Economic Substance Requirements: What Are They?

“What are economic substance requirements?” In practice, they are a set of regulatory standards designed to prevent a company from operating—or declaring profits—in a jurisdiction where it does not carry out any real activities. These rules, which are widespread internationally, apply mainly to entities in offshore or low-tax countries that carry out mobile activities (e.g., finance, IP, distribution services). 

The objective is simple: to ensure that profits and value created in a territory correspond to the people, assets, and decisions actually present there. 

This is a global reference point for founders, companies, and investors. Ascot works in a transnational context, and the practices described apply in multiple jurisdictions, with local variations.

Definition of Economic Substance Requirements

Economic substance requirements are rules that companies must follow to demonstrate to regulatory authorities their effective economic presence in a given jurisdiction.

Their purpose is to demonstrate the actual economic substance of their activities, preventing base erosion and profit shifting (BEPS). These criteria are essential to discourage shell/brass plate companies that intentionally shift profits and income to more favorable jurisdictions.

To ensure that a company registered in a jurisdiction actually has a real economic presence there, the authorities use substantial activity tests.

In practice, these are a set of criteria that the company must meet every year. This is to demonstrate that its main activities take place physically and operationally in the country of registration. Some examples? The Core Income-Generating Activities (CIGA), which indicate the relevant functions of a company to be carried out on site. Or “Adequate Substance”, which means the actual presence of employees, expenses, and equipment.

Why Economic Substance Rules Were Introduced

The reasons behind the introduction of economic substance regulations are many and are not the result of an isolated initiative, but rather of coordination between each jurisdiction. Global initiatives include:

• The OECD BEPS project launched by the G20 member countries to combat unfair tax practices such as base erosion and profit shifting;
• The EU Code of Conduct Group, established by the Council of the European Union and tasked with monitoring offshore jurisdictions (BVI, Cayman, Bermuda, Jersey, Guernsey, etc.);
• Increased pressure on borderline jurisdictions, including them on blacklists and increasing controls, thanks in part to regional bodies.

Ultimately, ESRs are required to discourage misconduct and profit transfer to tax havens. Companies that do not comply with these prerequisites risk being blacklisted, resulting in financial isolation.

What Entities Must Comply With Economic Substance

Not all entities are required to comply with economic substance criteria. These criteria are mainly aimed at companies operating in low-tax environments. Some examples:

• Offshore companies, typically known for shifting profits to areas with favorable tax regimes;
• International Business Companies (IBCs) used for global trade;
• Some holding companies due to their international activities and multiple underlying entities.

Among the relevant actions that trigger compliance by companies are:

• Banking: Deposit taking, payment services, lending, etc.
• Insurance: Includes the underwriting and management of policies such as life insurance, claims, and health coverage.
• Fund Management: Inherent in the management and administration of funds;
• Finance and Leasing: Corporate loans and financing, leasing, etc. Refers to any activity in which an entity grants capital or assets to third parties or group companies in exchange for a financial return.
• Headquarters and Distribution Services: Warehouse management, logistics, and coordination between marketing, sales, IT, or HR departments at a central level.
• Intellectual Property Holding: The exploitation and management of intangible assets.
• Shipping: Relates to the management of ships engaged in international trade.

Key Components of Economic Substance Compliance

In order to comply with the fundamental pillars of economic substance, companies must—precisely—meet the following requirements:

• The company must demonstrate that it makes operational decisions within the area of registration;
• Similarly, all core activities are carried out within the jurisdiction;
• The company must have a physical presence (i.e., offices, infrastructure, etc.) consistent with its business;
• Operating expenses and local staff must be proportionate to the scale of the business.

Finally, adequate financial reporting and record keeping ensure compliance and avoid penalties or additional audits. Authorities could also apply a substance test to confirm that operational and governance requirements are genuinely met.

Penalties for Non-Compliance

Failure to meet the economic substance criteria entails:

• Financial penalties that vary progressively according to the severity of the offense;
• Exchange of information with foreign tax authorities, which in some cases can trigger reviews under a double taxation treaty, resulting in a series of tax audits in the beneficiaries’ countries of residence;
• Administrative dissolution of the company, rendering it unable to operate legally;
• Inclusion in public registers of non-compliance with enormous reputational damage and the impossibility of opening financial accounts.

All these risks inevitably lead to major reputational damage, compromising the company’s credibility and operations.

Jurisdictions That Enforce Economic Substance Requirements

Growing external pressure from the OECD, the EU, and international bodies has prompted many areas to comply with substance legislation. For example:

• The British Virgin Islands (BVI) with introduced regulations in 2019;
• The Cayman Islands, which applies some substance regulations through the Cayman Islands Monetary Authority (CIMA);
• Bermuda: First jurisdiction to adopt the substance doctrine in 2018;
• Jersey: Places great emphasis on fund management and the requirement that the main activity be managed from the island;
• Guernsey: Obligation to maintain personal records on the relevant entity on the island.
• United Arab Emirates (RAK and DIFC): The Emirates have adopted very strict reporting requirements and substance regulations since 2019. The application is differentiated for RAK ICC (Ras Al Khaimah International Corporate Centre) and DIFC (Dubai International Financial Centre).

Although the rules are very similar in essence, the implementation thresholds and definitions vary considerably between the different areas under review.

Structuring a Compliant Offshore Company

What does effective implementation look like? For some businesses, especially those new to compliance, understanding related governance roles, such as what is a registered agent, can also help clarify responsibilities.

• Local footprint matched to activity. Secure real premises and systems appropriate to the scale and complexity of the business; maintain books and records locally.
• People and governance. Employ or contract suitably qualified personnel in-jurisdiction; schedule and minute board/committee meetings locally; ensure directors understand the business.
• CIGAs mapping. Map each relevant activity to its CIGAs under local guidance; keep execution and oversight onshore (when outsourcing, retain control and access to working papers).
• Documentation discipline. Align intercompany arrangements and transfer-pricing documentation with operational reality; maintain consistent evidence over time.

These are the factors regulators actually test against when applying the economic substance requirement to a specific activity, and they are often also covered during professional offshore company formation counseling for new entities.

FAQs

What is the purpose of economic substance requirements?

The purpose of ESRs is to ensure that companies conduct their business in the jurisdictions where they are incorporated and pay taxes.

Do all companies in offshore jurisdictions need to comply?

No. Companies that carry out specific activities as set out in the article must adhere to the ESR. However, annual declarations are often mandatory.

Can I outsource my company’s substance requirements?

Yes, it is possible to outsource functions in some jurisdictions. However, supervision and control remain the responsibility of the company.

What happens if I submit an inaccurate or incomplete substance report?

The consequences vary depending on the severity. They range from financial penalties to exchanges of information with foreign authorities and requests for detailed tax reports.

Are holding companies subject to the same rules?

Holding companies can benefit from reduced requirements. However, they are still required to demonstrate a minimum level of substance in terms of local management and documentation.

References

Conyers. (2022). Ten things you need to know about… BVI economic substance requirements. Conyers.  https://www.conyers.com/publications/view/ten-things-you-need-to-know-about-bvi-economic-substance/ITR+5Conyers+5astra-trust.com+5

Conyers. (n.d.). Economic substance: what does it mean for international financial centres? Conyers.  https://www.conyers.com/publications/view/economic-substance-what-does-it-mean-for-international-financial-centres/Conyers+2griffithsandpartners.com+2

Offshore‑Protection.com. (2025, February 11). Economic substance requirements: What are they? https://www.offshore-protection.com/economic-substance-requirements