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Physical and economic sabstance: what is it?

In recent years, the word sabstance has become very popular when it comes to structuring and conducting international business. In particular, since about 2010 the requirements of banks and tax authorities in many countries of the world regarding the economic presence (i.e. substance) of the company in the country of registration began to be gradually tightened. Before we take a detailed look at what substence is, what it is for and how to create it, let's find out why substence has become so relevant now. You can watch a video on this article here.

First came the KYC (know your client)/AML (anti money laundering) requirements, which caused offshore jurisdictions to lose their popularity, and countries like Singapore to tighten laws regarding opening bank accounts and controlling businesses. This was followed by TIEA (Tax Information Exchange Agreements or Bilateral Tax Information Exchange Agreements) and MCMAATM (Multilateral Convention on Mutual Administrative Assistance in Tax Matters) agreements on disclosure of anonymity of bank information.

In 2010, FATCA (Foreign Account Tax Compliance Act, automatic exchange of information on bank accounts of American citizens) was adopted. In 2014, the CRS (Common Reporting Standard) regulation appeared.

In 2016, the Organization for Economic Cooperation and Development (OECD) action program BEPS (combating tax base erosion and profit shifting) was launched, which includes 141 countries.

The objectives of the BEPS action program are to combat tax evasion, improve the consistency of international tax rules, as well as to ensure a more transparent tax environment and address the tax challenges posed by the digitalization of the economy. That is, eliminating all opportunities to use international corporate structures in order to obtain zero taxation due to deficiencies in tax agreements between countries.

The reason for the intensification of this program was the frequent cases of tax evasion, for example, by distancing profit centers from the centers of actual activity.

Offshore and preferential jurisdictions played a huge role in this process, as they required neither real activity on their territory, nor compliance with other requirements of economic presence. By opening a company earlier in some offshore jurisdiction, the taxpayer could anonymously accumulate profits in the accounts of such an offshore company instead of accumulating them in the jurisdiction where he directly performs activities and where he would have to pay taxes.

All this seriously damaged the reputation of offshore territories and territories with preferential taxation by international organizations.

The main signs of a shell company:
  • No office (physical premises) in the country of registration
  • No telephone number in the country of registration
  • Absence of a company web-site in the country of registration
  • Absence of employees in the country of registration
  • No company reports to/from the tax authorities on a zero basis;
  • Company does not pay taxes in the country of registration and does not provide proof of payment of taxes in another jurisdiction.

Proof of Substance.
Due to all these changes, in the last few years owners of many foreign companies have been faced with the requirement to prove the real presence of their business in the country of incorporation, in other words proof of "substance".

Substance is the economic and physical presence of the company in the jurisdiction, i.e. the presence of not only the legal shell (the fact of registration and the presence of the constitutional documents), but also the real presence of the company in the territory of a particular country.

Legal entities that meet the requirements for sabstance in the country of incorporation have a large number of advantages. Rules regarding economic presence are regularly tightened and are aimed at combating tax evasion and deoffshorization. In some countries so far enough, for example, a lease agreement for office space. In other countries the presence of a physical office, a certain number of employees, contracts with business partners in the country is mandatory.

In order to confirm the presence of the company in the country two criteria must be met - physical and economic sub-standards:
  • physical sabstance is the actual presence of the company in the country (having a real office, employees, director, etc.)
  • Economic sub-standard - this is the actual implementation of the company's activities in the country (the presence of local costs, counterparties, the generation of profits, etc.).

  • In the absence of physical and/or economic presence, a company may face the following risks:
  • Difficulty in opening a bank account for the company
  • Risks of closing an existing account(s)
  • Loss of tax benefits/double taxation of income
  • Problems with determining tax residency
  • Problems with tax authorities - tax audits, fines and litigation.

Advantages of
  • Having a physical and/or economic presence will give the company the following benefits:
  • No problems with opening and maintaining bank accounts
  • Resident benefits
  • Tax benefits
  • Legal and clean running of the business, which is important in terms of the company's reputation and shareholders

Next: How to set up a substandard company in Singapore?