Located in the immensity of the Pyrenees, Andorra has been crowned as one of the favorite destinations for entrepreneurs and investors at the international level. Not only is it a country with a high quality of life, but it also has the freest tax measures. However, there is one concept that is very important for entrepreneurs looking to establish themselves in Andorra: economic substance.
What is the economic substance of companies?
Economic substance refers to the need for an entity’s business, financial, and operating activities to coincide with where revenues and costs are recorded for tax purposes.
This means that if a company benefits from a favorable tax regime in a given country, it is expected also to have a “substantial” commercial presence and activity.
Therefore, economic substance involves having employees, housing assets, and making business decisions within the same tax territory.
What are the main components of economic substance?
To make sure that a company has economic substance, you need to pay attention to the following components:
Real activity: The company has to develop tangible business operations from the country where it is registered for tax purposes. It can produce goods, provide services, or any other legitimate activity.
- Real activity: The company has to develop tangible business operations from the country where it is registered for tax purposes. It can produce goods, provide services, or any other legitimate activity.
- Tangible assets: When a company invests in tangible assets such as offices, machinery, and inventory, it is generally because it resides in the country. It is not just a matter of having a mailbox and a postal address in a favorable tax territory.
- Employees: If a company has its resident manager, employees with functions, decision-making, and management of day-to-day operations, it is more likely to have economic substance.
- Decision making: A company that decides its strategies and operations in the country where it is registered is more likely to have economic substance.
In addition to these essential factors, to ensure that a company has economic substance, consideration should be given to contracts and agreements (negotiated, signed, and executed in the jurisdiction), local records (such as accounting), and regular audits to ensure compliance with local regulations.
After all, the economic substance does not have to be reviewed only once but must be updated frequently as companies grow and international regulations change.
How important is it for companies?
Economic substance in companies brings some essential benefits:
- Legitimacy: Helps demonstrate that companies have legitimate operations in the territory and are not seeking to avoid taxes.
- Avoidance of double taxation: Economic substance helps businesses benefit from treaties to avoid double taxation, i.e., eliminate the risk of being taxed twice.
- Reputation: The fiscal practices of companies are increasingly controlled, and having economic substance helps to have a more professional image.
On the other hand, not presenting economic substance in the country where the company is registered for tax purposes carries risks. Moreover, it is pursued by the OECD (Organization for Economic Cooperation and Development) and the EU. Below, we present them to you:
- Adjustments: The tax authorities may adjust when analyzing that the income and costs declared do not reflect the company’s economic reality.
- Penalties: Failure to have economic substance may result in substantial financial penalties, depending on the jurisdiction.
- Denial of treaty benefits: If you have no economic substance, accessing a treaty to avoid double taxation becomes more complicated.
- Reputational damage: Tax evasion is highly penalized in terms of image, ethics, and public relations.
- Litigation: Lack of economic substance can result in protracted and costly litigation with tax authorities.
Andorra and the economic substance of companies
Andorra is a country in constant evolution. It has carried out several reforms and new regulations to follow international guidelines and regulations in tax matters.
This reflects that Andorra is a country with transparency and international tax cooperation. Here are some of the most important changes and regulations:
- Corporate Income Tax (IS): Establishes a tax rate for corporate profits, departing from the previously non-existent corporate taxation.
- Personal income tax (IRPF): It is applied to the income of individuals. Before this reform, Andorra did not have this tax.
- Double Taxation Avoidance Agreements (DTAA): Andorra has been working hard to reach agreements to avoid double taxation with countries such as Spain, France, Portugal, Luxembourg, Liechtenstein, Malta, UAE, Cyprus, and San Marino. The objective is to encourage investment in the countries involved.
- Automatic exchange of information: Andorra has adopted the OECD’s Common Reporting Standard (CRS) to automatically exchange financial information to combat tax evasion.
- Law on permanent establishments: This law is aligned with OECD guidelines to define and regulate the figure of permanent establishments in Andorra.
- Tax system modification law: This law adjusted Andorra’s tax system in areas such as indirect taxation and withholding taxes.
- Reforms in the banking sector: to maintain consistency with global standards, Andorra has carried out several reforms in its banking sector to increase transparency and combat money laundering.
- Adherence to international conventions: Andorra has joined international conventions such as the OECD Convention on Mutual Administrative Assistance in Tax Matters.
In conclusion, economic substance is an essential concept in modern international taxation. Companies must ensure their presence and operations in the country where they carry out their tax effects to avoid legal problems and serious reputational penalties.
