Do Economic Substance rules apply to Private Trust Companies?
An overview of the potential application of economic substance laws to private trust company structures
Although the economic substance laws are not enacted under UK law, they are present in various jurisdictions that are highly relevant in the private wealth space, including the British Virgin Islands, the Cayman Islands and the Crown Dependencies, all of which are commonly used in private trust company (PTC) structuring.
Many advisors are aware that the economic substance rules do not apply to trusts, but can economic substance principles apply to PTC structures? This article will discuss several scenarios where the directors of PTCs will need to be aware of the potential application of economic substance laws to the various entities administered and owned as part of a PTC, as well as some of the more common issues arising since the enactment of economic substance laws, in the context of their application to PTCs.
How PTCs may be relevant or legal entities
Economic substance laws are regulations that require ‘relevant entities’ carrying on ‘relevant activities’ to show economic substance in their jurisdiction of incorporation. A private trust company (PTC) may be structured to include a mix of both incorporated and non-incorporated vehicles – such as companies, trusts (charitable, purpose and discretionary) and foundations – so it is quite conceivable that more than one vehicle may be conducting a relevant activity.
Jurisdictions such as Singapore, the Crown Dependencies and parts of the Caribbean allow PTCs by law. However, not all of these jurisdictions have enacted economic substance laws. A PTC set up and administered in Singapore, for example, is not currently subject to economic substance rules.
A company incorporated in any one of the jurisdictions currently enacting economic substance laws will usually meet the threshold test of being a relevant entity – called a ‘legal entity’ under British Virgin Islands (BVI) economic substance law.
For example, in the case of the BVI, a PTC will be a legal entity if it is:
- a company or limited partnership, where company is defined as: (a) a company within the meaning of s.3(1) of the Business Companies Act, 2004; (b) a foreign company within the meaning of s.3(2) of the Business Companies Act, 2004 that is registered under Part XI of that Act;(1) and
- not resident for tax purposes outside of the BVI.
Note that a claim to the BVI’s International Tax Authority (ITA) with supporting evidence must be made to that effect.(2) Examples of the ‘supporting evidence’ required were later clarified by Rule 3 of the BVI economic substance rules published in February 2020, which notes the following:
‘Evidence which the ITA will accept to support the claim in rule 2 includes:
(a) a letter or certificate from, or issued by, the competent authority for the jurisdiction in question stating that the entity is considered to be resident for tax purposes in that jurisdiction, or
(b) an assessment to tax on the entity, a confirmation of self‑assessment to tax, a tax demand, evidence of payment of tax, or any other document, issued by the competent authority for the jurisdiction in question.’
COVID-19 has had an impact on how PTCs make decisions. In the past, it was common for the board to meet regularly in the jurisdiction of the PTC, but this may no longer be possible. An interesting feature of any PTC board is that most will be populated by a mix of family members, advisors and external service providers. Issues may now arise where the family and the professional board members reside in different jurisdictions and attend board meetings via teleconference. This may give rise to tax residence in another country and can have wide-ranging consequences: a BVI PTC that is resident for tax purposes outside of the BVI will not meet the legal entity definition for BVI economic substance purposes.
‘Issues may now arise where the family and the professional board members reside in different jurisdictions and attend board meetings via teleconference’
Relevant Activities of a PTC
In addition to acting as trustee, a PTC will own shares in one or more underlying companies and, in some cases, may finance group activities. The activities carried out by the PTC will therefore usually lend themselves to the relevant activity of either a ‘holding company business’ or ‘finance and leasing’. The question then is whether the PTC is doing enough to fall within the specific relevant activity.
For example, a BVI-incorporated PTC will be carrying on the relevant activity of a holding company business if it is in the business of being a ‘pure equity holding entity’, where pure equity holding entity is defined as a legal entity that only holds equity participations in other entities and only earns dividends and capital gains. In comparison, although a Guernsey-incorporated PTC will be carrying on a holding company business(3), the economic substance guidance of the Crown Dependencies implies that PTCs will not be carrying out holding company business, as the PTC is not the beneficial owner of the assets but rather functions as a trustee for one or more trusts.(4) The guidance does note, however, that the company should consider whether it carries on any other relevant activities for its own account, not acting as trustee.
Financing and Leasing
In the BVI, a PTC will be carrying on the activity of financing and leasing if it is in the business of providing credit facilities of any kind for consideration,(5) such as serving a treasury function or providing loans to other entities within the structure. This is similar across the relevant jurisdictions.
Acting as a Trustee
The business of acting as a trustee is not usually caught by economic substance rules. However, in light of the various economic substance law developments we have seen in many jurisdictions (such as the BVI and the Crown Dependencies’ recent amendments to include partnerships without legal personality in the scope of entities caught by economic substance rules, which were previously out of scope), intermediaries, whether
advisors or trustees, need to be prepared to adapt as rules change. Over time, it is likely that the scope of the economic substance rules will continue to change or widen.
