Substance Requirements vs. Shell Companies: Key Differences

The line between a legitimate international structure and a paper facade often comes down to one concept: substance. Over the past decade, tax authorities, banks, and regulators have raised the bar for what counts as a real business. I’ve sat in reviews where well-meaning founders were shocked to learn that a local director and a PO box don’t move the needle. Conversely, I’ve seen lean cross-border setups sail through audits because they could show control, people, and decision-making where the company claimed to be resident. This article breaks down substance requirements, how they differ from shell companies, and how to build or assess a robust footprint that withstands scrutiny.

Why the distinction matters

Shell companies aren’t illegal by default. They can be valid vehicles for IPOs, securitizations, or asset ring-fencing. The trouble starts when shells are used to shift profits without corresponding activity, or to obscure ownership. The fallout has been regulatory: OECD’s BEPS project, the EU’s push for “Unshell,” and economic substance laws in former “zero-tax” hubs. Banks have tightened onboarding, insurers and auditors run enhanced due diligence, and counterparties push back on counterparties that look hollow.

The numbers explain the pressure. The OECD has estimated annual global corporate tax revenue losses from profit shifting in the range of $100–240 billion. That scale has driven countries to focus not just on nominal rates but on where value is actually created. If your business earns margins in a jurisdiction, regulators expect to see the people, assets, and decisions that generate those margins in the same place—or a defensible reason why not.

Definitions: cutting through the jargon

What are substance requirements?

Substance requirements are legal and regulatory tests that a company must meet to show it carries on genuine economic activity in the jurisdiction where it claims residency or benefits. They typically look for:

Management and control: strategic decisions made locally by directors with authority.

People and functions: employees or contractors performing core income-generating activities.

Premises and assets: suitable office space and equipment, not just an address.

Risk and capital: the company bears commercial risk and has financial capacity to do so.

Records and governance: local books, board minutes, and contractual evidence.

Compliance: timely filings, taxes, payroll, and adherence to local laws.

Many jurisdictions codify substance in economic substance regulations (ESR), especially international finance centers such as the BVI, Cayman Islands, Bermuda, Jersey, Guernsey, and the UAE. Others rely on case law and tax residency tests (e.g., “central management and control” in the UK, “place of effective management” in India).

What is a shell company?

A shell company is a legal entity with no significant operations, employees, or physical presence. It may exist to hold assets, issue securities, or facilitate a transaction. A shell becomes problematic when it’s used as a conduit to obtain tax treaty benefits, shift profits, or hide ownership without corresponding substance. Regulators also use adjacent terms:

Letterbox company: an entity with a registered address but little else.

Conduit company: an intermediary that passes income through without adding value.

Special purpose vehicle (SPV): often a legitimate shell with narrowly defined activities (e.g., securitization, project finance). SPVs can be shells in the operational sense yet still be compliant when their limited purpose and oversight are clear and documented.

The policy backdrop: why substance is a headline issue

OECD BEPS: The 15 Actions pushed countries to align taxation with value creation. Two areas hit substance hardest: anti-treaty shopping (Principal Purpose Test, Limitation on Benefits) and transfer pricing for intangibles (DEMPE functions—Development, Enhancement, Maintenance, Protection, Exploitation).

Multilateral Instrument (MLI): Many treaties now include the Principal Purpose Test. If one principal purpose of an arrangement is tax benefit without sufficient substance, treaty relief can be denied.

EU measures: Anti-Tax Avoidance Directives (ATAD), enhanced transparency (DAC6), and a proposed “Unshell” directive (often called ATAD 3). While Unshell has been debated and not adopted as of this writing, it reflects the EU’s intent to deny benefits to entities with minimal substance.

Economic Substance Regulations (ESR): BVI, Cayman, Bermuda, Jersey, Guernsey, Bahamas, and the UAE require in-scope entities carrying “relevant activities” to demonstrate local substance or face penalties and information exchange with foreign tax authorities.

AML/KYC and Beneficial Ownership: FATF standards and national laws require verified UBO data. Shells without clear beneficial ownership pathways are high-risk for banks and counterparties.

