Eugene Yeung, Director, and Johnson Tee, Senior Manager, Corporate Tax Advisory practice of KPMG China, overview the new Economic Substance Laws and explain how regulatory changes in the Cayman Islands and the British Virgin Islands impact Hong Kong businesses with holding companies in those offshore jurisdictions.

Effective from 1 January 2019, certain offshore jurisdictions, including the Cayman Islands and the British Virgin Islands (BVI), have issued new Economic Substance Laws (ES Laws) that introduce certain reporting and economic substance requirements for entities conducting ‘relevant activities’ in local jurisdictions.

This is game-changing for corporate groups for the way in which they manage and control their Cayman and BVI incorporated companies. Corporate groups and even individuals with these offshore companies may need to restructure their holding and operational structures to ensure that they are carved out or that they satisfy the economic substance test.

This article focuses primarily on the impact of the ES Laws on Hong Kong businesses with holding companies in these offshore jurisdictions and outlines the new compliance requirements, reporting deadlines, penalties for non-compliance and mitigation strategies.


In response to efforts made by the Organisation for Economic Co-operation and Development (OECD) to enhance global tax transparency under Action 5 of the Base erosion and profit shifting (BEPS) initiatives, as well as an investigation by the European Union’s (EU) Code of Conduct Group (COCG) into certain low– or no–corporate income tax regimes, various offshore jurisdictions have enacted new ES Laws. These include the governments of the Bahamas, Bermuda, BVI, the Cayman Islands, Guernsey, the Isle of Man, Jersey, Mauritius, the Seychelles and the Marshall Islands, whose updated economic substance rules came into effect on 1 January 2019.

Of particular interest to Hong Kong are the implications for BVI and Cayman Island companies, both of which are locations where many corporate groups have established holding companies, investment funds and/or special purpose vehicles (SPVs).

What are the Economic Substance Laws about?

The ES Laws are designed to ensure that if profits are being earned by an offshore company, then those profits needs to be aligned to where the business or profit-generating activities are being carried out, thus potentially affecting the tax outcome. The level of economic substance required in these jurisdictions needs to be commensurate with and support the business. This will have an impact on Cayman and BVI companies that are being used to conduct businesses or hold investments to generate income.

In December 2018, the Cayman Islands and BVI passed the International Tax Co-operation (Economic Substance) Law, 2018, and the Economic Substance (Companies and Limited Partnerships) Act, 2018, respectively, both effective from 1 January 2019.

The Cayman Islands subsequently issued the Cayman Islands’ Economic Substance for Geographically Mobile Activities Guidance version 1.0, on 22 February 2019, and an updated Guidance version 2.0, on 30 April 2019 (the Guidance). Similarly, BVI released its draft Economic Substance Code, dated 22 April 2019 (the Code).

What entities are in-scope?

Generally, all ‘relevant entities’ carrying out ‘relevant activities’ are obliged to fulfil the economic substance requirements, with certain exclusions.

Definition of a relevant entity

Most of the local entities and ‘exempt’ or ‘offshore’ entities incorporated or registered in the offshore jurisdictions are in-scope. These include:

  • locally incorporated companies
  • foreign companies registered in the relevant jurisdictions, and
  • limited partnerships.

Definition of a relevant activity

Relevant activities consist of the following nine types of business, namely banking, distribution and service centres, finance and leasing, fund management, headquarters businesses, holding companies, insurance, intellectual property (IP) holding and shipping.

What level of substance is required?

Where a relevant entity carries out one or more relevant activities in a relevant jurisdiction, the relevant entity must fulfil the local economic substance requirements in relation to each activity being carried out.

Broadly, the economic substance requirements are met if the relevant entity is directed and managed in an appropriate manner from the relevant jurisdiction; conducts core–income generating activities (CIGA) in the relevant jurisdiction; and has adequate operating expenditure, physical presence and full-time employees in the relevant jurisdiction.

The economic substance requirements vary with different types of relevant activities. Specifically, entities carrying out an IP holding business are presumed to be non-compliant with the economic substance requirements. To meet the rigorous substance requirements for an IP holding business, these entities are required to take strategic decisions, and to manage the risks associated with the development and exploitation of the IP, using locally based employees to conduct the CIGA and trading activities through exploitation of the IP.

Holding companies

Conversely, a pure equity holding company is subject to reduced substance requirements. Using a very specific definition, a pure equity holding company is a company that holds equity shares and which only earns dividends and capital gains.

Based on the Cayman Islands’ Guidance, the economic substance requirements are met if a pure equity holding company:

  • has complied with all applicable filing requirements under the Company Law, and
  • has adequate human resources and adequate premises in the Cayman Islands for holding and managing equity participation in other entities.

The substance requirements can be outsourced to local service providers.

In addition, for a pure equity holding entity incorporated in BVI:

  • there is no requirement for the entity to be directed or managed in BVI
  • there is no requirement for the entity to carry out CIGA, nor to outlay a certain level of expenditure, in BVI (as there is no CIGA relating to a holding business), and
  • there are no restrictions on the extent to which a pure equity holding entity may outsource its activity.

In effect, the administrative burden of complying with the reduced substance requirements in the Cayman Islands and BVI does not appear to be too onerous for pure equity holding companies. In practice, and depending on the circumstances, existing company secretarial and entity maintenance outsourcing may be sufficient.


It is worth noting that there are certain instances where Cayman Island or BVI entities are not required to comply with the ES Laws. These exclusions include, but are not limited to, the following items.

