26 February 2019

The real deal: Offshore jurisdictions introduce economic substance requirements

The EU Council required several offshore jurisdictions to introduce by the end of 2018 economic substance requirements for entities that carry on geographically mobile” business activities from their territories (criterion 2.2 jurisdictions). Failure to introduce substance laws in a form acceptable to the EU Council could result in the jurisdiction being placed on the EU Council’s list of non-cooperative jurisdictions for tax purposes, or blacklist. The criterion 2.2 jurisdictions are Anguilla, the Bahamas, Bahrain, Bermuda, the British Virgin Islands, the Cayman Islands, Guernsey, the Isle of Man, Jersey, the Marshall Islands, Turks and Caicos, the United Arab Emirates, and Vanuatu.

Most criterion 2.2 jurisdictions conferred with the EU Council, the OECD’s Global Forum on Harmful Tax Practices, other criterion 2.2 jurisdictions, and their financial services industries when drafting their substance laws. The laws vary slightly by jurisdiction, possibly because of the tight time frame for implementation and the differences between the jurisdictions’ economies, legal frameworks, and understanding of EU Council expectations.

The EU Council is expected to meet early this year to assess the adequacy of each criterion 2.2 jurisdiction’s substance laws, which could prompt amendments to those laws. Many criterion 2.2 jurisdictions have not yet issued related regulations or guidance.

This article outlines:

  • the economic substance requirements and their background;
  • the entities and activities covered;
  • what entities carrying on relevant activities must have in place in the jurisdiction to comply;
  • the enhanced regime applied to entities carrying on “high-risk intellectual property activities”;
  • confidentiality;
  • the relevant reporting, enforcement, and exchange of information requirements; and
  • the transitional provisions.

This article primarily examines the substance requirements introduced by Bermuda’s Economic Substance Act and Regulations, each of which  became operative on December 31, 2018. [i] It also makes observations on differing aspects of major offshore financial centres’ substance laws.


The EU Council has indicated that requiring criterion 2.2 jurisdictions to introduce economic substance laws is intended to prevent international businesses from benefiting from countries’ differing tax laws by artificially transferring profits to jurisdictions that impose little or no income tax.

In 2017 the EU Council’s Code of Conduct Group (CoCG) assessed the tax regimes of 92 countries against its good governance criteria regarding tax transparency, fair taxation, and implementation of measures to combat base erosion and profit shifting. The CoCG acknowledged that most offshore financial centres had cooperated with the assessment and implemented international tax transparency and BEPS measures.

As part of the fair taxation assessment, the CoCG assessed jurisdictions’ low or zero rates of corporate income tax against its criterion 2.2, which states: “The jurisdiction should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction.”

The CoCG expressed concerns that the criterion 2.2 jurisdictions might not impose adequate legal substance requirements on entities doing business in or through them and that their tax regimes were therefore potentially harmful. In late 2017 Bermuda and other criterion 2.2 jurisdictions committed to enact laws by the end of 2018 to address the CoCG’s concerns.


Potentially Covered Entities

The laws introduced by many criterion 2.2 jurisdictions essentially require specific types of entities that are resident in the jurisdiction and carry on relevant activity to satisfy economic substance requirements.

The substance laws primarily target companies. Some jurisdictions, such as the crown dependencies, limit the application of their substance laws to resident companies (not including limited liability companies) that receive gross income from relevant activities. Bermuda’s Economic Substance Act provides that the following entity types are covered if they carry on relevant activity:

  • companies subject to Bermuda’s Companies Act 1981, including overseas companies with a permit to engage in business in Bermuda;
  • LLCs formed under Bermuda’s Limited Liability Company Act 2016; and
  • exempted partnerships, exempted limited partnerships, and overseas partnerships as registered under Bermuda’s partnership laws (if they have elected to have separate legal personality).

In some jurisdictions, such as the Cayman Islands and the British Virgin Islands, overseas companies registered there might be exempt from the economic substance requirements if they can show that they are tax resident in another jurisdiction.

The types of entities targeted by a jurisdiction’s substance laws could depend to some extent (but not exclusively) on the types of entities that can be established under that jurisdiction’s laws. Cayman law does not allow limited partnerships to elect to have separate legal personality. Perhaps as a result, Cayman limited partnerships are not identified as entities covered under the jurisdiction’s substance laws, whereas Cayman limited liability partnerships and LLCs (both of which have separate legal personality under Cayman law) are. Bermudian law does not provide for the formation of LLPs (as distinct from limited partnerships), and its substance laws therefore do not address them.

As a jurisdiction’s laws evolve to provide for the formation of new entity types, consideration may be given to whether those entities should be covered by its substance laws. For example, Jersey only recently enacted laws providing for the formation of LLCs. Some entity types may, by their nature, not be intended or suitable to carry on relevant activities at all, or in a manner the EU Council is concerned with.

