BVI economic substance: Takeaways from the first economic substance reporting period

For many companies incorporated in the British Virgin Islands (BVI), the first deadline for reporting on economic substance compliance was 29 December 2020.[1] Indeed, Carey Olsen has advised numerous businesses in APAC on compliance with the BVI ES requirements and assisted them with reporting to the BVI International Tax Authority (ITA). 

Classification

The classification exercise determines whether a BVI legal entity (e.g. a company) is 'in scope' for the purposes of the relevant ES requirements and needs to be made with a detailed understanding of all the activities carried out by the BVI company.

Where a BVI company is (as is often the case) part of a larger corporate group, the activities of the group and the role of the BVI company within the group need to be fully understood in order to correctly classify the BVI company for ES purposes.

The BVI ES regime has particular nuances that need to be understood to ensure that the entity is correctly classified and that only the ES requirements to which it is actually subject are compiled with. A good example of this is the reduced ES test that will apply to a 'pure equity holding entity' (being a legal entity that only holds equity participations in other entities and only earns dividends and capital gains). In some cases the reduced ES test may be satisfied by retaining a registered agent and registered office in BVI. If an entity holds other assets (e.g. real estate) it will not be a 'pure equity holding entity' and will either fall outside the ES requirements entirely or within one of the other categories of business subject to ES requirements.

Once a business has been classified, it will either be 'in scope' or 'out of scope'. If 'out of scope', nothing further needs to be done (other than to report as such to the ITA). If in-scope, the next step involves consideration of the ES requirements applicable to that type of business and how to comply with such requirements.  

Various corporate and legal service providers in the market offer a classification service. However, classification of a business is only the first step towards compliance. A number of businesses approached us having received a classification from their registered office provider or advisor, but who were unsure as to the further steps to be taken to establish and maintain compliance (as to which see below).

Advice

Once a BVI company had been classified and determined to be in-scope, it was necessary to consider the level of ES required to be demonstrated in the BVI (in terms of employees, expenditure and premises) for that particular business over the financial period in question (which for companies subject to the reporting deadline of 29 December 2020, was 30 June 2019 to 29 June 2020).  

As the level of substance is different for every business (it will vary according to the type of business carried on and, in some cases, the level of income derived from that business) each business needs to be considered on a case by case basis.

BVI companies are extremely popular in APAC and are widely used for commercial purposes as diverse as real estate holding, personal investment, asset finance and leasing and as funding vehicles for onshore businesses. We found that clients saw significant value in having a reasoned legal opinion from BVI lawyers outlining the applicable requirements for their individual business and, where relevant, providing a risk assessment of any compliance issues and offering solutions for remediation. 

Having advice on file also provides comfort for directors and other stakeholders who are required to make certain declarations to the ITA via an ES reporting form. It also positions those businesses to demonstrate that they have considered and taken advice on their applicable ES obligations.

Structuring and restructuring

The deadline has firmly focused the market on compliance with ES requirements and the implications of non-compliance (for in-scope businesses and also parties contracting with them). 

In our corporate transactional practice, we have noticed that parties are increasingly considering the implications of ES requirements on new and existing transaction structures. This is understandable given the potential penalties for non-compliance described below. 

Where a corporate or finance transaction involves BVI companies, it is sensible to examine the proposed structure and funds flow to anticipate and address any ES considerations early on.

For some businesses, an orderly unwind of certain in-scope activities (for example, assigning loan receivables from a BVI entity to an onshore group member) while continuing with other activities (e.g. real property holding or capital raising, both of which are often out of scope) can be considered.  

For other businesses, outsourcing certain business activities within the BVI or putting local management in place may represent a path to compliance. 

Outsourcing is expressly permitted under the BVI ES regime subject to certain requirements, including the requirement that core income-generating activity (CIGA), if outsourced, can only be outsourced within the BVI. So, for example, a BVI-based finance and leasing business could outsource outside the BVI non-CIGA such as HR or payroll support, but its CIGA (which for a finance and leasing business includes activities such as agreeing funding terms and managing any risks) may only be outsourced to a provider whose own employees work in BVI.

Outsourcing which meets the above requirements can be taken into account in demonstrating substance in BVI (in terms of adequate expenditure, employees and premises). Engaging a BVI-based accountant, director and other outsourced business services can therefore assist to demonstrate substance (and accordingly compliance) for the purposes of the BVI ES regime.  

Enforcement risk and mitigation

Businesses are understandably concerned to understand the risk in the case of any potential non-compliance.   

As enforcement of the BVI ES regime is untested, it remains to be seen the approach the ITA will take in practice. The Organisation for Economic Co-operation and Development (OECD), whose base erosion and profit shifting (BEPS) framework provided the impetus for ES rules in BVI and elsewhere will be keen to see robust enforcement. 

What is also clear is that the BVI authorities will be dealing with an unprecedented number of ES reports in early 2021. The fine for a first breach of ES requirements is a minimum US$5,000. A determination of non-compliance by the ITA is appealable and must explain the reasons for the determination. Further (increased) fines and, ultimately, striking-off from the register of companies (or partnerships as the case may be) can follow as a result of continued non-compliance. 

ES compliance is an ongoing requirement (BVI companies subject to the 29 December 2020 deadline are currently midway through their second financial period of 30 June 2020 to 29 June 2021 and will be required to report for the second financial period on or before 29 December 2021). As the activities of a business change over the financial period, the applicable ES requirements also change. 

Having regularly updated legal advice on file will assist businesses to manage risk and to show that they are considering and actively managing their ES compliance in BVI. For new transactions and business structures involving BVI companies, considering and addressing ES requirements early on should become a matter of course

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An original version of this article was first published in Asia Business Law Journal, March 2021.