Other entities in a PTC Structure
Figure 1 gives an example of a typical PTC structure and possible entities in this type of structure, several of which could be holding companies.
If the primary function of the entity is to hold equity participations, which are controlling stakes in other companies, and it has no other assets, then the entity is likely to be conducting the relevant activity of being a holding company and will be subject to the (reduced) economic substance test in its jurisdiction of incorporation. Jersey Co. 1 is the sole shareholder of Jersey Co. 2 and it has no other assets. It will therefore be a pure equity holding company under the Jersey economic substance rules.
In addition, entities within this structure may be financing and leasing businesses if they make loans to other entities within the structure and charge interest, i.e., if the lending is on commercial terms. For example, if Jersey Co. 1 provides a loan to BVI Co. 1 then it will also be carrying out the relevant activity of ‘financing and leasing’ and will be subject to the regular economic substance test.
Trustees have a fiduciary duty as regards their beneficiaries and should be monitoring trust investments and assets. If there are entities within the trust that are carrying out relevant activities, then the trustees should be aware of these activities, especially as it may be their obligation to instruct a service provider to arrange filing.
In addition, although this is less common, some structures may have their own fund or fund management entity. This business may not be widely trading if it only manages investments for the family or closed circle of beneficiaries. Fund management is a relevant activity, so this should also be on the trustees’ radar.
‘If nominee or corporate directors are used, they should be used sparingly and ideally be centralised in one location in order to ensure that the directed and managed test applicable to the entity’s relevant activity can be met’
Outsourcing of services by PTCs
Outsourcing of various corporate and administration services is very common in PTC structures. There are two aspects of outsourcing that may be relevant to economic substance laws:
- The provider of the outsourced service could fall within applicable economic substance rules unknowingly if the activity/ies provided is one of the relevant activities (e.g., a headquarters business) under the laws in their particular jurisdiction.
- If the directors of the PTC outsource extensively, the PTC could be at risk of having little to no substance in the jurisdiction of incorporation and could therefore come under scrutiny for being a ‘shell’ company.(6)
A key consideration in any economic substance analysis taken therefore needs to be the interactions between entities within the structure and third parties, in particular regarding outsourced services.
A special note of caution should also be made regarding the use of nominee directors, given the latest published revisions to the Financial Action Task Force (FATF)’s Recommendation 24,(7) noting that ‘countries should take measures to prevent and mitigate the risk of the misuse of nominee shareholding and nominee directors’. The FATF noted that said revisions were scheduled to be discussed during its February 2022 meeting.
As nominee/non-executive directors are relatively commonplace in PTC structures, it is easy to see how PTCs could be the focus of enquiry by tax authorities in the future. The situation could be further complicated if a corporate director is used with its own board populated by individuals (usually employed by the corporate service provider) in different countries. Given that one of the economic substance requirements for entities (other than holding entities and those conducting intellectual property business) is that its activities be managed and directed in the jurisdiction of incorporation, issues may arise if individuals outside of the jurisdiction populate the board of the corporate director and participate in its decisions. This set-up is seen especially in the case of larger intermediaries with a global reach, where client handlers and relationship mangers may not work in the jurisdiction of the PTC. The takeaway here is that if nominee or corporate directors are used, they should be used sparingly and ideally be centralised in one location in order to ensure that the directed and managed test applicable to the entity’s relevant activity can be met.
Ownership of a PTC
The shares of a PTC are commonly owned through an ‘orphan’ structure such as a purpose or charitable trust, but a PTC can also be owned by a company limited by guarantee or the PTC itself could be structured as a foundation, thereby eliminating the need for a shareholder at all. Will the economic substance laws catch a non-traditional legal entity?
Companies Limited by guarentee
In general terms, a company limited by guarantee has members who are guarantors rather than shareholders, with the liability being limited (as per a limited liability company). The biggest difference in this type of company compared to the latter is that there can be no share capital. Companies limited by guarantee are not exempt from reporting obligations, whether used in a PTC structure or not.
Under the Cayman Islands economic substance law, companies limited by guarantee fell under the definition of ‘domestic company’, which was automatically not a relevant entity. In 2020, the definition of ‘domestic company’ was amended, so that companies limited by guarantee will no longer be defined as domestic companies (and therefore not relevant entities) unless they otherwise satisfy the criteria in the definition of that term. In the BVI, on the other hand, under the Business Companies Act, 2004, the definition of company includes BVI companies limited by guarantee,(8) which means such entities are in turn caught under the definition of the BVI economic substance law definition of legal entity and are automatically in scope.
Foundations are now legally recognised under the laws of both Guernsey and Jersey and are therefore permissible legal entities in both jurisdictions.(9) However, if the PTC is set up as a foundation established under the Foundations (Guernsey) Law, 2012, it will be automatically out of scope of being a relevant entity under current Guernsey economic substance law, by virtue of a specific carve-out within an amendment to
the legislation.(10) We have not yet seen the same carve-out under either Jersey or Isle of Man economic substance law.
