Hong Kong SAR's economic substance requirements for offshore jurisdictions

As many corporate groups comprise a large number of companies incorporated in offshore jurisdictions, this is potentially a game changer for groups operating in Asia, especially with respect to their approach in using, managing and operating offshore companies going forward.

The new laws essentially require all entities that fall within the regime to maintain a level of operational substance that is commensurate with the income generating activities of that entity.

Effective from January 1 2019, the laws applying to the Cayman Islands, BVI and Bermuda will apply to entities that are conducting "relevant activities". Such activities are broadly defined to include a wide range of businesses including: banking, insurance, fund management, finance and leasing, distribution and service centre business, headquarter businesses, intellectual property businesses, shipping, and holding company businesses.

There is likely to be a reduced level of substance requirements for a pure investment holding company, but this will be subject to further guidance. There are some important carve-outs for certain companies in jurisdictions. such as the Cayman Islands and the BVI where the entity is a tax resident elsewhere. Furthermore, in the Cayman Islands, investment funds and their investment holdings are specifically excluded.

The objective of these laws is to ensure that the substantive operations at the local entity level are commensurate with the profit generating activities carried out by the entity. However, there remains a level of uncertainty and ambiguity over the application of the new substance rules in practice, and the level of substance that will be needed to satisfy compliance with the rules.

The Cayman Islands issued its guidelines on February 22 2019. However, it is understood that an update to the guidance will be issued in the near future, and it is hoped that greater clarity will be provided around:

• The level of substance requirements regarding the income derived from the relevant activity carried out in the Cayman Islands;

• The necessary amount of operating expenditure that must be incurred in the Cayman Islands;

• What is considered a sufficient physical presence (including maintaining a place of business or plant, property and equipment) in the Cayman Islands;

• The number of full-time employees or other personnel with appropriate qualifications needed in the Cayman Islands; and

• Whether outsourcing of "core income-generating activities" within the jurisdiction is permitted and can count towards satisfying the substance requirements, provided the entity can monitor and control the carrying out of that activity by any delegate.

Generally speaking and subject to local variation, existing companies at December 31 2018 will have a six-month transition period (i.e. until July 1 2019) to comply with the new rules. For companies established on or after January 1 2019, substance requirements need to be satisfied from the time they provide the relevant activities.

In some cases, there will also be annual reporting obligations to the local tax authorities with respect to compliance with the new rules. In addition, penalties for failing to satisfy the requirements may be imposed and other sanctions such as entities potentially being struck off local registers may arise.

Many organisations use these offshore jurisdictions within their group holding and operating structures. The laws will require such organisations to review their entities to evaluate whether or not they will need to comply, or be carved out and exempted from the new substance requirements.

Furthermore, if they need to comply, a determination of the level of additional substance required will need to be evaluated.

This presents another challenge for these offshore jurisdictions following broader scrutiny by the EU and the OECD through their tax transparency related initiatives.

Amongst these, country-by-country reporting is now starting to be reviewed by tax authorities, and groups with significant assets or income in entities in jurisdictions with little or no substance and tax paid currently will likely be a particular focus area.