Substance abuse

When the EU raised concerns that companies domiciled in Bermuda might not be conducting sufficient business of economic substance on the Island, the government had to work fast to address those concerns.

A European Commission fact sheet published in March states that countries that “choose to have no or zero-rate corporate taxation should ensure that this does not encourage artificial offshore structures without real economic activity. They should therefore introduce specific economic substance requirements and transparency measures”.

In early 2019 Bermuda was working hard to meet the EU’s deadline in proposing how it intended to do just that. When it missed its deadline and was temporarily placed on the EU’s blacklist of “non-cooperative jurisdictions in tax matters” on March 12, the European Council justified the move, saying: “Bermuda facilitates offshore structures and arrangements aimed at attracting profits without real economic substance and has not yet resolved this issue.”

An official at the EU explains: “Bermuda had committed to address the criterion 2.2 related to economic substance (existence of tax regimes that facilitate offshore structures which attract profits without real activity) by 2018. When the list was reviewed in early 2019, Bermuda had not implemented the necessary reforms and was therefore added to the EU list of non-cooperative jurisdictions.”

Too important to ignore

Bermuda’s links with the EU were too important to allow this problem to persist. According to the Association of Bermuda Insurers and Reinsurers (ABIR) the Island’s market has paid $72.8 billion to EU policyholders and cedants during the past 20 years. Even the Cayman Islands, which had decided not to pursue equivalence with the EU’s Solvency II regime because the majority of its business is with the US rather than Europe, had taken the necessary steps to comply with the economic substance requirements.

However, being put on the blacklist did not turn out to be as catastrophic as it might have been, partly because it was understood, and clearly communicated, from the moment it was put on the list, that Bermuda was working flat out to resolve the problem. Authorities always maintained the problem had been a technical omission in the submission, rather than an indictment of Bermuda as a tax haven.

One lawyer based in Bermuda says: “In terms of my legal practice, it was notable how little impact the blacklist actually had, other than several queries. Clients appeared to understand that the move was caused by an administrative error and once we explained that the matter would soon be resolved, business went on as usual.”

Whether it had been an administrative error or a bigger problem of policy, the blacklist meant that technically the EU had found Bermuda’s economic substance regulations submission fell short of rules set by the EU Code of Conduct Group in December 2017.

The Island’s authorities acted quickly to resolve the matter, and committed to establish an economic substance framework for collective investment funds that was acceptable to the EU as part of the deal to remove it from the blacklist.

The result of that commitment was the Economic Substance Amendment Act 2019 (ESAA), which was passed by the Bermuda parliament in June. It exempted entities that are tax resident in a qualifying jurisdiction from the substance requirements of the Economic Substance Act (ESA) 2018.

Under the previous rules Bermuda did not exempt entities that are resident in another jurisdiction for tax purposes from economic substance requirements. Curtis Dickinson, Bermuda’s minister of finance, told the House that “this puts Bermuda at a serious commercial disadvantage relative to all of our competitors”.

It could have meant up to 20 percent of Bermuda registered entities being “forced to relocate from Bermuda to one of the other ‘2.2 jurisdictions’ (a subset of the EU’s grey list encompassing many traditional offshore centres) simply because those other jurisdictions have the certainty of a tax residency exclusion,” Dickinson told the House. This represents about $14 million in government fee revenue and between $30 million and $40 million in service provider fees, he added.

The passage of the ESAA 2019 brought the Island into full compliance with EU rules, and those of the Organisation for Economic Co-operation and Development’s (OECD) forum on harmful tax practice, and it was promptly removed from the blacklist.

Share and share alike

At the time Albert Benchimol, president and chief executive officer of AXIS Capital and the chair of ABIR, praised Premier David Burt, finance minister Dickinson and Bermuda Monetary Authority (BMA) chair Jeremy Cox for “immediately and effectively marshalling resources to demonstrate Bermuda’s long-standing tradition and commitment to meet and exceed international standards”.

