OECD guidance on the concept of substance for no or only nominal tax jurisdictions

On November 15^th 2018, the Organisation for Economic Co-operation and Development (“OECD”) published technical guidance for the application of the substance requirement to “low or no tax jurisdictions”. In a report dated 1998, the OECD had already taken the view that one of the most effective means of combating harmful tax practices ( i.e., no-tax jurisdictions and harmful preferential tax regimes) adopted by certain jurisdictions, was to oblige them to provide for a substantial activity requirement in their national legislation. Under this requirement, taxpayers could only benefit from a favourable tax treatment, if they had a sufficient presence on the territory of the jurisdiction.

While Action Point 5 of the Base Erosion and Profit Shifting (“BEPS”) Project mainly dealt with the substantial activity requirement with regard to preferential tax regimes, the OECD, in this newly released report, extends the substance requirement to “no or low tax jurisdictions”, in order to avoid harmful relocations of activities to low or no tax jurisdictions. This requirement should apply not only to jurisdictions which do not impose a corporate income tax, but also to jurisdictions which impose only nominal corporate income tax.

In addition, the OECD specifies that the substance requirements should only apply to activities that are geographically mobile, such as financial and other service activities. It nonetheless makes a distinction between activities generating income from intellectual property (“IP income”) and all other geographically mobile activities (“non-IP income”).

With regard to non-IP income, “no or only nominal tax” jurisdictions should introduce legislation to: (i) define the core income generating activities; (ii) ensure that these activities are effectively undertaken in the jurisdiction, (iii) require the entity to have an adequate number of qualified employees and (iv) have a transparent mechanism to ensure compliance and provide for an effective enforcement mechanism if these activities are not effectively undertaken within the jurisdiction (e.g. striking an entity from the register).

With regard to IP Income, the OECD recommends that the jurisdiction implements the “nexus approach”. This approach consists in (i) defining a formula to identify the income eligible for a reduced rate and (ii) providing for a rule to determine the tax treatment of non-eligible income. Since “no or only nominal tax” jurisdictions will not levy tax at an ordinary rate, the OECD proposes to apply a similar approach as for non IP activities, meaning that taxpayers must have sufficient activity in order to benefit from a no or only nominal tax rate.