Economic Substance compliance: what captives boards need to know

Bermuda’s Economic Substance (ES) legislation took effect from July 1, 2019, meaning those entities with a December 31, 2019 year-end were required to file their first ES return by June 30, 2020. The Registrar of Companies’ (ROC) newly created online portal enables filings to be made electronically.

ES legislation was enacted in Bermuda and other offshore captive domiciles to address EU concerns that offshore structures were generating profits disproportionate to the real economic activity taking place within the jurisdiction.

The ES legislation applies to all captives that are carrying on a core income generating activity (CIGA) with respect to a relevant activity, such as insurance, and are deemed to be “tax resident” in Bermuda.

Captives that can demonstrate their tax residency as being outside Bermuda will be considered a “non-resident” entity and not subject to ES requirements. In such cases, the captive will need to provide evidence that all its income from relevant activities is liable to tax in that jurisdiction.

Such evidence may take the form of actual tax filings and/or a letter or certificate from the foreign tax authority stating the entity is resident for tax purposes in that jurisdiction.

There are five areas that the captive’s board of directors will need to be aware of whereby the entity will be required to demonstrate that it is complying as follows:

The ROC will consider if, and to what extent, each entity satisfies the ES requirements in light of the applicable relevant activity or activities being conducted by that entity, taking into account the nature, scale and complexity of its business.

The legislation does allow for the outsourcing of CIGA provided that such outsourcing takes place within Bermuda and is performed by suitably qualified professionals.

The captive’s board of directors should consider the following within each of the areas.

Managed and directed in Bermuda

Does the board have local (Bermuda-based) directors? If not, consideration should be given to appointing suitably qualified board members who can bring expertise to the board that complements existing areas of expertise. Such expertise may be around Bermuda captive insurance legislation and/or corporate governance, for example.

Local directors can also be available to hold physical meetings more readily when travel may be difficult for non-resident board members. The board should ensure that physical meetings are held where real strategic decisions are made.

The board should ensure that an adequate number of operational meetings take place in Bermuda by qualified professionals who are responsible for the oversight and execution of the entity’s CIGA. Areas of focus should be around underwriting and claims, corporate governance, and investment activities.

Sub-committees within each area should be considered where formal meetings are held and documented (minutes) for presentation to the board for approval.

CIGA to be performed in Bermuda

The board should be mindful that all activity resulting in gross income reported in Bermuda would be subject to ES requirements in Bermuda. The board and its service providers should consider each of the relevant activities and put in place where necessary suitably qualified local professionals to carry out these tasks.

Again, local oversight of these activities must be adhered to.

Adequate physical presence

While the ES regulations require that the entity have adequate physical presence in Bermuda, what is considered “adequate” will depend on the nature, scale and complexity of the business of the entity.

This requirement may be satisfied either with the entity maintaining its own premises or through an outsourcing arrangement with a local service provider. Again, the board must ensure the premises are adequate to carry out the relevant activity of the entity.

Adequate suitably qualified employees

Whether these resources are employees of the entity or outsourced to local service providers, the board should consider that sufficient time is allocated to CIGA in proportion to the size and complexity of the activity.

In calculating (and reporting) these activities, the board should base this on “full-time equivalent” units. Directors should be comfortable that the amount of time being spent by employees is sufficient to carry out that activity adequately.

Adequate operating expenditure

Local Bermuda expenditure in the areas of business expenses, fees, goods, services, and employment costs incurred by the entity should be tracked and reported on the entity’s annual ES filing. There is no prescriptive amount, but the board should be comfortable that the amounts being incurred by individual CIGA are sufficient for that activity.

At the time of writing there has not been any feedback provided by the ROC regarding those entities who filed by June 30, 2020. The expectation is that the board of directors will consider each of the above areas and adopt revised business practices where they deem necessary to ensure their captive is fully compliant with the ES regulations.

Richard Daley is managing director at Strategic Risk Solutions (Bermuda). He can be contacted at: richard.daley@strategicrisks.com