Substance in practice: what actually counts

The pillars of real substance

From years of designing and defending structures, these pillars consistently matter:

Decision-making and governance

Board meetings held in the jurisdiction with a quorum physically present.

Directors who understand the business, review real board packs, and can refuse proposals.

Resolutions prepared contemporaneously, not backdated.

Major contracts negotiated or approved locally, not rubber-stamped.

People and functions

Employees or seconded staff performing core income-generating activities (CIGAs).

Job descriptions and KPIs tied to the entity’s revenues and risks.

Payroll and HR records showing consistent local presence.

Premises and infrastructure

Dedicated office space proportionate to activity—co-working can work for small teams if consistent and documented.

IT systems, data access, and records maintained locally or with controlled remote access.

Local professional service providers (legal, accounting) engaged where appropriate.

Risk and capital

The entity bears commercial risk (credit, market, IP infringement, etc.) and has the financial capacity to bear it.

Intercompany agreements and transfer pricing reflect real risk allocation.

Insurance coverage aligns with the entity’s exposures.

Books, records, and compliance

Local bookkeeping, audited financials (if required), timely ESR returns, tax returns, and regulatory filings.

Substance files: board packs, management reports, policies, and operational evidence.

ESR “relevant activities” at a glance

Jurisdictions vary, but common ESR categories include: headquarters, holding company, distribution and service center, financing and leasing, fund management, shipping, insurance, banking, and intellectual property. Each category has tailored CIGAs. For example:

Holding company: acquiring and holding shares, receiving dividends, managing equity investments.

Finance: negotiating terms, managing credit risk, monitoring and enforcing loan agreements.

IP: directing DEMPE functions—not just passively collecting royalties.

Distribution/service: managing logistics, inventory, customer service, and vendor relationships.

How authorities test substance

Tax residency and management tests

Central management and control (UK and common law): where top-level decisions are made, not where day-to-day operations occur. A non-resident board that approves key decisions by email from different countries can undermine claimed residency.

Place of effective management (POEM): where the most senior management functions are actually carried out.

Domestic factors: registered office, principal place of business, director residency, and where records are kept.

Treaty access

Principal Purpose Test (PPT): if obtaining a treaty benefit was one of the principal purposes of an arrangement and granting that benefit is inconsistent with the treaty’s object and purpose, relief can be denied.

Limitation on Benefits (LOB): objective tests (e.g., public listing, ownership/base erosion thresholds, active business test) that a company must meet to access treaty benefits.

Transfer pricing and DEMPE

For IP-heavy structures, auditors look for who performs DEMPE functions. If the IP company collects royalties but does not develop, enhance, maintain, protect, or exploit the IP (or does not control outsourced DEMPE work), it’s high risk. Substance is not just about bodies in seats; it’s about capability and control over the functions that drive profit.

Documentation expectations

During reviews, I’ve seen authorities request:

Multiple years of board minutes with agendas and supporting analysis.

Employment contracts, org charts, and timesheets.

Lease agreements and office access logs.

Bank signatory lists, payment approvals, and treasury policies.

Contracts showing negotiation history and correspondence.

Transfer pricing files and benchmarking studies.

Evidence of where key executives were physically located during decisions (travel logs, calendar invites).

If your documentation tells a coherent story, you’re halfway there.

Shell company indicators: red flags to avoid

Common features that scream “shell” to auditors and banks:

No employees and a “virtual office” address only.

Nominee directors who sit on hundreds of boards and cannot articulate the business.

Contracts drafted elsewhere, with local directors signing blindly.

Board meetings by email with timestamps from multiple time zones.

A thin interest margin in a finance company that doesn’t manage credit risk or liquidity.

An IP entity with no engineers, product managers, or brand managers; royalty income far exceeds local capabilities.

Cash pass-through within days of receipt with no justification.

Outdated websites or inconsistent public profiles (e.g., LinkedIn shows entire team elsewhere).

Inconsistent financials: high revenue, negligible local expenses.

Practical examples: what passes and what fails

Example 1: Pure holding company

Scenario: A regional holdco receives dividends and manages equity stakes.

Weak setup: PO box, corporate secretary only, dividends paid onward immediately, no local meetings. High risk of being treated as a conduit, especially for treaty claims.