Relevant Activity

Under Bermuda’s Economic Substance Act, the term “relevant activity” means carrying on as a business at least one of the following activities:

  • banking;
  • insurance;
  • fund management;
  • financing;
  • leasing;
  • acting as headquarters;
  • shipping;
  • acting as a distribution and service centre;
  • holding IP; and
  • acting as a holding entity.

That list appears materially consistent with  those of other criterion 2.2 jurisdictions, perhaps with the exception of the Cayman Islands, which has excluded the carrying on of “investment fund business” as a relevant activity. Each criterion 2.2 jurisdiction’s substance laws further detail what activities characterize each relevant activity, and they differ slightly in this regard. However, most appear to require that the relevant activity is carried on as a business, which suggests that one-off or occasional transactions, or activities not carried on with a view to profit, might not be in scope.

Economic Substance Requirements

Bermuda’s Economic Substance Act provides that the economic substance requirements are satisfied if:

  • the entity is managed and directed in or from Bermuda;
  • the relevant activity’s core income-generating activities are undertaken in Bermuda;
  • the entity maintains an adequate physical presence in Bermuda;
  • there are adequate full-time employees with suitable qualifications in Bermuda; and
  • adequate operating expenditure relative to the relevant activity is incurred in Bermuda.

Bermuda’s approach appears broadly consistent with that of other criterion 2.2 jurisdictions.

We have developed a tool to help businesses establish if the economic substance requirements apply to specific entities. Launch the Bermuda tool.

Managed or Directed in the Jurisdiction

Regarding whether an entity is managed or directed in or from Bermuda, Bermuda’s Economic Substance Regulations require the entity to provide details regarding:

  • the location of strategic or risk management and operational decision-making, or where the entity’s management meets to make decisions regarding business activities;
  • the presence in Bermuda of an adequate number of senior executives, employees, and other persons who are suitably qualified and responsible for oversight or execution (or both) of the entity’s core income-generating activities; and
  • the location, nature, and frequency of management meetings held in Bermuda relative to the overall number of those meetings.

Bermuda’s approach again appears broadly consistent with that of other jurisdictions, although many place express emphasis on the recording of board minutes to evidence compliance.

Core Income-Generating Activity

Under various jurisdictions’ substance laws, what constitutes core income-generating activity depends on the type of relevant activity being undertaken and the entity’s circumstances. Bermuda’s Economic Substance Regulations outline the core income-generating activities for each relevant activity; there is no one-size-fits-all. Guidance issued by the criterion 2.2 jurisdictions is expected to include examples to demonstrate what constitutes adequate premises, employees, and expenditures. Outsourcing to affiliates or service providers in the jurisdiction may count toward the satisfaction of those requirements.

Requirements Based on Activity

Most jurisdictions’ substance laws provide that “pure equity holding entities” are subject to minimum economic substance requirements as long as they do not carry on any other relevant activities. Under Bermuda’s substance regulations, a pure equity holding entity is an entity that holds only equity participations in one or more entities and earns only passive revenue from dividends, distributions, capital gains, and incidental income.

Many criterion 2.2 jurisdictions’ substance laws provide that entities licensed in the jurisdiction that are subject to existing governance and regulatory requirements there (which are considered substantively equivalent to the new substance requirements) are deemed to comply with economic substance requirements if they comply with those existing requirements. The treatment under Bermuda’s substance laws of banking and insurance businesses licensed in Bermuda exemplifies that approach.

At the other end of the spectrum, most jurisdictions’ substance laws provide that in scope entity types carrying on IP activities are presumed to fail the economic substance requirements. That presumption can typically be rebutted if the entity satisfies enhanced IP economic substance requirements, which essentially involves overcoming an evidential burden to demonstrate that the entity’s revenues from IP activities in the jurisdiction are not derived from merely passively holding IP assets. The evidential burden is more onerous when the entity is engaged in “high-risk IP activities,” such as generating revenue from IP assets in transactions with foreign affiliates.

Annual Reporting

Entities subject to the economic substance requirements must file an annual economic substance report (or declaration, as the case may be) with the relevant authority. Bermuda’s Economic Substance Act requires an annual declaration to be filed with Bermuda’s Registrar of Companies. The relevant government authority will primarily rely on those reports to determine if entities have complied with the economic substance requirements.

