Economic Substance Requirements Explained: Global Compliance Guide

Tax scrutiny of offshore and low-tax jurisdictions has intensified. If you run or own a company incorporated in a zero-tax or low-tax jurisdiction, you must assess whether economic substance (ES) rules apply to your business.

These frameworks were introduced following the OECD’s Base Erosion and Profit Shifting (BEPS) project, particularly Action 5 on harmful tax practices, and the European Union’s tax governance screening process. They are designed to address “brass plate” companies—entities with no real management, personnel, or operations in the jurisdiction where they are incorporated.

As a result, many offshore financial centers have enacted ES legislation requiring entities carrying on defined relevant activities to demonstrate adequate local management, expenditure, employees, and physical presence. Jurisdictions such as the British Virgin Islands (BVI), Cayman Islands, Bermuda, Jersey, and Guernsey operate active ES regimes. In the United Arab Emirates (UAE), standalone Economic Substance Regulations applied from 2019 to 2022 and were withdrawn for financial years beginning on or after 1 January 2023, although substance considerations may arise under the corporate tax framework.

Non-compliance can result in financial penalties, information exchange with foreign tax authorities, and strike-off or other regulatory action.

What is Economic Substance?

Governments have long been concerned about multinational groups shifting profits to low-tax or no-tax locations. These arrangements exploit differences between national tax systems and are commonly known as Base Erosion and Profit Shifting (BEPS).

The Organisation for Economic Co-operation and Development (OECD) estimates that BEPS leads to global corporate tax revenue losses of approximately USD 100–240 billion annually, or around 4–10% of worldwide corporate income tax revenues. Although many of these structures complied with domestic laws at the time, they raised concerns about fairness, market distortion, and erosion of national tax bases.

To address this, the OECD and the G20 developed the BEPS Package and created the Inclusive Framework, now joined by more than 140 jurisdictions. The reform package contains 15 Actions aimed at improving transparency, limiting tax avoidance, and ensuring profits are taxed where value is created.

Four of these Actions are minimum standards:

• Action 5 – Harmful tax practices
• Action 6 – Treaty abuse prevention
• Action 13 – Country-by-Country Reporting
• Action 14 – Mutual Agreement Procedure improvements

Economic substance requirements originate primarily from Action 5, which targets harmful preferential tax regimes. The core principle is simple: profits should not accumulate in low-tax environments without corresponding real activity. Where certain types of mobile income are earned, entities must demonstrate adequate local presence, management, and operational capacity.

At the same time, the Council of the European Union adopted its Code of Conduct for business taxation to counter harmful regimes globally. In 2017, the EU Code of Conduct Group reviewed both member states and selected non-EU financial centers against standards of tax transparency, fair taxation, and anti-BEPS implementation.

Following this review, several offshore centers — including Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, and Jersey — committed to introducing substance legislation to address EU concerns.

These laws now require entities carrying out specified “relevant activities” to show genuine local presence. This typically includes being directed and managed locally, conducting core income-generating activities there, and maintaining appropriate expenditure, personnel, and physical premises.

Together, the OECD BEPS reforms and the EU Code of Conduct process form the policy foundation for modern economic substance frameworks across many offshore financial centers.

The Importance of Economic Substance Compliance

Economic substance compliance is closely connected to the EU list of non-cooperative jurisdictions for tax purposes (commonly referred to as the EU tax blacklist), introduced in 2017.

As of 2026, the following jurisdictions are listed:

• American Samoa
• Anguilla
• Guam
• Palau
• Panama
• Russian Federation
• Turks and Caicos Islands
• U.S. Virgin Islands
• Vanuatu
• Vietnam

Jurisdictions on the EU blacklist face increased scrutiny. EU Member States may apply defensive tax measures such as withholding taxes, denial of deductions, stricter CFC rules, or enhanced reporting requirements. Transactions involving listed jurisdictions often attract heightened due diligence from banks and counterparties, and access to certain EU funding programs may be restricted. The specific measures depend on the individual EU Member State.