Robust setup: Two resident directors with investment experience, quarterly board meetings in the jurisdiction, a part-time analyst, documented investment policy, local bank relationship, and a modest office. Expenses are reasonable for a holding role. Treaty claims supported by PPT analysis.

Evidence: Board packs reviewing performance, M&A analysis, directors’ remuneration, and clear treasury policy for cash retention and distributions.

Example 2: Intra-group finance company

Scenario: FinanceCo lends to group companies and earns a 1.5% margin.

Weak setup: Agreements negotiated by HQ treasury elsewhere, standard docs copied, no credit analysis, all payments processed automatically. Auditors likely classify as a conduit; TP adjustments and treaty denial possible.

Robust setup: Local team of two treasury professionals prepares credit assessments, monitors covenants, sets pricing within an approved policy, manages liquidity and hedging with oversight from the board. Appropriate capitalization, risk committee minutes, and insurance.

Evidence: Credit memos, covenant monitoring reports, FX/interest risk policy, market-based transfer pricing study, and clear decision logs.

Example 3: IP licensing entity

Scenario: IPCo owns patents and trademarks and licenses them to operating companies.

Weak setup: IPCo collects royalties but all R&D, brand management, and prosecution decisions occur in another country. This is classic high-risk IP. Expect aggressive challenges under DEMPE.

Robust setup: IPCo employs or contracts senior product, legal, and brand leaders; it sets development priorities, approves budgets, and controls contractors globally. Even if some work is outsourced, IPCo directs and bears risk. Royalties align with DEMPE analysis, not just legal ownership.

Evidence: Product roadmaps approved by IPCo boards, prosecution strategies, budget approvals, KPIs for outsourced teams, and periodic performance reviews.

Example 4: Distribution and service hub

Scenario: Regional hub buys from manufacturers and sells to affiliates, providing after-sales support.

Weak setup: Pure invoice-processor; logistics, pricing, and customer relationships handled elsewhere. Thin local costs. Authorities may disregard the hub and reallocate profits.

Robust setup: Local team manages supply contracts, inventory, demand forecasting, pricing within policy, and key customer escalation. Contracts and commercial risk sit with the hub. Profits consistent with functions and risk profile.

Evidence: Supplier negotiations, price committee notes, inventory risk management, and service-level metrics.

Step-by-step: building real substance

I like to structure implementation in five phases, with milestones and a “substance file” from day one.

Phase 1: Assess and design (2–6 weeks)

Map current structure: entities, people, contracts, cash flows, and where decisions are truly made.

Identify risk hotspots: high-margin entities with no staff, treaty claims, high-risk IP, or finance activities.

Choose jurisdiction fit: talent market, time zone, costs, treaty network, regulatory regime, and language.

Design target operating model (TOM): functions, headcount plan, governance, and internal controls.

Align transfer pricing: confirm pricing matches functions and risks, plan for documentation.

Deliverables: TOM, substance plan, board calendar, initial org chart, job descriptions, and policy drafts.

Phase 2: Establish presence (1–3 months)

Lease suitable office space; set up utilities, IT systems, and document retention.

Recruit directors and initial staff. Avoid over-relying on corporate service provider personnel for core functions.

Open bank accounts; set signatory matrix and payment policies.

Deliverables: Lease, employment contracts, IT policy, bank mandates, HR registrations.

Phase 3: Operationalize governance (ongoing)

Hold board meetings on-site according to an annual calendar. Circulate meaningful board packs: financials, risk reports, strategy memos.

Implement treasury, procurement, credit, and IP policies. Ensure approvals are made locally.

Sign new contracts under the local entity after negotiation/approval in jurisdiction.

Deliverables: Board minutes, policy acknowledgments, approval logs, contract repositories.

Phase 4: Evidence and compliance (quarterly/annual)

Maintain a substance file: minutes, travel logs, org charts, performance reviews, leases, photos of the office, vendor invoices, and IT access logs.

Prepare ESR filings, tax returns, and statutory accounts on time.

Review transfer pricing annually; refresh benchmarks and intercompany agreements.

Deliverables: ESR report, TP master/local files, audited financials (if applicable), statutory registers.

