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04 September 2020

18 months on: A review of the economic substance rules

Reshentha Beeby,
Associate Director

What have economic substance regulations achieved since their introduction? Reshentha Beeby, Associate Director, Private Equity (Jersey) explains how the legislation has been a welcome development for offshore entities by codifying the already strong standards of offshore corporate governance, and helping many companies systemise how they operate at board level.

The introduction of substance rules

The Economic Substance legislation was introduced by the Crown Dependencies and Overseas Territories on 1 January 2019. This prompted resident “in scope” companies to examine their day-to-day activities and governance in relevant jurisdictions, with an emphasis on ensuring compliance with the new regulations and further enhancing well-ingrained business practices.

The substance requirements

Broadly speaking, economic substance requirements will be met if an “in scope” entity can demonstrate:

  • It is being directed and managed in the relevant jurisdiction;
  • It has adequate qualified people, premises and expenditure in the relevant jurisdiction; and
  • It conducts Core Income Generating Activities (CIGA) in the relevant jurisdiction,
    collectively (the “Requirements”).

We have previously published detailed comment on all substance requirements, which can be read in last year’s summary write-up and comprehensive Q&A document.

Below, we’ve re-visited each of the requirements, summarising the details and reflecting on our observations from 18 months working in line with the regulations.

The requirement to be directed and managed in the relevant jurisdiction

The new rules prompted a review of board compositions, leading us to also review the physical presence of boards for board meetings, ensuring this first requirement could be met. We have found that many client boards required no changes, as firstly, non-local directors would travel to the relevant jurisdiction for board meetings and, secondly, boards were made up of locally appointed, highly experienced non-executive directors (NEDs) and / or directors from local service providers.

Our observations

Where changes have been viewed as necessary, some of the steps taken have included:

  • The appointment of new directors from the relevant jurisdiction, thereby creating a majority;
  • The appointment of alternate directors, who can step into a director’s shoes and attend the board meetings on their behalf (however, it is worth remembering that to meet the requirements, the alternate director has to be considered as someone with enough knowledge and experience to comfortably make decisions on behalf of the director they stand in for); and
  • The delegation of CIGA decision-making powers to newly constituted committees, typically located in the relevant jurisdiction or with the ability to travel at short notice.

It is worth adding that there is some flexibility to allow for urgent strategic decisions to be made without a board majority in the relevant jurisdiction, for example where face to face negotiations might be vital to a successful outcome.

The requirement to have adequate qualified people, premises, and expenditure in the relevant jurisdiction

I will look at each of these areas separately but, firstly, by way of a reminder: the term “adequate” has not been defined in the substance requirements. We therefore refer to the dictionary definition, which tells us “adequate” means “enough or satisfactory for a particular purpose”. When using this definition in the context of the substance rules, it really comes down to the board considering the relevant activities that the entity undertakes and taking a view. It is also worth noting that there were already stringent regulatory requirements covering entities undertaking a number of the relevant activities, which meant an overlap with the substance requirements.

Let’s now move to an overview of the three specific areas that need to be met:

  1. Adequate qualified people
    When considering the number of employees, this includes all directors and employees, as well as individuals that work on an entity via a service provider. The guidance is clear that there must be no double counting, so careful analysis of the numbers is key. When we consider the level of qualifications required, this depends on the relevant activity undertaken, the CIGA undertaken in the jurisdiction, and the duties performed by those employees.
  2. Adequate premises
    It is helpful that the rules permit the offices of an appointed service provider to be included. Alternatively, the board would need to consider which premises the employees work from (based on that number being “adequate”) and be comfortable they are also adequately qualified (see the above definition).
  3. Adequate expenditure
    This needs to be proportionate to the level of activity undertaken in the jurisdiction.

Our observations

Certainly, where there is an appointed service provider, we have not seen any potential issues with meeting these three requirements. Noting the age of the industry in our relevant jurisdictions, this means there are suitably experienced NEDs / directors sitting on the boards, service providers have adequate premises and experienced employees, and existing regulatory requirements are being adhered to – all of which can give boards comfort that certain aspects can be deemed “adequate”.