Bermuda’s economic substance rules require insurance companies conducting business in Bermuda from 2020 to file an annual declaration within six months of the end of its financial year. The declaration must describe the core income-generating activities undertaken in Bermuda, as well as financial information such as income and operating expenses and the number of employees. It must also name its owner or ultimate parent entity and describe any outsourcing arrangements and relationships that are in place.

Insurers are also potentially subject to tax information exchange-related powers created by the ESA, meaning information provided to the registrar can be shared with other jurisdictions, under the Tax Information Exchange Agreement Act 2005.

Under the terms of the act, insurers must be managed and directed in Bermuda, with a significant physical presence on the Island, including employing qualified Bermudans in a full-time capacity. They must also conduct their core income-generating activities in Bermuda and incur adequate operating expenditure on the Island.

Benchimol says: “As the global centre of risk transfer, ABIR believes Bermuda’s international business sector meets or exceeds worldwide requirements. We applaud the government’s legislative reform package which further enhances that framework, and its commitment to ensuring clients and markets worldwide continue to benefit from Bermuda’s financial capacity and leading risk management expertise.”

Although the content of Bermuda’s economic substance regime has been approved, the EU is still reviewing the monitoring mechanisms by which compliance with the legislation is assessed. The EU is expected to make a decision about the worthiness of its monitoring structures in December.

The assessment will involve the examination of the registrar’s resources and methodology, says finance minister Dickinson. “The registrar is in the process of developing an e-registry system that will allow him to collect and analyse economic substance information and to enforce economic substance requirements,” he told the House.

Doing the right thing

In recent months Bermuda’s Ministry of Finance has turned its attention to other areas of the Island’s legislative framework requiring amendment.

“In order to harmonise our legislation with equivalent jurisdictions, Bermuda initiated preliminary discussions with the relevant EU and OECD officials in April and those engagements are continuing, both at the political and technical levels, to ensure that any proposed amendments are acceptable to both the EU and the OECD,” Dickinson explains.

John Huff, president and chief executive officer of ABIR, says his group would continue to work with the BMA and the Bermuda government on the ESA regulatory guidance, both to ensure efficient and fair implementation of standards and to avoid any duplicative regulation.

“ABIR’s members are good corporate citizens in Bermuda and in the worldwide markets they serve and are prepared to continue to address the world’s critical risk needs,” says Huff.

However, concern remains that there is no guarantee that the EU rules as they are currently constructed are set in stone. The decision about whether and how to change requirements for economic substance, and how these rules are applied with regard to third countries like Bermuda, is one for the European Council, taken by all EU member states.

In theory, the Council could change its rules at any time, depending on the policy prerogatives of the EU rulemakers and changes in tax practices. Nobody in Bermuda knows if and when that might happen, how often the rules could be reviewed or how they might evolve in the future.

An EU official says the criteria used to establish the EU’s list of non-cooperative jurisdictions were decided in 2016 and insisted there are no plans to change them. “However, some criteria are still being reviewed and/or specified,” the official says.

One Bermuda-based lawyer says: “The EU’s principles will certainly change over time, for tax reasons or other reasons. But the government of Bermuda will remain in close dialogue with the EU, so I am confident that when the EU makes any changes which will impact Bermuda, the jurisdiction should be able to adapt quickly to address those changes.”

The nightmare scenario would be if the US decided to insist on offshore financial centres complying with its regulations, as the EU has done, giving Bermuda and others the problem of adhering to two different sets of regulations. But this is unlikely, says Thomas Dawson, partner at McDermott Will & Emery in New York.

“US states do not have economic substance requirements for companies incorporated in their states,” Dawson says. “Think Delaware and the more than a million companies incorporated there, but with headquarters, operations and people located elsewhere.

“This is also true for re/insurers. So, it would be difficult for any US state or US insurance regulator to insist on local presence/economic substance.”