Economic Substance of a Foreign Company: Why Business Registration Alone Is No Longer Enough

A foreign company can be registered within a few days, provided with a registered office, and have a director appointed. However, formal presence in a public register is no longer sufficient to qualify for tax benefits, open a bank account, or take advantage of international treaties.

Tax authorities and banks assess whether the company conducts genuine business activities in its country of registration. The place of management, employees, expenses, business decisions, and whether the structure corresponds to the nature of the business all matter. Together, these factors are referred to as economic substance, or substance.

What Does a Company’s Economic Substance Mean?

There is no single universal set of economic substance requirements. They depend on the laws of the particular country, the type of activity, and the purpose of the assessment.

In one case, a company may need to confirm its tax residency; in another, its eligibility for a special regime, the application of a double taxation treaty, or compliance with a bank’s requirements.

The general principle is that the declared structure should correspond to the actual operations of the business. If a company earns significant profits in one country but has no management, employees, expenses, or business processes there, the question arises as to why the income should be attributed to that particular legal entity.

The international approach to combating base erosion is also based on the principle that profits should be taxed where the economic activities that generate them are carried out and where value is created.

Why Economic Substance Is Necessary

Confirming Tax Residency

A company’s registration and its tax residency are not always determined according to the same rules. Some countries take into account the place of effective management: where key decisions are made, where executives are located, and where the company’s activities are controlled.

If a company is registered abroad but is actually managed by its owner from the country where the owner resides, the local authorities may consider the company to be a tax resident of that country. This creates a risk of additional taxation and a dispute between several jurisdictions.

Application of International Treaties

Double taxation treaties may reduce taxes on payments of dividends, interest, and royalties. However, registering a company in a country with a favorable treaty does not by itself guarantee access to a reduced tax rate.

Treaty benefits may be denied if one of the principal purposes of the structure was to obtain a tax benefit without sufficient business justification. The company should be an independent participant in the transactions rather than a formal intermediary through which funds are transferred to the actual recipient.

Using Tax Incentives

Special regimes often require genuine business activity in the country. The requirements may relate to the location of employees, the amount of operating expenses, the use of office premises, and the performance of key functions.

Obtaining a status or certificate is not sufficient. The company must comply with the applicable requirements throughout the entire period in which the incentive is used and retain documents confirming its compliance.

Opening a Bank Account

A bank assesses not only the incorporation documents but also the economic rationale of the structure. It may want to know why the company is registered in the chosen country, where its clients are located, who performs the work, and where the funds come from.

A lack of connection with the country of registration does not always result in rejection, but it makes the review more difficult. This is particularly true when the owners, director, employees, and clients are located in other countries and only a mailing address is used in the country of registration.

What Constitutes Genuine Economic Substance?

Economic substance cannot be created with a single document or by renting a workspace. The overall circumstances are assessed.

Company management. Key decisions should be made by the bodies and individuals specified in the corporate documents. The location of meetings, the content of minutes, the procedure for signing agreements, and the director’s actual authority all matter. A director who merely signs documents prepared by the owner does not always demonstrate independent management.

Employees and contractors. Their number and qualifications should correspond to the company’s activities. A holding company may not require a large staff, whereas it may be difficult to justify an operating or technology business without specialists performing its core functions.

Office and infrastructure. The premises should correspond to the scale of the business. A small company may only need an equipped workspace, while an organization with employees, equipment, or regulated activities may require a fully functioning office. A registered address shared by a large number of companies generally does not demonstrate genuine business activity.

Local expenses. Rent, salaries, accounting, communications, equipment, and professional services demonstrate that the company is genuinely conducting activities in the country. The amount of expenses should be proportionate to its functions and income.

Operational independence. The company should control its own funds, bear commercial risks, and perform the functions specified in its agreements. If all activities are carried out by another organization and the foreign legal entity merely receives and transfers payments, its role may be called into question.

How Much Substance Is Required?

Not every foreign company needs a separate office and a large staff. The requirements depend on its functions.

A holding company that owns equity interests and makes corporate decisions differs from a trading company with daily operations. An organization that owns intellectual property should be able to demonstrate who creates, develops, and protects the relevant assets. A consulting business needs to demonstrate that it has professionals who actually provide the services.

Therefore, economic substance should not be maximized but justified. A company should have the resources necessary specifically for its stated activities.

Formally creating individual indicators of substance does not solve the problem either. Renting an empty office or appointing a local director without genuine authority increases costs but does not prove that the business is actually managed and operated in the country.

How to Demonstrate Genuine Business Activity

Economic substance is demonstrated not by a single certificate but by documents generated in the ordinary course of business:

• an office lease agreement and proof of rental payments;
• employment agreements and payroll records;
• invoices for communications, equipment, and professional services;
• minutes of meetings of directors and shareholders;
• bank statements;
• agreements with clients and suppliers;
• documents confirming work performed;
• local accounting and tax filings.

All documents should be consistent with one another. For example, minutes stating that decisions were made in the country of registration may be unconvincing if the director permanently resides in another country and business correspondence shows that the decisions are actually made by the owner.

When Does a Lack of Economic Substance Become a Risk?

It is particularly important to review the structure if a foreign company applies a reduced tax rate, receives substantial payments from related parties, or uses an international treaty to reduce withholding tax.

Additional attention is required when a company owns intellectual property but does not participate in its creation or management, or generates most of its revenue without employees or significant operating expenses.

A risk also arises if all decisions are made outside the country of registration. In this case, the issue is not limited to insufficient substance but may also involve the company being considered a tax resident or having a permanent establishment in another country.

How to Establish Economic Substance

The first step is to determine the company’s functions: what it does, which assets it uses, which risks it assumes, and where its income comes from. It is then possible to determine which people, premises, expenses, and management processes are required to perform those functions.

Next, the company’s actual activities should be compared with its corporate documents, agreements, and banking transactions. If the structure is already operating, it is necessary to check whether the documentation supports the stated allocation of functions.

Economic substance must be maintained on an ongoing basis. A single directors’ meeting or a short-term office lease is not sufficient if all other activities are organized elsewhere.