Under Bermuda’s Economic Substance Act, annual declarations must include minimum information, including the following regarding the entity’s financial year:

  • whether the entity is carrying on relevant activity and the type of relevant activity undertaken;
  • whether the entity is engaged in high-risk IP activity;
  • the entity’s physical premises in Bermuda;
  • the names and physical addresses of directors (for companies) or equivalent (for other entity types) who are ordinarily resident in Bermuda;
  • the entity’s holding entity, ultimate parent entity, owner, or beneficial owner;
  • the gross income, operating expenses and assets, and number of full-time employees;
  • details of core income-generating activities conducted in Bermuda for the relevant activity;
  • a declaration regarding whether the entity satisfies the economic substance requirements; and
  • such other information as the Registrar may reasonably require.

Bermuda’s Economic Substance Regulations further require entities to provide information demonstrating:

  • the management and direction of the entity in Bermuda;
  • the nature and extent of the relevant activity engaged in by the entity and its core income-generating activities for each relevant activity; and
  • whether employees or persons responsible for the oversight and assessment of the implementation of outsourcing to affiliates or service providers in Bermuda are suitably qualified and able to monitor and control the outsourcing arrangement to ensure the outsourced entity has adequate capacity to execute the outsourcing arrangement.

Other criterion 2.2 jurisdictions’ substance laws also have comprehensive reporting requirements.

Exchange of Information

Bermuda’s Economic Substance Act provides that when an in-scope entity type that carries on a relevant activity in a relevant financial period does not satisfy the economic substance requirements or is engaged in high-risk IP activity, Bermuda’s competent authority must provide information about that entity for that period to the competent authorities of the EU member states in which the holding entity, ultimate parent entity, owner, or beneficial owner of the entity is incorporated, formed, registered, or resident. Some jurisdictions’ substance laws also require information exchange with competent authorities in non-EU jurisdictions where the entity maintains connections - perhaps foreshadowing the OECD’s intention that the requirements take root globally. The competent authorities of the British Virgin Islands and the Cayman Islands, for example, are also required under their respective substance laws to automatically exchange information with foreign jurisdictions where the entity claims to be tax resident.


Each criterion 2.2 jurisdiction’s substance laws provide for the issuance of remediation notices and civil penalties for noncompliance, as well as fines and imprisonment for some offenses, such as knowingly reporting false information. In most jurisdictions, if the entity successfully appeals a determination of noncompliance, the matter may be referred to a court. The substance laws generally give a jurisdiction’s courts wide discretion to make orders regarding noncompliance, such as requiring the entity to take action to satisfy the economic substance requirements, restricting the conduct of the entity’s affairs or business; and ordering that the entity be wound up.

The quantum of fines and penalties may vary slightly between jurisdictions. The British Virgin Islands, for example, impose higher civil penalties on noncompliant entities engaged in high-risk IP activities.


Most criterion 2.2 jurisdictions’ substance laws appear to include provisions addressing confidentiality to various degrees, including:

  • providing that confidentiality obligations are not breached if disclosure is made to comply with, or duly perform functions (for government authorities) under, the substance laws — but otherwise prohibiting disclosure; and
  • precluding disclosure of economic substance information in response to requests for information under a jurisdiction’s public access for information laws.

Commencement and Transition

Each criterion 2.2 jurisdiction’s substance laws apply to financial periods starting on or after January 1, 2019. Entities within scope established on or after that date are generally required to comply with the substance laws on formation or, as in the Cayman Islands, on commencement of relevant activity. Bermuda’s Economic Substance Act includes transitional provisions under which existing entities have a transitional period of six months from the commencement of the Economic Substance Act to comply with the economic substance requirements. Several other criterion 2.2 jurisdictions provide transitional periods for existing entities; however, it is understood that the EU Council will not accept a transitional period longer than six months.


The economic substance requirements could have a material effect on the way entities carry on relevant activities in or through criterion 2.2 jurisdictions. Many entities may find they readily satisfy the requirements, but others might be prompted to restructure to ensure more core income-generating activities occur in the criterion 2.2 jurisdiction, or to wind up their affairs there. Any perceived advantages of a particular criterion 2.2 jurisdiction’s substance laws over another’s might be quickly eradicated by the EU Council’s assessment process if the EU Council perceives that those advantages or inconsistencies conflict with its objectives. The EU Council and OECD clearly want as much uniformity as possible, with a global standard for economic substance being what they ultimately consider ideal.


[i]This article does not detail amendments to Bermuda’s Investment Funds Act 2006 made by the Economic Substance Act, which are primarily intended to keep Bermuda’s investment fund regulatory regime consistent with international standards.


An original version of this article was first published by Tax Notes International, January 2019.

© Carey Olsen 2019.

Carey Olsen Bermuda Limited is a company limited by shares incorporated in Bermuda and approved and recognised under the Bermuda Bar (Professional Companies) Rules 2009. The use of the title “Partner” is merely to denote seniority. Services are provided on the basis of our current terms of business, which can be viewed at: www.careyolsen.com/terms-business.

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