Phase 5: Monitor and improve (annual)

Perform a substance gap review before audits or refinancing.

Stress-test treaty claims under PPT/LOB.

Adjust staffing and processes as the business grows; document changes.

Deliverables: Annual substance review memo, remediation plan, updated TOM.

Budgeting and timelines: realistic ranges

Costs vary widely, but rough planning numbers I’ve used for mid-market structures:

Office lease (per month): $1,000–$4,000 for modest space in hubs like Dublin, Luxembourg, Singapore outskirts; $5,000–$10,000+ in prime areas.

Local director fees: $5,000–$25,000 per director annually, depending on responsibility and risk.

Professional staff: $60,000–$150,000 per FTE per year (treasury, IP counsel, product managers).

Corporate services, audit, and compliance: $15,000–$75,000 annually.

Set-up timeline: 2–4 months to be operational; 6–12 months before substance is demonstrable in practice.

Common mistakes that sink substance—and how to fix them

Renting a mailbox and calling it an office

Fix: Lease dedicated space proportionate to activity. Keep evidence: floor plan, signage, photos, visitor logs.

Nominee directors without real control

Fix: Appoint directors with relevant expertise. Provide training, set expectations for challenge and oversight, and compensate appropriately.

Decision-making by email from another country

Fix: Calendar on-site meetings. If urgent approvals happen remotely, record where directors were and plan a ratification meeting locally.

Over-reliance on outsourced providers

Fix: Outsourcing is allowed, but the entity must direct and control the provider. Keep contracts, SLAs, and oversight reports. Hold quarterly performance reviews.

Backdated paperwork

Fix: Prepare contemporaneous minutes and memos. Document decision paths as they happen, not months later.

Misaligned transfer pricing

Fix: Align functions and risk with pricing. If the local entity is a limited-risk distributor, don’t book entrepreneurial profits there. Refresh TP studies regularly.

Ignoring indirect taxes and payroll

Fix: Register for VAT/GST if required, with proper invoicing. Put employees on local payroll with social contributions.

Treating IP as “passive”

Fix: If the entity earns IP returns, it must manage DEMPE or pay others at arm’s length and control those relationships.

One-size-fits-all templates

Fix: Tailor policies, board packs, and contracts to the actual business. Avoid boilerplate that contradicts reality.

Substance amnesia after year one

Fix: Keep cadence. Authorities look for sustained activity, not one-off theatre.

Audit and review readiness: your substance file checklist

I encourage clients to maintain a “substance pack” that can be shared under NDA within 48 hours:

Corporate governance

Board calendar, agendas, minutes, attendance, and travel evidence.

Director bios, appointment letters, and D&O insurance.

People and operations

Org charts, job descriptions, employment contracts, timesheets, and performance reviews.

Office lease, photos, access logs, IT asset inventory.

Finance and risk

Bank mandates, treasury policies, credit memos, hedging strategies.

Insurance policies covering the entity’s risks.

Commercial documentation

Intercompany agreements with clear functions, risks, and pricing.

Key customer/supplier contracts and negotiation evidence.

Compliance

ESR notifications and reports, tax returns, VAT/GST filings.

Transfer pricing master and local files with benchmarks.

Statutory accounts and audits.

How banks and counterparties assess shells

Bank onboarding teams and large customers look for similar signals:

KYC/AML: verified beneficial owners, source of funds, and expected activity.

Operations: number of employees, office location, and transaction patterns.

Governance: local directors and board minutes.

Financials: consistency between revenue, expense base, and narrative.

Red flags: sudden large cross-border flows, circular payments, or dormant periods punctuated by big movements.

Practical tip: give your relationship manager a concise dossier—org chart, business summary, substance evidence, forecast flows. It reduces the back-and-forth and shows you’re serious.

When a special purpose vehicle is acceptable—and how to prove it

SPVs are intentionally “hollow” in operations but can be fully compliant when:

Their purpose is narrow and documented (e.g., securitization, aircraft finance, real estate holding).

Independent directors or trustees oversee critical decisions.

Cash and asset flows are ring-fenced with robust legal frameworks.

Investors and rating agencies require the structure for risk isolation.

