Substance: meaning and requirements

How to achieve a better level of substance

Achieving an optimal level of economic presence in the relevant jurisdiction requires several key steps. The main ones include:

🏢 Office. It’s better if the office is not just a virtual address hosting dozens of companies but a physical location that inspectors can visit. Additionally, the company may have a signboard or nameplate on the street or at the office door and provide a link to the location on Google Maps on the company’s website.

🔐 Storage Facilities. For product-based, logistics, or trading companies, having a separate lease agreement for premises to conduct business with records of visits can strengthen the company’s substance.

👥 Staff. Local employees and directors with official employment contracts are crucial to confirming a local presence.

📲 Services. Engaging local service providers specifically for the company, such as a local phone number, internet services, or data centers, supports substance.

🛒 Purchases. This can include equipment necessary for operations (e.g., phones, laptops, machinery), vehicles, or office and warehouse spaces.

👨‍💻 Local Counterparties. Interaction with local companies, such as accountants, marketers, SEO specialists, or clients, demonstrates actual economic activity in the jurisdiction.

🤝 Contracts. All agreements entered into by the company (with clients, suppliers, and partners) should be signed and reviewed in the country of the company’s registration.

💡 Management. Important decisions (e.g., dividend distribution) should be made at board meetings in the country of registration. Minutes of meetings and travel documents can substantiate actual management activities.

📃 Certification. The company must comply with local laws and have all necessary permits and licenses.

📰 Advertising. Conducting local advertising campaigns or participating in trade shows enhances the brand’s recognition in the local market.

🗄Insurance. This involves having insurance policies for the company’s employees and its activities in the country of registration.

📊 R&D. Investing in research and development projects in the country of registration to support social and commercial initiatives can strengthen the company’s presence.

📝 Publications. Publishing articles, press releases, or other materials in local media or on local websites in collaboration with other local companies adds credibility.

💰 Grants. Participation in local financial programs to secure funding for specific projects or initiatives demonstrates integration into the local ecosystem.

🔋 Memberships. Joining associations or professional organizations underscores the company’s integration into the local business community.

💸 Sponsorships. Sponsoring local events, conferences, or exhibitions displaying the company’s logo increases brand recognition.

💼 Policies.Well-developed policies published on the company’s website, indicating its location and dispute resolution mechanisms, reflect its operational transparency.

Trademark (TM). A registered trademark shows that the company invests in protecting its name and plans to operate long-term.

Not all companies need to implement every point listed above. They can choose what’s appropriate depending on their activities. However, each measure reinforces the company’s position and confirms its real economic presence in the jurisdiction where it is registered and operates.

Additional Confirmation. Rather than using a payment system like an EMI, opening a bank account further supports substance. In most European jurisdictions, compliance processes require companies to demonstrate genuine economic and physical presence in the country to the bank, which can also serve as a positive signal for other stakeholders.

Legislative framework

Compliance with substance requirements may be regulated by local laws applicable in each territory. Typically, these laws establish requirements for companies depending on their jurisdiction of registration and for owners depending on their place of tax residency.

However, local regulators and tax authorities must also adhere to international standards, which can be even more comprehensive, such as:

🇪🇺For the European Union, several directives apply, including:

• Anti-Tax Avoidance Directives (ATAD 1 and ATAD 2): Establish rules to counter aggressive tax planning.
• Directive on Administrative Cooperation (DAC 6 and DAC 7): Require tax authorities to report cross-border agreements, including those related to digital platforms that may be used for tax evasion.
• Directive on Combating the Use of Shell Companies for Tax Purposes (ATAD 3): This is not yet in force but has been approved by the European Parliament with amendments. It will set minimum requirements for the level of economic substance for EU-resident companies.

🇺🇸 For the United States, requirements are established through specific provisions, including:

• Section 7701(o) of the U.S. Tax Code – Economic Substance Doctrine: Ensures that companies conduct actual economic activities with commercial objectives, not merely for reducing tax liabilities.
• Section 482 of the U.S. Tax Code – Allocation of Income and Expenses: Establishes the “arm’s length” principle to prevent artificial underpricing or overpricing of goods and services among group companies.
• Sections 951–965 of the U.S. Tax Code – Controlled Foreign Corporation (CFC) Rules: Prevents using foreign entities to accumulate income in low-tax jurisdictions.

🇬🇧 For the United Kingdom, substance requirements are generally regulated by:

• Companies Act 2006: Establishes basic requirements for company registration, management, and reporting.
• Corporation Tax Act 2010: Regulates corporate income taxation, including provisions on transfer pricing and controlled foreign corporations.
• Finance Act 2019: Establishes provisions for the taxation of digital services and enhances substance requirements for such companies operating in the UK.

Summary

Regulatory requirements in all stable jurisdictions mandate that companies may need to prove actual economic activity in the jurisdictions where they are registered. This includes maintaining real offices and local staff and engaging in managerial activities.

Failure to meet these requirements can lead to penalties, backdated tax payments, and the loss of access to certain tax benefits previously granted to the company. Furthermore, such companies and their owners and directors may attract increased scrutiny from tax authorities, raising the likelihood of mandatory audits.

Therefore, maintaining a proper level of substance not only confirms a business’s legality in a specific country but also demonstrates its genuine contribution to the economy. This helps mitigate the risk of sanctions from tax authorities.