MAY 2020

Economic substanceregulations

Background on Non-IPActivities

Collaborating frim of ANDERSEN GLOBAL

Action 5 of BEPS requires substantial activity not only for IP regimes but for allpreferential regimes. The FHTP has therefore considered the application of thesubstantial activity requirement to other preferential regimes that have been identifiedand reviewed by the FHTP.Because IP regimes are designed to encourage R&D activities and contribute to growthand employment, the principle underlying the substantial activity requirement in thecontext of IP regimes is only to permit taxpayers that did in fact engage in suchactivities and did incur actual expenditures on such activities to benefit from theregimes. In the context of other preferential regimes, the same principle can also beapplied so that such regimes would only be found to meet the substantial activityrequirement if they also granted benefits only to qualifying taxpayers to the extentthose taxpayers undertook the core income generating activities required to producethe type of business income covered by the preferential regime. A brief description of the type of activities that might be required for the differenttypes of preferential regime is set out below.

HEADQUARTERBusiness

Headquarters activities grant preferential tax treatment to taxpayers that providecertain services such as managing, co-ordinating or controlling business activities fora group as a whole or for group members in a specific geographical area. Theseregimes may raise concerns about ring-fencing or because they provide for anartificial definition of the tax base where the profits of an entity are determined basedon a “cost-plus” basis but certain costs are excluded from the basis or particularcircumstances are not taken into account. These features could be addressed by theexisting factors, but these activities raise concerns in respect of substance.

BACKGROUND ON NON-IP ACTIVITIES

INFORMATIONEXCHANGE

The international standard oninformation exchange uponrequest covers not only theexchange of information but alsothe availability of information,including ownership, banking,and account information. Thework on monitoring this standardis carried out by the GlobalForum on Transparency andExchange of Information on TaxPurposes. Under its revisedterms of reference, the GlobalForum has incorporated theprinciples of the Financial ActionTask Force (FATF) standard ofbeneficial ownership and as aresult countries will be assessedon their ability to provideinformation on beneficialownership where relevant andwhere this forms part of arequest for exchange ofinformation.

DISTRIBUTION & SERVICESECTORBusiness

Distribution centre activities provide preferential tax treatment to entities whose mainor only activity is to purchase raw materials and finished products from other groupmembers and re-sell them for a small percentage of profits. Service centre activitiesprovide preferential tax treatment to entities whose main or only activity is to provideservices to other entities of the same group. A concern with such activities is that theymay have ring-fencing features. In addition, they may raise concerns that they permitan artificial definition of the tax base. Although these concerns may be addressedthrough the existing factors, concerns with respect to substance could remain.

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FINANCING/LEASINGBusiness

Financing and leasing activities are activities which provide a preferential taxtreatment to financing and leasing activities. The main concerns underlying theseregimes include, among others, ring-fencing considerations and an artificial definitionof the tax base.

FUND MANAGEMENTBusiness

Fund management activities grant preferential tax treatment to income earned by fundmanagers for the management of funds. In exchange for its services, the fund managerreceives compensation that is computed on the basis of a pre-agreed formula. Thefocus is not the taxation of the income or gains of the fund itself or of the investors ina fund but the income earned by fund managers from the management of the fund.The remuneration of the fund manager and how and where this is taxed may raiseissues of transparency and these could in part be dealt with by the compulsoryspontaneous exchange of rulings.

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BANKING & INSURANCEBusiness

Banking and insurance activities provide preferential tax treatment to banking andinsurance activities. The main concern is linked to the benefits that they provide toincome from foreign activities. If benefits are only provided to foreign income, thenthis could be addressed through the existing ring-fencing factor. In terms ofsubstance, the regulatory environment, where applicable, should already ensure that abusiness is capable of bearing risk and undertaking its activity. However, in thecontext of insurance, it may be more difficult to easily identify those activities thatraise concerns in respect of substance versus those that do not because of thepossibility that risks may have been re-insured.

PREVENTTREATY ABUSE

The result of this Action takesthe form of new model treatyprovisions and recommendationsregarding the design of domesticrules to prevent the granting oftreaty benefits in inappropriatecircumstances. The work doneunder this Action should addressconcerns about the use ofholding companies to receivetreaty benefits.

NEUTRALISETHE EFFECTSOF HYBRIDMISMATCHARRANGEMENT

The result of this Action takesthe form of new model treatyprovisions and recommendationsregarding the design of domesticrules to neutralise the effect ofhybrid instruments and entities.The work done under this Actionhas led to a recommendation todeny a dividend exemption andother types of relief granted torelieve economic double taxationon deductible payments. Thiscould again address some of theconcern that “dividend” incomecan go untaxed.

BACKGROUND ON NON-IP ACTIVITIES

SHIPPINGBusiness

Shipping activities provide a preferential tax treatment to shipping activities and aredesigned taking into considerations significant non-tax considerations. In addition toissues of ring-fencing and transparency, they may also raise concerns under thesubstantial activity analysis where they permit the separation of shipping income fromthe core activities that generate it.

HOLDING COMPANYBusiness

those that provide benefits to companies that hold a variety of assets and earndifferent types of income (e.g. interest, rents, and royalties) and those that apply only to companies that hold equity participations and earn onlydividends and capital gains.

Holding company activity can be broadly divided into two categories: 1.

2.

In the context of (1) above, to the extent that holding company activity providebenefits to companies that earn income other than dividends and capital gains, thesubstantial activity requirement should require qualifying taxpayers to have engaged inthe core activities associated with those types of income. Holding companies that fall within category (2) above and that provide benefits only todividends and capital gains, however, raise different policy considerations than otherpreferential regimes in that they primarily focus on alleviating economic doubletaxation. They therefore may not in fact require much substance in order to exercisetheir main activity of holding and managing equity participations. These regimes could,however, raise policy concerns that are not directly related to substance. Concerns include whether holding companies enable the payer and payee to benefitfrom treaty benefits in circumstances that would not otherwise qualify for benefitsand whether holding company regimes are ring-fenced. Some of these concerns mayalready be addressed in other work or under other existing factors. For instance:

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RING FENCING

If countries are concerned thatequity holding companies areproviding benefits to income onlyfrom foreign companies and thatthis income is not already taxedanywhere or the regime isotherwise targeting foreigninvestors, this concern is alreadyaddressed under the existingring-fencing factor.

OTHERMEASURES

Such as the work done underAction 3 of the BEPS Action Planto strengthen controlled foreigncompany (CFC) rules.

BACKGROUND ON NON-IP ACTIVITIES

Anurag ChaturvediCEOE: anurag@charteredhouse.aeM: +971 558860948

Kanika DusejaManagerE: kanika.d@charteredhouse.aeM: +971 555867304

Chartered HouseTax Consultancy

Office#1711 The Metropolis TowerBusiness Bay, Dubai, U.A.E. T: +97142435666E: info@charteredhouse.aeW: www.charteredhouse.ae

Collaborating firm of ANDERSEN GLOBAL

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Disclaimer: Please note that Chartered House Tax Consultancy’s views are not binding on any authority or Court, and hence, no assurance is given that a position contrary to the opinionsexpressed herein will not be asserted by any authority and/or sustained by an appellate authority or a Court of law. Our view herein is based on our understanding of the factsprovided within the clarification. Further, unless specifically requested and agreed, we are not obligated to update the suggestions made herein for subsequent changes ormodifications to the law, to the rules/ regulations, or to the judicial and administrative interpretations thereof.