requirements.
The reduced level of requirements for a pure equity holding company are that it must have an adequate level of persons and physical presence in Guernsey proportionate to the level of activity required to hold and manage the shares in the subsidiaries. The company must also meet its corporate law obligations. In your case, because the company will be administered by a licenced corporate service provider, the expectation is that you would be meeting these reduced level substance requirements as part of your normal services. So as far as drafting your pitch is concerned and estimating your costs, you could base it on your standard service-level offering for corporate administration but allow for additional costs if, in practice, looking after the subsidiaries is more involved than it first appears. That is because meeting substance is fact dependant.
What if Hold Co uses the funds in its bank account to pay off invoices incurred by the subsidiaries? Would that make a difference?
Laila: You mean Hold Co will be providing a 'treasury' function for the subsidiaries held within the trust?
Yes, basically it will be receiving dividends in dollars, sterling and Euros, from its subsidiaries, which it would place in a multi-currency bank account, so it could use those funds to pay off expenses incurred by its worldwide subsidiaries. The subsidiaries would then pay Hold Co a small processing fee which would cover its costs for doing this.
Laila: In that case, these services would be regarded as carrying on a commercial activity that takes the company out of the Guernsey classification of a pure equity holding company. Depending upon the circumstances, Hold Co could then find it meets another classification for substance purposes – one that applies to a company carrying on a Relevant Activity.
I've heard that there are seven Relevant Activities which could bring a company into scope of substance. I know that three of these are Guernsey Financial Services Commission regulated activities for banking, insurance and fund management, but what about the remaining four Relevant Activities – do any of them apply here?
Laila: Out of the remaining four classifications, one is shipping, which does not apply to Hold Co. That leaves three that could apply, namely financing and leasing, distribution and service centres, or headquartering.
To be a financing and leasing company, Hold Co would have to provide credit to its subsidiaries for consideration. Even making one loan at interest would be sufficient to make it a financing and leasing company. To see if this applies in your case, we need to look at the mechanics of the 'treasury' function. If a subsidiary incurs some expense. It then sends the invoice to Hold Co for payment. Hold Co pays the invoice, and then waits to receive reimbursement from the subsidiary. In this example there may be a period during which Hold Co is out of pocket and has provided 'credit' to the subsidiary, whilst it waits for reimbursement. Would Hold Co be charging interest during this period of credit?
There is no intention to charge interest. The idea is simply to centralise the payment mechanism using the dividends it accumulates in different currencies to pay off the invoices.
Laila: In that case we can rule out financing and leasing for Guernsey substance purposes. Instead, as I see it, the fee charged by Hold Co is a processing or handling charge; not interest payable on the outstanding loan.
What if Hold Co lends money to a beneficiary of the trust?
Laila: If the loan is at interest, this could make Hold Co a financing leasing company. But if the loan is interest free, then again, this would not bring Hold Co within the definition of a financing and leasing company. So whether the borrower is a beneficiary of the trust, another entity within the trust fund or a third party external to the trust structure, it the loan by Hold Co is at interest or other consideration, it will result in the company being subject to substance requirements. This is therefore a consequence which the trustees may have to factor in when considering the terms of the loan to be made by the company to a beneficiary.
Distribution and Service Centre
The next Relevant Activity which we need to look at is whether Hold Co will be a distribution and service centre for the subsidiaries. The definition of distribution and service centre covers two types of business activities:
(a) buying raw material or finished products from non-resident members of the group and selling them on for profit; and
(b) the provision of services to other non-resident members of the same group.
We know in your example that it's not doing the first business activity; however, providing invoice processing services could fall within the second categorisation of Relevant Activity. Will Hold Co be providing any other services for its subsidiaries?
Well there is some discussion that Hold Co might also oversee the group's overall performance and provide strategic advice to the subsidiaries on their businesses and assets so that they are all working towards the same goals and have the same risk exposures. It will also be charging a fee for doing this, with those fees financing Hold Co's own ongoing costs and pay for its time and expertise in overseeing the group's activities.
