How to Get It Right on Business Substance?

NOV 16, 2018

How to Get It Right on Business Substance?

The concept of business substance has become very important today, than any other time in history. However, this concept is often shrewd in controversy. The recent proclamation by the EU that companies in zero tax territories will need to demonstrate substance or attract severe penalties has jolted investors and entrepreneurs to refocusing on this crucial component.


What exactly is business substance?

Business substance (also called economic substance) is the economic reality of an enterprise to avoid high tax burden on its operations and related tax challenges resulting from many tax authorities.

The focus is on ensuring that a business is providing economic substance in line with its status, operation, and profits. The concept is aimed at preventing businesses that need protection from tax burden taking undue advantage over others even after growing in profitability.

Why is business substance important?

Starting from 2016, many banks and tax authorities began requiring companies to demonstrate substance. Under the latest OECD action plan targeting Base Erosion and Profit Shifting (BEPS), firms and transaction have fallen under serious threat of missing substance.

Today, there are many enterprises with structures that feature double tax where no taxes are levied on international transactions.

BEPS targets to prevent abuse of the treaty benefits when multinationals with structures that are only crafted to enjoy benefits that come with DTAs (double tax arrangements).

BEPS utilizes different tools including the following to ensure that the treaty is not abused:

  • Substance requirements to facilitate benefits under DTAs.
  • Anti-abuse regulation in different DTAs.
  • Installation of anti-abuse tools in respective home countries.
  • Controlled Foreign Company (CFC) rules.

The target of all the economic substance measures is to enhance genuine business operations of the company structures and its transactions. When a company misses substance, it risks severe penalties or even getting blocked from the market.

What are the dangers of missing business substance?

Businesses and transactions that do not demonstrate tax substance are at risk of getting slapped with the following penalties:

  • Missing on various tax deductions.
  • Double taxation.
  • Court battles and severe penalties.
  • Controlled Foreign Company (CFC) rules.

What is the correct level of business economic substance?

Demonstrating the correct level of business substance is dependent on size as well as underlying transactions. Therefore, you need to review the business structure and its operations to be able to reach the right level of substance. Here are some red flags you need to know.
  • The director lacks ample qualifications to run the business operations, and the working is not commensurate to a reasonable workload.
  • The business has missing tools such as phone lines and computers in the balance sheet. This is considered a fake substance approach.
  • The business and location transaction types are not matching where the aim of the company is tax based and not related to the added value.

The primary goal of business substance is ensuring that enterprises and their transactions are genuinely reflected so that tax benefits are enjoyed as a side effect as opposed to being the core goal of the company structure.

Indeed, an artificial economic substance is not a reason enough for company protection from tax authorities. The recent adoption of common reporting standards (CRS) and the implementation of The Foreign Account Tax Compliance Act (FATCA) took away the bank privacy that companies and individual enjoyed previously. Now, the business planning structures are easily exposed.

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Requirement for Tax Substance in Tax Planning Designs

Oct 28, 2018

Requirement for Tax Substance in Tax Planning Designs

The concept of substance over the legal form has become crucial in the rightful representation as well as the reliability of info captured in financial statements. The main goal of the concept is ensuring that all business transactions are presented in a manner that demonstrates the real position of the business.

This post demonstrates how the principle applies outside the focus of financial statements. In particular, it looks at how it affects the larger tax planning community.

A closer look at the concept of substance over the legal form

The concept, substance over the legal form enables the tax authorities to set aside the legal form of a business and take a glance at what actually took place in transactions. The aim is preventing the artificial structure from abuse especially through tax avoidance.

For any company to enjoy a beneficial tax regime (jurisdiction with lower tax rates), it is required to comply with tax substance requirements set by the tax authorities. These requirements often vary from one country to another. Here is an outline of these requirements;

  • The substance of the business structure includes things such as location (physical presence) and presence of all the operational components such as staff, assets, and directors.
  • The substance of the business transactions revolves around the nature and where the transactions were done. It also seeks to answer the question, “How does the party benefit?”

A glance at the tax rulings in the Netherlands

The Netherlands, one of the countries with a very advanced mechanism of real substance identification uses a system referred to as tax rulings. The tax ruling is a confirmation from the tax authorities that allow business owners to establish well in advance the tax burden, their rights, and duties in various circumstances.

The tax ruling framework uses two types of agreements from the tax authorities; the advance tax ruling and advance pricing agreement.

  • The advance tax ruling is an agreement based on the Dutch tax system classification of international businesses based on the applicability of participation exemption as well a permanent establishment.
  • The advance pricing agreement is an agreement that approves the determination of the method of calculating profit in relation to cross-border transactions between a company and foreign establishments.

In order for a tax ruling to be issued, the tax authorities must ensure that the cross-border transactions where a Dutch company is a party actually took place. Here are the requirements for tax substance.

  • Half of the company’s managing directors reside in the Netherlands.
  • Managing director resides in the Netherlands and is qualified for the position.
  • The company has salaried employees.
  • The company has running bank accounts in the Netherlands.
  • Bookkeeping is done in the Netherlands.
  • The company has met all fiscal obligations.

Steps to make your company demonstrate substance

Having looked at the case of the Netherlands, the main question remains, how can you demonstrate substance in your situation? Like in the Netherlands, the concept of substance is tailor-made. This implies that any attempt to generalize the books or presentation will not work.

The target for your business should be redefining your operational goals and make the operations open. Here are some of the ready solutions to help you demonstrate substance:

  • Always seek a tax opinion about transactions and the entire concept of tax substance in relation to your enterprise.
  • Make sure to follow proportionality when distributing the business functions, losses, profits, and assets.
  • Ensure to maintain a functional office with all the functions such as staff and assets.
  • Keep the business records well and continuously develop the company.
  • Comply with all the tax and other laws in the country of operations.

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