Economic substance

What it means

Economic substance is a company's real business presence in a country. It includes an office, qualified staff, the place where decisions are actually made and activities that match the profits reported. A company without substance is merely a legal shell with an address.

Substance has grown in importance with international measures against aggressive tax planning, especially the BEPS project and the EU ATAD directive. Tax authorities today look not only at where a company is registered but at where it actually creates value.

The concept is linked to the principle of substance over form. If a legal structure lacks economic justification and its main aim is a tax advantage, the tax authority may disregard it when assessing tax and judge the transactions by their real nature.

How it works in practice

Substance matters for holding structures and foreign companies. If a Slovak company pays dividends, interest or royalties to a foreign company, benefits under a double tax treaty may be denied if the recipient is not the beneficial owner of the income.

Conversely, for a Slovak entrepreneur with a foreign company, the question is whether management is in fact exercised from Slovakia. If so, the foreign company may be tax resident in Slovakia or have a permanent establishment there, and its profits may be taxed here too.

Substance is evidenced by office leases, employment contracts, minutes of board meetings held in the country, bank accounts and records of real costs. These are best in place before any tax audit rather than created after the fact.

What to watch out for

A virtual office or nominee directors without real powers do not create substance. In an audit the tax authority looks at who decides, where the people are and where the work is done, and formalities without content tend to raise suspicion rather than dispel it.

In addition, controlled foreign company rules may apply, under which undistributed profits of a low-taxed foreign subsidiary without substance are added to the tax base of the Slovak parent. The structure should therefore be reviewed regularly.