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Island faces ‘substance’ challenge

Bermuda's insurance and banking industries have little to fear from imminent legislation to address European concerns over “economic substance”.

That is the view of Christian Luthi, chairman of international law firm Conyers Dill and Pearman, who is confident the island can adapt to the upcoming new rules.

However, another source, a retired industry veteran who asked not to be named, believed that many of the island's captive insurers could struggle to meet the substance test.

The Bermuda Government has committed to enacting new laws by the end of this year to keep Bermuda off the European Union's list of noncooperative jurisdictions.

The object is to end the practice of international companies cutting their onshore tax bills by diverting profits to offshore entities that lack economic substance.

Mr Luthi said that Conyers was one of the industry stakeholders to have worked closely with the Bermuda Government over the past year on developing draft legislation.

“Many Bermuda entities already meet the requirements,” Mr Luthi said. “Indeed, for certain of our key industries such as insurance and banking, the EU has expressly recognised the substantive nature of those industries in Bermuda.

“It is expected that, for such entities, compliance with their existing regulatory requirements will be deemed to satisfy the new economic substance regime.”

Bermuda has only four banks, all of which provide services to residents and employ local people.

Most of the island's international insurance and reinsurance companies can also point to their local staffs, including executives and underwriters, and locally held board meetings as evidence of “substance”.

However, the substance argument may be more difficult to make in the case of captive insurers, according to a source who worked in the industry for more than four decades.

Captives insure the risks of their parent corporations and some write third-party business as well. Hundreds of captives are domiciled here and are overseen by captive management companies.

“The captive managers do not make underwriting decisions — in my experience, the premiums are decided by the captive owners,” the source said. “And I'm not aware of any captives that have claims teams here.”

Bermuda's legislation will be based largely on the European Code of Conduct Group's scoping paper on economic substance, published in June this year. The paper referred to “intragroup captive insurance” as an activity “likely to need further analysis”.

However, the bulk of the island's captive business is focused on North America and for many of these, tax avoidance is not a charge that can be levelled at them.

As Mike Parrish, head of business development for Marsh Management Services Bermuda, said during a captive-focused session at last month's Bermuda Executive Forum event in London, most captives take the 953(d) tax election, meaning their companies are subject to US taxation.

Subsidiaries of multinational corporations who employ no one, conduct few economic activities on the island and book significant profits derived from sales elsewhere are the real targets of the EU. Many such entities exist in Bermuda.

They contribute significantly to the island's prosperity, according to Bob Richards, the former finance minister.

“While such companies may not directly and individually employ people in Bermuda, collectively, the administration of such companies does indeed employ many, many Bermudians and results in the collection of millions of dollars of tax revenues by the Bermuda Government,” Mr Richards wrote in an op-ed in The Royal Gazette in June this year.

Although the substance requirements are a European initiative, they are set to become a global standard, as the Organisation for Economic Co-operation and Development has stated that its Forum on Harmful Tax Practices will eventually replace the EU's “2.2 substance regime”.

Mr Luthi said Conyers was one of many stakeholders to have helped the Government to balance addressing EU concerns with Bermuda's economic interests within the new rules.

“Conyers has been working closely with Government over the past year, as part of a focused consultation group tasked with developing draft economic substance legislation,” Mr Luthi said.

“A great deal of time and thought has been put in by Government and industry to ensure that the new law and regulations meet EU and global requirements, while protecting Bermuda's interests and ensuring our business model remains competitive.

“While this is a significant change that will affect a number of Bermuda-domiciled entities, it is important to view the legislation in its global context.

“The EU substance requirements — soon to be a global OECD standard — apply to all offshore jurisdictions. The Channel Islands, Cayman Islands, BVI and many others are all in the process now of tabling materially similar legislation, with the expectation for all such jurisdictions that the legislation will be in place by the end of this year.”

David Burt, the Premier, has argued that the legislation is necessary for Bermuda to continue to meet global standards and added that it will be tabled in the ongoing parliamentary session.

Mr Luthi said that the impact of the changes may not be all bad for Bermuda.

“Bermuda and its business community have a long history of adapting to change and making the most of any opportunities it affords,” Mr Luthi said.

“As a strong and transparent jurisdiction, we are confident that Bermuda is well placed to manage the introduction of substance requirements.

“At Conyers, we have already informed our clients of the pending changes with regard to substance requirements. We continue to be available to help them understand the requirements and meet their obligations.”

The legislation is likely to add regulatory burdens and costs, for both companies whose substance will be monitored, and whatever public-sector entity has the responsibility of doing the monitoring.

Some have noted the lack of specifics in the requirements in the EU scoping paper, which, for example requires “an adequate number of employees with necessary qualifications and an adequate amount of operating expenditure with regard to the core income-generating activities”.

There will undoubtedly be differences of opinion over what constitutes “adequate” for different companies and different sectors, raising the possibility of legal challenges.

“One problem is that the requirements are vague, but there is no independent system to rule on whether jurisdictions have complied,” Richard Teather, a tax policy consultant who advised Jersey on its “substance” legislation, wrote in the Cayman Financial Review.

“The sole arbiter is the EU Code of Conduct Group, and if it decides that a jurisdiction is not demonstrating sufficient commitment to economic substance — in its laws, its enforcement and its reporting — then that jurisdiction can be placed on the blacklist.”

He did not expect the substance rules to have the EU's desired effect.

“Studies into the reaction of businesses and investors to these requirements have found that, rather than moving operations back to high-tax countries and facing ever-increasing tax bills, they will do the opposite and move more of their actual activities to low-tax locations, to make it easier to demonstrate economic substance there,” Mr Teather said.

“This will be a huge problem for the European Union, because when those economic activities are moved out, they do not only lose corporation tax, but they lose jobs, income and employee taxes as well.”

We can adapt: Christian Luthi, chairman of law firm Conyers

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Published December 06, 2018 at 8:00 am (Updated December 06, 2018 at 8:19 am)

Island faces ‘substance’ challenge

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