The growing reach of the economic substance rules

In November 2020, the EU Code of Conduct Group submitted a report to the Council of European Finance Ministers stating that the economic substance rules should be extended to cover partnerships within the Crown dependencies and the British overseas territories. This was because in 2018 these jurisdictions gave political commitments to the EU Code Group to extend the economic substance rules to resident companies and the Code Group now considers that partnerships should be considered within that original commitment.

On 11 May 2021, the Guernsey Revenue Service issued Circular 18 which announced that the economic substance rules will be extended to partnerships. It makes clear that the extension will apply to limited partnerships (with and without legal personality), limited liability partnerships and foreign partnerships, including limited partnerships and limited liability partnerships which are foreign incorporated, but with their place of effective management located in Guernsey. There are difficulties with bringing partnerships into the scope of the rules due to the nature of partnerships as transparent vehicles and the fact that there is no established principle of tax residence. It is not clear whether Guernsey will adopt the international definition of "place of effective management" that is commonly understood to mean "the place where key management and commercial decisions that are necessary for the conduct of the business are in substance made".

Any such partnership that derives income from a “relevant activity” as defined in the legislation (including financing, banking, insurance and fund management) will trigger the newly extended economic substance rules. The rules will be applicable to partnerships conducting a relevant activity formed on or after 1 July 2021, or, for partnerships formed on or prior to 30 June 2021, the extended rules will be subject to a transition period and such partnerships will come into their scope for accounting periods on or after 1 January 2022 to give them time to adjust to the new requirements.

As the rules will follow on from those applicable to companies, the partnerships caught by the new extension will have new filing requirements to adhere to. These include:

• all partnerships (not just those to whom the newly extended economic substance rules apply) will apply to register with the Guernsey Revenue Service;
• all partnerships will make an annual filing giving confirmation that the economic substance rules do or do not apply to them; and
• all partnerships will file an annual tax return with any required financial statements (the deadline of which will be aligned to the deadline for companies).

It is clear that the extension of the rules to partnerships is likely to have an impact on both the private equity and investment management sectors and is an important, if not unexpected, development. It is also anticipated that Jersey will follow suit, having recently closed its consultation on the extension of the economic substance rules on 1 March. The full impact of the rules remains to be seen, in particular:

• whether Guernsey, Jersey or any other relevant jurisdictions adopt the common definition of "place of effective management";
• how different types of fund income will be classified under the “relevant activities”, for example, whether all income received by the general partner or manager will meet the definition of the “fund management” relevant activity, or whether all income received by a carry or co-invest vehicle will meet the definition of the “financing” relevant activity; and
• what levels of substance will be required in practice, for example, regarding location and frequency of board meetings.

We await the final form legislation for details.