Economic Substance Rules Explained for Cross-Border Groups

What is an economic substance test?

An economic substance test asks whether a company actually does meaningful business where it is registered. Regulators look at who makes decisions, where staff sit, where money is spent, and whether core income-generating activities happen locally.

The rules grew out of the OECD's work on harmful tax practices. Low- and no-tax jurisdictions adopted them so that companies could not book profit in a location with no people or operations.

Which activities are usually covered?

Most regimes list 'relevant activities' such as holding company business, headquarters, distribution and service centres, finance and leasing, banking, insurance, fund management, shipping and intellectual property.

If an entity earns income from a relevant activity, it normally has to file an annual substance notification or report and show adequate local people, premises and spending.

How groups fail the test

The most common failure is governance: board meetings held in another country, or directors who never visit. Another is outsourcing core work abroad without local supervision.

Using the same director across several entities in different jurisdictions can weaken the substance position of each one.

Practical checklist

Hold board meetings physically in the jurisdiction and minute them there. Keep a local register of decisions. Employ or contract qualified people locally in proportion to the income. Keep records of local spending. Review every year — thresholds and guidance change.

Related guides

• Transfer Pricing Basics for Growing International Businesses
• How to Choose a Holding Company Jurisdiction