Laila: The provision of this sort of advice, oversight and risk monitoring for non-resident group companies, falls within the definition of headquartering, which is the third Relevant Activity that could be applicable.
Based on what you've told me, Hold Co is likely to be within scope of Guernsey's substance requirements as a Relevant Activity company, with income that makes it a distribution and service centre and/or income that makes it a headquartering company. Either way, Hold Co will need to meet the substance requirements that apply to that Relevant Activity when it receives income for providing that service in the reporting period.
In theory you will need to keep tabs on what services are provided during the year by Hold Co and the relevant income streams received. However, it's important to note that the legislation and Guidance says that if the distribution and service centre activities are part of the normal headquartering services that the company offers, then you can treat all the services under the classification of headquartering, and vice-a-versa. This is to avoid duplicate reporting. When looking at income streams received by the company, you do not need to worry about what happens at the shareholder level of the corporate trustee, but of course, as the service provider with overall responsibility for the structure in Guernsey, you will want to be sure the company is fully compliant with its tax reporting and substance requirements. In practice, this means that the trustees will need to be aware of the company's activities and income even if it is not required under the terms of the trust to interfere in the company's affairs from a commercial perspective. The trustees will still have a duty to ensure that the company meets all filing and reporting obligations under applicable law.
What are the substance requirements for a Relevant Activity company?
Laila: Whichever Relevant Activity you are reporting upon for Hold Co in any given year, the company must meet the following substance requirements:
- it must be 'directed and managed' in Guernsey;
- it must carry on the core income generating activities (CIGA) in Guernsey in relation to that Relevant Activity; and
- Hold Co must have an adequate level of employees, operating expenditure and physical presence in Guernsey proportionate to the Relevant Activity carried on here.
For the first requirement, the legislation and Guidance sets out the parameters for what needs to be done at company board level to meet this test. Often the trust service provider will provide directors for underlying companies such as Hold Co. In terms of the second requirement, CIGAs are the key essential and valuable activities that generate the income received by Hold Co, whether that is the charge made for processing invoices or the advisers fee for providing advice and monitoring risks of the subsidiaries.
So how does this impact on drawing up my pitch and preparing costings for this potential new business?
Laila: In a pitch it would be a good idea to set out the different levels of functions of the company and the corresponding income streams. At the lowest level this would be simply holding shares in the subsidiaries and receiving dividends in which case it's a pure equity holding company. In the middle there might be processing the invoices for the group – for which it charges at cost. If that is all the company does during the year then it will be classed as a distribution and service centre even if this service is charged at cost. Finally, at the higher end where you are providing management advice and oversight in relation to the group's business and risks, and for which it receives an advisers fee, then it will fall under the classification of headquartering. But remember, if you're also processing invoices at cost, you can report on that activity under headquartering if it is part of the normal services rendered.
So I could layer my estimate to reflect the three different levels of 'busyness' of the company that may be required during the year, depending upon the activities undertaken? And, if the facts turn out to be different from how I set them out on the pitch, at least we will still be able to isolate those additional factors and see how they impact on our costs.
Laila: Yes, that's right. It will help you to keep a track of the company's activities and the corresponding services that you provide to support those activities. Then when you deliver your bills, you will be able to manage your client's expectations and demonstrate what activities were undertaken during the year and how you supported them. And remember, this is in addition to any fees you will be charging for trust administration or for providing the corporate trustee that sits above the company. In fact, having this level of oversight of the company's day-to-day activities could be a helpful tool for the trustees when demonstrating that they meet their fiduciary and regulatory obligations to manage the investments and custody of the trust's assets professionally and competently.
What about the services that we must provide to ensure that the company complies with substance requirements? We plan to hold all board meetings in Guernsey. Will that be sufficient to meet the directed and managed in Guernsey test?