The requirement to conduct CIGA in the relevant jurisdiction

For each of the relevant activities, the types of CIGA are explained in detail in the legislation and supporting guidance notes.  It is important to remember that an entity can be conducting more than one relevant activity, so CIGA for all must be considered.

Our observations

To ensure that CIGA is conducted in relevant jurisdictions, we have seen increased planning around which board decisions need to be made during a fund’s lifetime, and whether those decisions should be categorised as CIGA decisions.

Clearly, the legislation never intended to impact the successful outcome of investments and, as noted above, there is flexibility to have some CIGA decisions taken out of the jurisdiction. With this in mind, we have been supporting client boards with the planning and scoping out of the types of decisions taken during the life of fund. We have then been able to determine the best framework to make these decisions in respect of the board composition.

Our role as an administrator has also seen us supporting with the enhancement of entities’ governance frameworks. This has involved existing minute logs being rebranded as substance registers, in order to capture all the information required for easy extraction and for inclusion in the annual tax return.

Examples

To bring the regulations to life, we have detailed a of scenarios worked on during the last 18 months:

Example 1

Entity details prior to substance rules
The board was made up of one Jersey-based NED, one Jersey service provider appointed director, one UK director and one EU-based director. Meetings were always held in Jersey, with all directors only attending quarterly meetings in person, to consider the fund reports and any investment decisions at that time. Other meetings held, including those for investment decisions, were typically telephone meetings.

Post Substance legislation
Changes have been made. A new Jersey NED was added to the board and suitably qualified Jersey alternates were appointed by the UK and EU directors. This has ensured a majority can be present in the resident jurisdiction.

Example 2

Monitoring prior to substance rules
Various information related to each board meeting held was maintained in a minute log, essentially to track dates of meetings, directors in attendance, a summary of agenda items and sometimes to include matters arising and a summary of related actions.

Post Substance legislation
In view of the requirement to track a lot more information for inclusion in an “in scope” entity’s tax return, the minute log was adapted to become a “substance register” to also track when and where CIGA decisions were considered, the physical location of each director in attendance, duration of the meeting and confirmation of qualification to ensure the board are suitably qualified in relation to the relevant activity. This allows for the easy extraction of the required information without any burdensome additional steps to existing processes.

Relaxation of the substance rules in a time of crisis

Of course, the coronavirus pandemic has created a level of disruption that no-one could have imagined just a few months ago. Fortunately, regulators have responded to this crisis with a reassuring amount of practical flexibility. Back in March, Guernsey and Jersey communicated that they would be taking a “pragmatic approach” in applying economic substance regulation for the foreseeable future, including the announcement that board meetings would not have to be attended in person, and could be attended via conference call or video conferencing. The relaxation of regulations extends to location only as there is still the expectation for companies to conduct the rest of their affairs in line with existing procedures still exists.

Overall, it is encouraging to see regulators evolve existing rules to suit changing circumstances, while helping to ensure boards can continue to function. However, we do expect the relaxation of the application of economic substance rules to be temporary.

So, what next?

With all the analysis completed and changes to the board composition and governance framework fully effected, boards of “in scope” entities are operating smoothly. Our focus is now on the extrapolation of the relevant data in order to be added to the tax returns, as these returns have seen a significant amount of change for “in scope” entities. This being the first year of returns for substance-impacted entities, careful attention is being paid to the process, ensuring utmost accuracy and no double counting. However, with all the data readily available and the latest technology at our fingertips, we do not envisage any issues.

We may also see new guidance issued over time and therefore we continue to have ongoing dialogue with ‘Big Four’ accountancy firms, and the industry in general.

Conclusion

The introduction of this legislation has not caused any serious concerns, as the intention of the substance requirements was to codify existing good practice. With careful planning and attention to detail, we have been able to make minor changes to board compositions and update relevant entities’ existing governance frameworks. Now it is back to business as usual.

Ultimately, the regulations have had a positive effect. Substance requirements have only helped to reinforce strong corporate governance already in place, further enhancing the reputation of the relevant jurisdictions in which we operate.


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