Economic Substance Tests Explained

What Is Economic Substance?

Definition and Core Principles

To understand what is economic substance, one must look beyond the mere registration of a company. It means your company must be "real" and not just a paper entity used solely for tax benefits. The overarching principle is "substance over form": complying with economic substance law requires that if you register a company in a jurisdiction, you must establish a physical presence and conduct actual commercial activity there.

Why Economic Substance Rules Were Introduced

Global economic substance regulations (introduced around 2019) now prevent businesses from using "shell companies" in tax havens solely to dodge taxes. The requirement driving economic substance legislation is clear: If you are registered in a specific location, you must actually work there. You cannot just use a mailbox; you need an office, staff, and real operations to satisfy the economic substance rules.

Activities Commonly Covered by Economic Substance Legislation

The economic substance legislation targets specific categories of business activities considered “relevant activities”. While definitions vary slightly by jurisdiction, the economic substance act in most regions covers: banking, insurance, fund management, financing and leasing, headquarters, shipping, distribution and service centers, holding companies, and intellectual property businesses.

Economic Substance Regulations and Legislation

Overview of the Economic Substance Act / Law

Economic Substance Act or Economic Substance Regulations usually apply to legal entities that are tax-resident in the jurisdiction and are not tax-resident in a higher-tax jurisdiction.

Certain entities are often exempt or out of scope: local companies doing business only within the country, entities tax-resident elsewhere, and investment funds are commonly excluded from being “relevant entities.”

Key Requirements Across Different Jurisdictions

While specific economic substance rules vary by jurisdiction, the fundamental requirements for relevant entities are globally consistent to ensure economic substance compliance:

• Notify authorities of business activities each year and complete the economic substance filing if "relevant activities" are conducted.

• Demonstrate a genuine physical presence.

• Maintain verifiable records such as payroll, lease agreements, and financial statements to substantiate the company's presence under economic substance legislation.

• Submit annual declarations to the regulator confirming full compliance.

High-Risk vs. Normal-Risk Relevant Activities

In practice, companies are commonly grouped into different "risk categories" when assessing economic substance compliance:

• Normal Risk. Most active trading companies fall here. It’s business as usual, you simply need to meet the standard requirements for having a physical presence and local staff.

• High-Risk. If you hold Intellectual Property (e.g., brand rights) that you didn't create yourself, regulators may presume a high-risk profile and require enhanced proof of substance. You face a much stricter burden of proof.

Economic Substance Test

What the Economic Substance Test Evaluates

The economic substance test simply verifies that your company isn't a "shell." To pass, your physical presence in the jurisdiction must match the income you earn.

Regulators look for these essentials:

• Strategic decisions and board meetings take place locally.

• The actual work driving profits happens there.

• You have qualified employees physically present.

• You incur adequate local operating costs.

• You have a real office or physical facility.

  
  

Directed and Managed Requirement

It’s not enough to just have staff. Decisions must happen locally. This means holding board meetings within the jurisdiction with a physical quorum of directors, where strategic decisions are made and recorded in minutes.

Core Income-Generating Activities (CIGA)

This is the "engine" of your profit. The actual work that makes money must happen in the country of registration. You can outsource tasks to local providers, but you must keep control, and the work cannot be outsourced outside the country.

Adequacy of Employees, Expenditure, and Physical Presence

The economic presence test requires sufficient resources in three areas: personnel, expenses, and physical presence. Their level must correspond to the scale of the business.

The company must have qualified employees in the jurisdiction, real local expenses, and a physical address or office where the business is actually conducted. Failure to meet at least one criterion may result in failure of the test.

Economic Substance Compliance

Who Must Comply and When

Full compliance targets companies performing relevant activities, typically standard offshore entities. If you pay tax elsewhere, you might be exempt, but you still have to file a notification to prove it.

The Timeline isn't a one-off checklist. Substance is an ongoing annual requirement. It applies every single year from the day you start business until the day you stop.

Reporting Thresholds and Exemptions

Substance regulations provide specific relief mechanisms for:

• Companies providing tax residency in another jurisdiction, though they must file an annual claim to validate this status.

• Pure equity holding companies face a simplified test.

• Investment funds and non-profits organisations.

There is generally no minimum income threshold: engaging in a relevant activity triggers obligations, even if the company generates zero income.

Documentation Needed for Compliance

To pass a substance audit, you must maintain a clear paper trail proving that your local activity is real, not just theoretical.

Essential records include local board minutes, office leases, staff contracts, payroll, and financial proof of local spending. In most jurisdictions, records must be kept for 5–6 years, even if the company is dissolved.

Economic Substance Filing

Annual Reporting Requirements

All jurisdictions with substance regimes require annual economic substance filings to confirm compliance. This usually involves two steps: an initial notification, where the entity declares whether it carried out relevant activities or claims an exemption, and a detailed economic substance report if it is in scope. The report includes information on income, employees, local expenditure, premises, and CIGA, along with a declaration of whether the substance test is met.

Deadlines and Submission Process

Deadlines vary by jurisdiction, but the clock typically starts ticking the moment your financial year ends.

BVI: report due within 6 months.

Cayman: report due within 12 months (Notification by Jan 31).

UAE: notification mid-year, report follows later.

Filings are strictly electronic via portals or agents. Penalties apply for delays. Even if you are dissolving the company, you are not exempt, you must file that final report.

