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In brief

Now may be a good time for multinational enterprises with subsidiaries in low or no tax jurisdictions to consider the amount of economic substance they have in these jurisdictions:

  1. to ensure compliance with economic substance rules, generally enacted from 2019 onwards, largely in response to the requirements of the OECD Forum on Harmful Tax Practices and the EU Code of Conduct Group; and
  2. to alleviate the impact of the Pillar 2 rules, which will begin to apply from 1 January 2024, multinational groups should consider substance for the “Substance-based Income Exclusion”.

Economic substance legislation in low-tax jurisdictions

We are aware some companies are now receiving fines for failing substance rules in jurisdictions with low or no corporation tax, which have been compelled to implement economic substance rules in response to the requirements of the OECD Forum on Harmful Tax Practices and the EU Code of Conduct Group. The jurisdictions are generally based in the Caribbean/Atlantic (e.g., Bahamas, Barbados, Bermuda, the BVI, the Cayman Islands) or the Crown Dependencies (Guernsey, Jersey, the Isle of Man) – jurisdictions traditionally popular as intermediate holding company jurisdictions or to carry out specific functions like intra-group financing or captive insurance.

The economic substance rules in these jurisdictions all follow a similar model. The rules are generally not part of a tax system, per se, but rather serve to place limits on low-substance companies operating in the jurisdictions. Financial penalties can arise to companies or their directors. Ultimately, companies can be struck off and barred from legally operating in these jurisdictions. More recently, substance rules are also being proposed in jurisdictions that offer tax exemptions from foreign source income, including Hong Kong, Malaysia, Seychelles and St Lucia. The consequences for failing substance rules in these latter jurisdictions involve the relevant income being brought within the charge to tax.

Despite the issuance of detailed guidance in many jurisdictions, there remains considerable scope for uncertainty on what having sufficient substance actually means. Substance rules generally require “adequate” levels of expenditure, people and premises, along with evidence of certain ‘core income generating activities’ in certain sectors (such as financing and leasing, headquarters activities, banking and insurance activities). The most stringent requirements are reserved for activities deriving income from intellectual property, with lighter requirements for long-term equity holding companies.

Whether the level of substance is “adequate” for the activity in question needs to be assessed on a case-by-case basis. This makes the tests inherently subjective. It is open to interpretation how many full-time employees (if any) are needed to, for example, manage intra-group shareholdings or a loan portfolio, especially where such investments are long term and passive in nature. In some circumstances, it may suffice to hold board meetings on a sufficiently regular basis rather than having permanent employees in the jurisdiction.

Many groups will now have experience of submitting mandatory economic substance returns, in which they will have had to disclose company-specific information on levels of substance to the local authorities. These economic substance returns give authorities an opportunity to develop their own assessments of whether economic substance tests are met on a case-by-case basis. Interpretations of what constitutes an “adequate” level of substance may vary across jurisdictions, as well as between the local authority and the taxpayer itself. Such circumstances can lead to fines or other penalties, but also the opportunity for engagement with the authorities and appeal, or failing that, rectification to avoid further penalties in the future.

Jurisdictions – which generally implemented substance rules to avoid being deemed non-cooperative or harmful by the EU and OECD – now need to demonstrate they are properly enforcing the rules. These international standard-setting bodies have made it clear that implementing the rules is not the end of the story: they want to see evidence of action being taken to remedy instances of perceived abuse.

Groups can take steps to mitigate the risks of penalties and sanctions. Groups will want to ensure they hold board meetings at sufficient regularity (and quality) and to consider hiring more local employees. Where it is too difficult to build up substance (or there is continuing uncertainty on exactly what substance is required), then groups may wish to consider restructuring and exiting the jurisdictions in question.

Pillar Two Substance-based Income Exclusion

political agreement among EU Member States in early December gave a further boost to an implementation timeline that is set to see the Pillar Two rules or “global minimum tax” take effect across the EU and many other major jurisdictions in less than a year’s time, from 1 January 2024.

The Pillar Two rules are designed to set a floor on corporation tax competition around the world by ensuring that multinational groups with global revenues greater than €750m pay a minimum 15% of corporation tax wherever they operate. For groups with subsidiaries in no or low tax jurisdictions, this will usually take effect by means of a “Top-up Tax” being imposed on the ultimate parent company of the MNE group on the difference between the local effective tax rate and the 15% minimum rate, multiplied by the amount of local profits.

The Substance-based Income Exclusion does not alter the effective tax rate of the jurisdiction, which remains locked as the percentage difference below 15%, but it reduces the amount of net profit to which that percentage is applied. The exclusion is based on two metrics: (1.) employee payroll costs; and (2.) the carrying value of tangible assets. The exclusion represents a carve out from profits of 5% of all payroll costs or the carrying value of tangible assets (with higher rates applying during a transitional period). In addition, by way of transitional relief, there are simplified rules that can apply during the first couple of years where this exclusion amount exceeds a jurisdiction’s Profit (or Loss) before Income Tax.

For no or low tax jurisdictions which attract more mobile, finance-related activities, employee payroll costs is likely to be the more relevant of the two metrics. Such activities tend to require few tangible assets but can involve highly-paid employees, and employees are also more mobile. As such, this substance carve out will increase the benefit of moving employees into these jurisdictions.


MNE groups with profits in low or no tax jurisdictions now have a choice to make (and they don’t have long to make it): increase substance in order to meet the local economic substance test and improve metrics under the Pillar Two Substance-based Income Exclusion, or restructure and exit these territories entirely.

For further information, please speak to your usual Baker McKenzie contact.


Emily Carlisle is a member of the London office's Corporate Department. She advises clients on a wide range of corporate matters with a focus on reorganising the corporate group structures of multinational companies. Emily joined Baker McKenzie in 2000 and was seconded to the Firm's New York office in 2006. She was admitted to the Law Society of England and Wales in September 2002.


Alistair Craig is a partner in Baker McKenzie's London office where he leads the Transaction Tax team. Before joining the Firm in 2013, Alistair worked in the transaction tax and international tax services groups at Ernst & Young.


Ed Swift is a Senior Associate in Baker McKenzie London office.

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