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.

business

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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