Penalties for Late or Incorrect Filing

Jurisdictions impose financial penalties for failing to file or filing inaccurate information. Fines range from $6,000 to over $100,000 depending on the jurisdiction and repeat offenses.

False reporting can lead to separate fines or even criminal consequences. A second consecutive failure can result in much higher penalties and possible strike-off. Regulators may share information with foreign tax authorities, and broader non-enforcement risks EU blacklisting.

Economic Substance Rules Across Jurisdictions

UAE Economic Substance Regulations (ESR)

The United Arab Emirates Economic Substance Regulations cover nine relevant activities: banking, insurance, investment fund management, lease-finance, headquarters, shipping, holding company, intellectual property, and distribution/service center.

Mainland and free zone companies must file an annual ESR notification and report. UAE entities that are owned by UAE residents and operate only within the UAE may be exempt, subject to meeting specific regulatory criteria. Companies must be managed and directed in the UAE, have adequate UAE staff and expenditure, and conduct CIGA in the UAE, outsourcing within the UAE is allowed.

Compliance is monitored by the Ministry of Finance and free zone authorities, with deadlines generally mid-year. Any UAE entity with relevant activities and foreign-sourced income must maintain adequate substance and keep up with ESR filings.

Cayman Islands Economic Substance Law

In the Cayman Islands any “relevant entity” conducting a relevant activity must satisfy an annual economic substance test. Relevant activities include banking, insurance, fund management, financing/leasing, headquarters, shipping, holding company, distribution and service centre, and IP business.

Every Cayman entity must file an annual Economic Substance Notification (by January 31), and if carrying on relevant activities, a full Economic Substance Return within 12 months of fiscal year end. Entities must have local CIGA, management and control in Cayman, and adequate personnel, premises, and expenditure, outsourcing is allowed if done in Cayman.

BVI Economic Substance Requirements

The British Virgin Islands Economic Substance Act applies to BVI companies and limited partnerships conducting relevant activities, with compliance overseen by the ITA.

BVI identifies the same nine relevant activities. Entities must file an annual Economic Substance report via the BOSS(ES) portal, generally within 6 months after the financial period. The substance test requires direction and management in BVI, adequate employees, expenditure, premises, and CIGA carried out in BVI, outsourcing must also be within BVI.

Pure equity holding entities have reduced requirements, while high-risk IP entities must show substantial activities in BVI. Failing to provide information or late filing carries fines.

Other Common Jurisdictions (Mauritius, Bermuda, Bahamas)

Several offshore jurisdictions have their own substance regulations:

• Mauritius: Global Business License companies must meet substance conditions (resident directors, local office, local spending) and show adequate presence to access tax exemptions.

• Bermuda: requires annual declarations and on-island records, enforcement by the Registrar.

• Bahamas: requires entities conducting relevant activities to meet substance tests and file annual returns, penalties include fines and strike-off.

Overall, rules differ by jurisdiction, but the structure is similar, multinational groups must comply with each regime separately.

Compliance Risks and Best Practices

Common Mistakes Companies Make

Common mistakes with economic substance compliance:

• Assuming that if your offshore company is not actively trading, you can ignore submitting documents about the nature of its activities. Usually, all legal entities must submit the relevant notification.

• Appointing a nominee who never visits the country doesn't work anymore.

• Not keeping proper minutes or documentation. A company might actually be compliant substance-wise.

• Missing changes in the law. The substance regulations and guidance can be updated. Companies that don’t stay informed might miss changes.

• Outsourcing important work without proper control or contracts.

How to Prepare for an Economic Substance Audit

To prepare for a potential economic substance audit:

• Reply quickly if regulators contact you

• Show that your company truly operates locally, not just on paper. Provide local utility bills, software subscriptions, and service fees paid within the jurisdiction.

• Keep board minutes that prove decisions are made in the jurisdiction.

• Keep emails or minutes showing your board reviewing the provider's work.

• Ensure directors and staff are genuinely qualified for the CIGA.

• For important cases, use professional advisors to check everything in advance.

• Submit your annual ES notifications and reports by deadlines.

Working With Professional Compliance Providers

You pay professionals to make sure everything is done correctly and on time, so you avoid mistakes, fines, and stress. For big businesses it’s a normal cost of doing business; for small ones, you can choose only the services you really need.

How Icon Partners can help you with Economic Substance:

• explain whether the rules apply to your company and what you must do.

• provide local directors or managers if required.

• handle key activities like accounting or administration locally.

• arrange office space and local staff.

• prepare and submit your annual substance reports.

• communicate with regulators for you if questions or audits arise.

• If you operate in several countries, we can manage compliance everywhere.

FAQ About Economic Substance

What companies must file an economic substance report?

Companies that conduct "relevant activities" and are tax-resident in the jurisdiction must file a report. Entities that are tax-resident elsewhere typically only need to file a notification to claim an exemption.

What happens if a company fails the economic substance test?

Companies face increasing fines, possible removal from the register, and detailed information may be sent to tax authorities in other countries.

Does an offshore company always need substance?

Substance rules only apply if the company conducts specific "relevant activities" and is not tax-resident in another jurisdiction.

What is considered adequate presence in a jurisdiction?

Adequate presence requires having physical premises, qualified employees, and operational expenditure within the jurisdiction that are proportionate to the company's income.

Can substance requirements be outsourced?

Yes, provided the outsourced activities are performed by a provider located within the same jurisdiction.

How often must economic substance filings be done?

Companies must submit their notifications and reports for every financial year, with deadlines typically falling 6 to 12 months after the financial year-end.