1. Local entities that do not carry out relevant activities

While on the surface this may appear to be straightforward, there are some uncertainties involved. For example, if a pure equity holding company makes an investment in a debt security, by definition it is no longer a ‘pure equity holding’ company, and yet it may not fall into the other types of relevant activities. It is unclear if these entities would need to comply with any of the economic substance requirements and whether this interpretation aligns with the legislative intent. Alternatively, the debt investments could be transferred out, leaving only an equity investment and thus qualifying as a pure equity holding company.

2. Local entities that are tax resident in another jurisdiction

A local entity is outside the scope of the ES Laws if it is tax resident in another jurisdiction. Based on the Guidance and the Code, to substantiate that the relevant entity is in fact resident in another location, satisfactory evidence is required. For example, such evidence may include:

  • a Tax Identification Number
  • tax residence certificate and assessment
  • payment of a tax liability, or
  • other documentary evidence that could support the tax residency.

From a Hong Kong perspective, this could be achieved by registering under Part 16 of the Hong Kong Companies Ordinance. That said, the potential historical and future tax implications would need to be considered prior to making this move.

3. BVI entities that do not generate income from a relevant activity in a financial period

Based on the draft Code, it is stated that a BVI company ‘can discontinue the activity, or modify it so it no longer falls within the scope of a relevant activity’.

With regard to the above, and based on a strict interpretation of the ES Laws and the draft Code, a position could be taken that if there is no relevant income, the BVI entity no longer falls within the scope of a relevant activity or activities, and is thus not required to comply with the ES Laws. As the economic substance is assessed by reference to financial periods (normally one year in length), if the BVI entity did not derive any relevant income for that financial period, it should not be required to meet the relevant economic substance requirements for that particular period.

Similarly, based on the Cayman Islands’ Guidance, a relevant entity that carries out a relevant activity but which has no relevant income is not obliged to meet the requirements of the ES Laws.

4. Investment funds and their SPVs

In the Cayman Islands, an investment fund is not considered a relevant entity for the purpose of the ES Laws and is not required to satisfy the economic substance test. The term ‘investment fund’ also includes any entity through which the investment fund directly or indirectly invests or operates, for example the fund’s Cayman Island SPVs.

In BVI, although not specifically excluded from the definition of relevant activity, the business of being an investment fund is not considered a relevant activity, and is thus outside the scope of the economic substance requirements.

Transition period and reporting obligation

For companies established on or after 1 January 2019 in both the Cayman Islands and BVI, compliance with the substance requirements is mandatory from the time they start providing the relevant activities.

In the Cayman Islands, existing companies as at 31 December 2018 had a six-month transition period (that is, until 1 July 2019) to comply with the new rules. In BVI, the government had introduced a beneficial ownership data collection regime, known as the Beneficial Ownership Secure Systems Act, 2017 (BOSS Act), which was later amended to accommodate the Economic Substance Act. The BOSS Act amendment was originally intended to come into force on 30 June 2019, but its effective date has now been deferred to 1 October 2019. This new date is not a filing deadline, and does not replace 30 June 2019 as the deadline for entities to be compliant with applicable economic substance requirements. However, by 1 October 2019, BVI entities are required to have completed 1) their internal review exercises on whether or not they wish to be BVI tax resident entities, 2) their financial reporting periods, and – should they decide to register as a BVI tax resident – 3) the establishment of their procedures to support the relevant substance requirements for their relevant activities.

Commencing in 2020, entities will have annual reporting obligations to Cayman Island and BVI authorities in respect of their compliance with the new rules. There are heavy penalties for failing to satisfy the economic substance test, with a fine for non-compliance of approximately US$10,000 applicable to the initial year and up to US$100,000 in subsequent years. The entities may also be struck off the Registrar of Companies for continuing non-compliance.

Mitigation measures and conclusion

The introduction of the ES Laws is potentially a game-changer for corporate group structures and multinational companies that commonly use Cayman Islands or BVI companies. Under the ES Laws, this will mean that unless the offshore entities or SPVs are carved out, these entities/SPVs will require a certain level of economic substance to be established in that jurisdiction.

This is a good opportunity to revisit the wider group’s holding structure and the purpose behind it, as well as the costs and benefits of maintaining such offshore entities, taking into consideration the changing global economic and tax
landscape and the various BEPS initiatives in order to formulate a longer-term solution.

Group companies will need to think about how the new rules impact their operational and holding structures. If they are caught out by the rules, management may need to restructure their holding and operational structures to ensure that they are carved out or that they satisfy the economic substance test. The substance requirements may be satisfied through deployment of services provided by certain platforms, or by service providers.

As part of the review of the group holding structure, management should critically assess the existence of, and need to use, these offshore companies – specifically, whether or not these offshore entities still serve the purpose they were originally established for and whether it would be viable to reduce the number of intermediate holding companies to save costs and administration. This typically involves the combined efforts of multiple internal departments. The resultant alignment of interests and expectations, as well as appropriate project management and coordination, are keys to success.

As a takeaway, given the development of the global tax environment towards greater transparency and the clamping down on harmful tax practices, economic substance requirements are likely to expand to even more jurisdictions, particularly those which have very low or no taxation. While existing operating structures may still be viable under current laws, management should keep a close eye on new developments and make appropriate changes in a timely manner in response to such changes.

Eugene Yeung, Director, and Johnson Tee, Senior Manager, Corporate Tax Advisory
KPMG China