Economic substance: everything you need to know about it

You may know by now that setting up a holding company in the Cayman Islands is an excellent way to make your Latin America-based company more tax efficient and attractive to investors. Yes, we know that the word “Cayman” may raise some eyebrows; but the bad rep is something from the past – back when there wasn't a lot of poking around.

There sure is now. To open an offshore holding in the Cayman Islands, there are a few steps you need to take to prove you're clean and operating legally. One of them is to show you have sufficient “economic substance” to confirm that you should not be taxed elsewhere.

What is Economic Substance?

ES, for short, is an international tax co-operation law from 2018. It was designed to ensure that there is substance (i.e. a legit business) behind the income streams that are under Cayman company structures.

ES legislation does not apply to all entities in the Cayman Islands. Rather, it focuses on certain “Relevant Entities” carrying out certain “Relevant Activities.” It sounds ominous, I know, but suffice to say it applies to holding companies with subsidiary entities underneath, so you might as well get ready for the ES Test if you're looking to set up an international fundraising-ready company structure.

What is the ES Test?

This is basically how you show your company's economic substance. In order to “pass,” your holding company must:

1. Make sure your business' core income generating activities match what you've set as the Relevant Activity in the Cayman Islands;
2. Be "directed and managed" according to the Cayman Islands' legal standards;
3. Be attentive to the level of relevant income derived from the Relevant Activity carried out in Cayman; and
4. Have adequate physical presence in the Cayman Islands – if you're a Latitud Formation customer, you'll have a registered office in the islands as part of the company formation package.

Where do I "take" the ES Test?

Proving Economic Substance for your Cayman entity essentially requires filling out a form. Although a lot of founders venture to complete it by themselves, some parts of it can be vague or confusing to the average person.

Unless you're familiar with the process and the legalese language, we would encourage you to hire a lawyer to handle this process. It is one of the necessary steps in the formation of a Cayman holding company, and getting it wrong may result in unnecessary headaches.

What if I skip the Economic Substance step?

Unfortunately, you can't. Well you can, but you definitely shouldn't.

If you do, penalties are hefty, and they escalate as follows:

• An initial non-compliance penalty of USD 12,200;
• The subsequent non-compliance penalty of USD 122,000;
• A removal from the companies register;
• And finally, a potential five years imprisonment for any person who provides false or misleading information to the Tax Information Authority.

Make sure you have the correct partners and hopefully these numbers won't even have to cross your mind.