The European Union will be keeping a close eye on the impact of Bermuda’s Economic Substance Act — and pressuring the island to get tough on companies who lack physical presence.

That was one of the clear messages to come out of last Friday’s KPMG presentation on the new law, which attracted hundreds of business people to the Hamilton Princess and Beach Club.

The Act came into force at the start of this year and is aimed at addressing EU concerns about tax avoidance by multinational corporations.

Those conducting relevant economic activities — including banking, insurance, shipping, intellectual property, headquarters and holding companies — will need to submit data to the Registrar of Companies, who will then decide which fail to make the grade.

The criteria include “adequate” staffing, premises, core revenue-generating activities and expenditure on island. However, there is still no numeric definition of what adequate means.

Those who fall short will receive notice to address their deemed lack of substance and ordered to pay a fine. A second and third notice can follow, with fines rising to a maximum of $250,000. After that the finance minister has the power to refer the case to the courts, which can ultimately strike the offending entity off the register.

Will McCallum, managing director and head of tax at KPMG Bermuda, said the Bermuda Government had not yet offered any guidance on what adequate means.

Clearly defined metrics on the number of employees and square footage office space that a specific type of company would need were not likely to emerge any time soon, he added.

However, more guidance would become available over time and actions by the pegistrar and responses from the EU would help to clarify where the goalposts were, Mr McCallum said.

“The EU is not leaving us alone. They’ll come back to see that this is working,” he said, adding that their clear expectation was that penalties would be imposed on those that failed the substance test.

“We know that the goalposts will move. With time it will be clearer what adequate looks like. We don’t have that information now and for a lot of people, that’s a challenge.

“The phone started ringing for us in mid-December. People wanted to understand the rules better.

“If you want to know where you sit in the crosshairs, you really have to start thinking about what adequate looks like. I think you would know when you’re completely inadequate, in terms of people, premises and spend on the island.”

In February, the EU is set to announce its list of noncooperative jurisdictions. Bermuda will find out then whether its substance legislation is sufficient to stay off it.

The good news for Bermuda’s insurance industry is that the EU is comfortable with the requirements of the Insurance Act 1978 as meeting the definition of substance, Mr McCallum said.

The Act requires insurers to have their head office in Bermuda and be directed and managed from the island. This effective carve-out from the substance rules for the island’s flagship international commercial insurers and reinsurers gives Bermuda a key advantage over offshore rivals, Mr McCallum said.

“This legislation aligns Bermuda with the new way of the world, the new world standard,” Mr McCallum said. “If it keeps us that off the blacklist, then it’s a good thing.”

The OECD has indicated that it will adopt the EU standard, meaning that substance rules will likely be required by the world’s richest economies.

Mr McCallum’s colleague Michael Penrose, senior manager, KPMG Advisory, gave an update on what other jurisdictions in the same boat were doing, particularly Cayman and the British Virgin Islands, as well as Crown Dependencies Jersey, Guernsey and the Isle of Man, all of which have passed their own substance legislation.

While Bermuda has about 16,000 international companies on its register, Cayman with 120,000 incorporations and the BVI with 400,000 have a larger-scale issue with substance.

The presentation highlighted two categories that will come under particular pressure from the ESA: entities based offshore to hold intellectual property that is licensed to other parts of its corporate group, and holding companies that store equity offshore without revenue-generating activities on island.

Offshore companies falling short on substance would face a choice: to ramp up their operations or move elsewhere. The decision would boil down to not only what made economic sense for the company, but also to the jurisdiction’s capability to accommodate their new needs.

“Looking across our peers, I can’t imagine a better place to deal with it, with real people with the right experience, infrastructure and physical presence, than Bermuda,” Mr McCallum said.

“You look at the core industries of our international business sector and there are real, qualified people here doing real stuff.”

Outsourcing of core activities can count as substance, the EU conceded in recent months, Mr McCallum said. However, employees of an outsourcing firm would have to be properly qualified to take on the responsibilities outsourced and could not be counted multiple times by multiple companies, Mr McCallum said, adding that it was not yet clear how this would be calculated.

One of the EU’s concerns was “that we’re worried that one firm could effectively manage two dozen banks with three people, or their people and their office space could be double counted. The EU wants to know that this a real outsourcing arrangement.”

KPMG believes one of the implications could be changes in the corporate services sector and the development of “super CSPs” equipped with experts to carry out the core activities required for a company to meet the substance rules.

Mr McCallum gave the example of the island’s shipping sector and the potential for an outsourcer to undertake fleet management.

New companies will be subject to the ESA rules immediately. Existing companies will have until July 1, 2019.

While six months is a short time for those needing to make fundamental changes to their businesses to comply, Mr McCallum saw extensions to the deadline as unlikely.

“Anecdotally, we know that Europe has indicated it would have severe issues with long transition periods,” he said. “So there’s a decent chance that six months is all we’ve got.”

Down the pipeline, Mr McCallum said it was likely that the EU would closely monitor enforcement of the ESA and also expected public beneficial ownership register legislation by the end of this year.