It is worthwhile to note that many jurisdictions have recently enacted amendments to their existing economic substance law to specifically include partnerships as legal entities for the purposes of economic substance law. Given the extension to partnerships, one can only wonder if foundations will soon be caught also.
OTHER REGIMES THAT MAY APPLY TO PTCs
Licensing of PTC Trusteeship
The provision of trust services is a regulated business in many of the commonly used trust jurisdictions, including most of the jurisdictions that have enacted economic substance laws since 2019. However, it is common to find exemptions from licensing for PTCs, usually based on the principle that the provision of trustee services to individuals who are blood relatives or within the same family line is not carried on in a commercial manner or for members of the public, which would usually trigger a licensing requirement. There will usually be a host of conditions attaching to an exemption from licensing and these may include requirements such as outsourcing of designated services to licensed service providers in the jurisdiction.
In the Cayman Islands, although a PTC must be registered as a PTC with the Cayman Islands Monetary Authority, a PTC conducting only ‘connected trust business’ (as defined by s.2(1) of the Private Trust Companies Regulations (2020 revision)) does not require a licence to carry on such business.(11) In the BVI, only unremunerated PTCs will be exempt from holding a trust licence.(12) This is an example of a criterion that must be monitored to ensure that an exemption continues to apply.
Care also needs to be taken in ascertaining whether any licensing exemption is automatic. For example, the provision of trustee services in Switzerland by a PTC to persons with whom they have economic or family ties is automatically exempt from ordinary licensing requirements under the Financial Institutions Act.(13) Compare this to the Cayman Islands, where entities must register with the Cayman Islands Monetary Authority and demonstrate that they fulfil the relevant requirements in order to be exempt from any licensing requirements.
Beneficial Ownership Registers
As more jurisdictions enact beneficial ownership or ultimate beneficial ownership registers, it is clear that this in an increasingly important area of law. Accordingly, PTCs are not immune to beneficial ownership considerations and are likely to be subject to some regulatory frameworks for beneficial ownership reporting. In the BVI, for example, under the Beneficial Ownership Secure Search System Act, 2017, the onus to supply documents and information on the entities for which they act as registered agent falls on the registered agent.14 The PTC must only file its memorandum and articles of association to become incorporated as a PTC, which are then publicly available but, of course, contain little information on the structure.
It is difficult to know how this area of law will expand over time and to what extent PTCs will have to abide by new beneficial ownership registers in any, many or all of the common jurisdictions.
Global Corporate Tax Regimes
A very clear global compliance trajectory is that more efforts are being made to tackle tax avoidance, evasion and non-compliance. The move towards transparency and combating tax avoidance is reflected in the economic substance legislation discussed in this article, but also in many other measures such as trust registers, automatic exchange of information regimes and anti-money laundering regulations. This clearly
applies to the corporate space and the private wealth space. It is vital that advisors are aware of the different measures projected to come into force and are able to help clients maintain good governance, full compliance and sensible long-term planning.
The legislation in this space and the scope of existing rules are likely to increase as a result of the trend towards more visibility into wealthy businesses and individuals. As models such as environmental, social and governance investments become more common and the balance between privacy and transparency is consistently debated, it is very important to be making future-proof governance choices. It is worth noting that this is an area of law that is subject to change. In the future, ‘carrying on business as a trustee’ may be a relevant activity in itself.
(1) Economic Substance (Companies and Limited Partnerships) Act, 2018
(2) Version 2 of the Rules on Economic Substance in the Virgin Islands, February 2020
(3) As defined within the Guernsey Income Tax (Substance Requirements) (Implementation) Regulations, 2021.
(4) 4.1 Example 3, Guidance on aspects in relation to the economic substance
requirements as issued by Guernsey, Isle of Man and Jersey (Version 2.0)
(5) s.3(1), BVI Economic Substance (Companies and Limited Partnerships) Act, 2018 (as amended)
(6) A shell corporation or shell company is a corporation without active business operations or significant assets.
(7) FATF, Revisions to Recommendation 24 and the Interpretive Note – Public
Consultation (Transparency and Beneficial Ownership of Legal Persons)
(8) s.5(b)(c), BVI Business Companies Act, 2004
(9) In Jersey, see the Foundations (Jersey) Law 2009 and in Guernsey, see the Foundations (Guernsey) Law, 2012
(10) s.2(3)(a), Income Tax (Substance Requirements) (Implementation) (Amendment) Regulations, 2018
11 s.4(1), Private Trust Companies Regulations, 2020
(12) s.5(1), Financial Services (Exemptions) Regulations, 2007
(13) Note that the Financial Market Supervisory Authority, Switzerland’s financial markets regulator, has recommended that a written confirmation of the exemption be obtained.
(14) s.9(1), Beneficial Ownership Secure Search System Act, 2017
The article was first published in Trust Quarterly Review (TQR), published by STEP and available to read on pages 25-30.