To avoid being blacklisted, jurisdictions are assessed against three main criteria:

• Tax transparency
• Fair taxation
• Implementation of international anti-BEPS standards

In relation to anti-BEPS standards, jurisdictions are expected to implement the OECD minimum standards, namely: Action 5, 6, 13, and 14.

Jurisdictions that commit to reform but have not yet fully implemented required standards are placed on the EU “grey list” (Annex II). These jurisdictions are monitored closely and must meet agreed commitments within a specified timeframe to avoid being moved to the blacklist.

Economic Substance Jurisdictions

The following jurisdictions currently maintain ES legislation applicable to certain entities conducting specified “relevant activities”:

• Anguilla
• Bahamas
• Bahrain
• Barbados
• Belize
• Bermuda
• British Virgin Islands (BVI)
• Cayman Islands
• Guernsey
• Isle of Man
• Jersey
• Marshall Islands
• Mauritius
• Panama
• St. Vincent and the Grenadines
• Turks and Caicos Islands

Crown Dependencies & British Overseas Territories

BVI, Cayman Islands, Bermuda, Anguilla, Turks and Caicos, Guernsey, Jersey, and Isle of Man all continue to operate active ES regimes aligned with OECD Action 5 principles.

Middle East

Bahrain maintains an ES framework.

The UAE’s standalone ESR regime applied from 2019–2022 but was withdrawn for financial years starting on or after 1 January 2023. Substance considerations now arise primarily under the UAE Corporate Tax regime (especially for Free Zone 0% qualification).

Asia

Hong Kong does not operate a standalone offshore-style ES regime. However, under its Foreign-Sourced Income Exemption (FSIE) framework (effective from 2023 and refined thereafter), certain foreign-sourced passive income may require an ES analysis.

Coverage of Economic Substance Rules

ES rules generally apply to entities that carry on defined “relevant activities.” In many ES jurisdictions, these activities typically include:

• Banking
• Distribution and service center
• Financing and leasing
• Fund management
• Headquarters
• Holding company business (including pure equity holding companies, often with simplified requirements)
• Insurance
• Intellectual property
• Shipping

However, not every entity conducting these activities is automatically required to meet ES requirements. Each jurisdiction defines which entities are “in scope” under its local legislation and may provide exemptions or reduced requirements in certain cases.

Tax residency is often a key factor. In some regimes, an entity that can demonstrate tax residence in another jurisdiction may be treated differently or fall outside local substance requirements, while entities regarded as locally resident (or unable to evidence foreign tax residence) may need to satisfy the full economic substance tests.

General Economic Substance Requirements

Across most economic substance (ES) jurisdictions, the core framework follows a similar OECD-aligned structure. An in-scope entity conducting a relevant activity (other than a pure equity holding business or high-risk intellectual property business, which may be subject to modified or enhanced requirements) is generally required to satisfy three cumulative tests.

First, the entity must be directed and managed in the jurisdiction. This typically requires holding an adequate number of board meetings locally, ensuring that a quorum of directors is physically present, making strategic decisions in the jurisdiction, and maintaining corporate records and minutes there.

Second, the entity must have adequate qualified employees, operating expenditure, and appropriate physical presence in the jurisdiction. What is considered “adequate” depends on the nature, scale, and complexity of the relevant activity.

Third, the entity must conduct its core income-generating activities (CIGAs) in the jurisdiction. Each relevant activity has its own defined CIGAs, and outsourcing may be permitted provided the activities are carried out within the jurisdiction and the entity retains sufficient oversight and control.

Each relevant activity has its own defined CIGAs.