Laila: You don't have to hold all Board Meetings in Guernsey because the legislation builds in flexibility to hold some meetings outside Guernsey. The important thing is that strategic decisions of the company are taken at the meetings held in Guernsey and these board meetings in Guernsey are held with 'adequate frequency'. But this will turn on the facts and could vary from year-to-year.
For example, you could say in the pitch that Hold Co will hold at least one meeting every quarter in Guernsey at which the strategic decisions for the company for that quarter are to be taken, and calculate your estimate on that basis. Then, if additional board meetings are to be held in any one quarter, you could review where and when they are convened in order to keep the balance of strategic decision-making meetings weighted in favour of Guernsey.
If the client is going to provide the directors for Hold Co, will they have to come to Guernsey when they are deciding matters of strategic importance?
Laila: Yes, it would also be a good idea to have on record their CVs so you can demonstrate that they have sufficient knowledge and expertise to discharge their duties at board level. If you are going to provide the directors then you will have to ensure that your directors have sufficient knowledge and expertise to discharge their duties as directors. The type of knowledge and expertise required for the company may well be entirely different from those expected of the trustees who will hold the shares in Hold Co as part of the trust fund.
And don't forget to factor in the secretarial function that all minutes and company records are kept in Guernsey. These are factors that will help you come up with an estimate of costs to meet the directed and managed test in Guernsey.
Similarly, whether you are reporting on the company meeting its substance requirements as a distribution and service centre or a headquartering company, the approach to the CIGAs is the same. Legislation sets out CIGAs for each Relevant Activity, and while you don't have to do all of the CIGAs that are listed, Hold Co must perform in Guernsey the CIGAs that generate the income that it receives. Guidance does allow isolated CIGA decisions to be taken off-island, but only in very, very limited circumstances.
And that's why I need to keep track of the different income streams – whether it’s the invoice processing charges on the one hand or the advisory fees or the other.
Laila: Yes. In very basic terms, for the invoice processing function the invoices should be received in Guernsey checked by staff here and then processed in Guernsey so that they can be paid by the bank. In terms of the providing advice and oversight, these functions should be performed and coordinated from Guernsey, even if board members then go out to visit the subsidiaries to deliver their advice or gather data for review back in Guernsey prior to taking management decisions here.
Given that you cannot tell in advance what will be required in practice, it will probably be best to set out your different hourly rates covering time spent at board level making the CIGA-related decisions as well as the costs at employee level for carrying out CIGA-related activities in Guernsey.
How do I cover the adequacy test for physical presence, employees and expenditure in Guernsey?
Laila: The good news is that the substance regime respects the outsourcing model, which in practice means that, where a Guernsey-based administrator provides appropriate premises and personnel to a company, this makes it easier to evidence that the company meets its substance requirements, in terms of physical presence, employees and expenditure in Guernsey. This is because you can use time recording and IT systems in your own corporate service provider business to demonstrate the resources used in practice for the company.
So in terms of physical presence in Guernsey, this will include keeping a note of time and dates on which board meetings are held in your offices. For employees you should count the number of full time equivalents working a full 35-hour week for the company.
In addition, if you use corporate directors for Hold Co you'll need to have different charge out rates according to the qualifications or experience of the individuals concerned. This is important because the company must show that the level of appropriately qualified employees is adequate for its Relevant Activities. Ultimately, what is regarded as 'adequate' for substance purposes will depend on the facts and the income arising from carrying on the Relevant Activity each year.
I can see that I will need to build some 'wiggle room' into my pitch to cater for additional work that may be required as the year unfolds.
Laila: Yes, and don't forget to factor in the time to hold regular review meetings so you can demonstrate adequate supervision by Hold Co of your outsourced services. This is an important part of ensuring that outsourcing in Guernsey is counted towards the company meeting its substance requirements in Guernsey. This form of oversight is also consistent with the duties of the trustees to ensure that the trust's assets are managed appropriately.
An original version of this article was first published by the Trusts & Estates Law and Tax Journal, November 2020.
© Carey Olsen 2020.