Banking

• Raising funds
• Managing credit, currency, and interest risk
• Taking hedging positions
• Providing loans, credit, or other financial services
• Managing regulatory capital
• Preparing regulatory reports

Distribution and Service Center

• Transporting and storing goods
• Managing inventory and orders
• Providing administrative or consultancy services

Financing and Leasing

• Agreeing funding terms
• Acquiring assets for leasing
• Setting financing or lease terms
• Monitoring and revising agreements
• Managing risk

Fund Management

• Making decisions on acquiring and disposing of investments
• Calculating risk and reserves
• Managing currency or interest exposure
• Preparing regulatory or investor reports

Headquarters

• Making key management decisions
• Incurring expenditure on behalf of group entities
• Coordinating group activities

Insurance

• Predicting and calculating risk
• Insuring or reinsuring risk
• Providing insurance services to clients

Intellectual Property (General)

• Research and development (for patents and similar assets)
• Branding, marketing, and distribution (for marketing intangibles)

Shipping

• Managing crew
• Maintaining vessels
• Overseeing voyages and deliveries
• Organising logistics

Substance Requirements for Equity Holding Structures

Entities that only hold equity interests and earn income from dividends and capital gains are typically subject to reduced substance requirements. These usually include:

• Complying with local corporate law obligations
• Maintaining adequate employees and premises for the holding activity

If additional activities are carried on, full ES requirements may apply.

Substance Requirements for High-Risk IP Businesses

High-risk IP business generally arises where:

• IP assets are acquired from related parties or funded through related-party arrangements outside the jurisdiction; and
• The IP is licensed, transferred, or exploited by related parties outside the jurisdiction.

In many jurisdictions, such entities face enhanced reporting obligations and a rebuttable presumption of non-compliance unless they can demonstrate substantial control over development, enhancement, maintenance, protection, and exploitation of the IP, supported by adequate qualified employees physically present in the jurisdiction.

Economic Substance vs Shell Companies

A “shell company” is generally understood to be a legal entity with little or no independent operations, employees, or physical presence. While shell entities are not automatically unlawful, their compliance position depends on whether they conduct a relevant activity within scope of an applicable economic substance regime.

If an in-scope entity does not maintain sufficient local resources or carry out required activities in the jurisdiction, it may fail to meet economic substance requirements. This assessment is based on the specific statutory tests discussed above.

Economic substance rules do not prohibit the use of holding structures or cross-border corporate arrangements. Instead, they require that where defined activities are carried on, the entity must demonstrate the level of local presence and operational capacity required under the applicable legislation.

Reporting and Compliance Requirements

Entities that carry on relevant activities are generally required to submit an annual economic substance return to the competent local authority in their jurisdiction of incorporation or registration.

The filing typically includes:

• Identification of the relevant activity (or activities) conducted
• Financial information, including gross income and operating expenditure
• The number of full-time employees engaged in the jurisdiction
• Details of premises and assets used for business operations

Entities must retain sufficient documentation to support the information reported. This commonly includes:

• Board minutes and resolutions
• Employment contracts and payroll records
• Lease agreements or premises documentation
• Financial statements and accounting records

For high-risk IP businesses, additional supporting documentation may be required under local legislation.

Filing deadlines, prescribed forms, and submission methods vary by jurisdiction. In many regimes, returns are submitted annually after the financial year-end, often through a registered agent or electronic portal. Late or inaccurate filings may result in administrative penalties.

Penalties for Non-Compliance

Economic substance laws provide for enforcement where an entity fails to meet substance or reporting requirements. Although sanctions vary by jurisdiction, the consequences commonly include administrative financial penalties, which may escalate for continued or repeated breaches.

Persistent non-compliance may result in the entity being struck off the register, affecting its legal status and ability to operate.

Jurisdictions are also generally required to exchange information on non-compliant entities with relevant foreign tax authorities, including those of the entity’s parent or ultimate beneficial owner.

Providing false or misleading information may attract additional penalties, and in some jurisdictions, criminal liability may apply.

Conclusion

Economic substance is now a central part of global tax compliance. Whether your company is incorporated in the British Virgin Islands, Cayman Islands, Bermuda, Jersey, Guernsey, or operating through Hong Kong, you must ensure that management, people, and core activities genuinely align with where profits are reported.

Non-compliance can trigger penalties, regulatory reporting, and reputational risk.

Air Corporate supports businesses with substance assessments, governance structuring, and cross-border compliance coordination. If you are unsure whether your structure meets current economic substance standards, speak with Air Corporate for a practical, jurisdiction-specific review.