What to document:

Transaction rationale and structure memorandum.

Trust deeds, agency agreements, and true-sale opinions (if relevant).

Board minutes showing independent judgment on key approvals.

Ongoing compliance reports to trustees, listing authorities, or regulators.

Penalties and consequences: what’s at stake

Consequences vary by jurisdiction but typically include:

Monetary penalties for failing ESR filings or tests. For example, some jurisdictions levy five-figure fines for non-filing and escalate into six figures for repeated failures or high-risk IP. In the UAE, repeat failures can trigger penalties in the hundreds of thousands of dirhams and information exchanges with foreign authorities. In the BVI, second-year non-compliance can lead to substantial fines and potential strike-off.

Spontaneous exchange of information with the company’s ultimate parent and residence countries, inviting audits elsewhere.

Denial of treaty benefits under PPT/LOB, leading to withholding tax costs.

Transfer pricing adjustments, back taxes, and interest.

Banking fallout: account closures or inability to onboard with reputable institutions.

The direct cash impact from a denied treaty claim or TP adjustment often dwarfs the cost of building substance properly.

Quick jurisdiction snapshots: substance flavors

This isn’t advice—just patterns I’ve seen work or fail.

BVI/Cayman/Bermuda/Jersey/Guernsey

Strong ESR regimes focused on relevant activities. Outsourcing allowed with control. Many clients successfully meet holding or fund management activity tests with modest teams plus robust governance. High-risk IP is scrutinized.

Expect rigorous annual reporting; penalties escalate with repeated failures.

ESR applies to a range of activities; corporate tax introduced at 9% for many businesses. Free zones can offer incentives but still require substance. Business-friendly hiring and premises but banks expect clarity on operating footprint.

Ireland/Luxembourg/Netherlands

Deep talent pools for finance, IP, and distribution. Authorities expect real headcount and decision-making locally, not brass-plate. Treaty networks are strong but PPT scrutiny is real.

Singapore/Hong Kong

Substance expected for incentives and treaty access. Singapore emphasizes control over functions; incentive regimes require headcount and expenditure commitments. Hong Kong focuses on profits tax nexus—substance and source of profits tests.

Central management and control doctrine drives residency. A company can be UK-resident despite foreign incorporation if strategic control sits in the UK. Document where decisions occur.

Remote work and hybrid teams: does it kill substance?

Not necessarily. The key is where strategic decision-making and controlled functions occur. Practical ways to handle hybrid:

Require directors to attend in-person quarterly meetings; record locations in minutes.

Maintain a local core team for CIGAs; allow remote support for non-core tasks.

Use secure systems with access logs tied to the jurisdiction; keep primary records locally.

If executives travel, track travel days and avoid making critical decisions outside the entity’s residence without a follow-up on-site ratification.

Auditors are pragmatic when the story and evidence are consistent with a hybrid model.

Already have a shell? Triage and remediation

If a self-assessment reveals shell characteristics, don’t panic—make a plan.

Risk triage

Identify high-risk entities: high-margin with low local spend, treaty claims, finance or IP without staff.

Estimate exposure: withholding tax risk, TP adjustments, ESR penalties.

Decide: build or exit

Build: hire key personnel, move decision-making, re-paper contracts, and establish premises. Prioritize entities claiming treaty benefits or bearing risk.

Exit: if there’s no real business case, simplify. Liquidate or merge. Better a clean exit than lingering risk.

Timeline and communication

Implement visible changes within 90 days (board meetings, hires, office).

Document remediation in a memo. If audited, show progress and intent.

Consider voluntary disclosure

In some jurisdictions, proactive engagement can mitigate penalties. Take counsel before approaching authorities.

A simple framework for decision-makers

When advising boards, I use three questions:

Where is value created?

People who make things happen—product, sales, risk—are your anchors. Tax follows them.

Where are decisions truly made?

If the board meeting can’t move without HQ approval, your “local control” is fiction. Fix governance or change the story.

Does the paper match reality?

Contracts, TP, and filings must reflect actual functions and risks. If not, align them—or change operations.

Frequently asked, briefly answered

Can I meet substance with contractors instead of employees?

Often yes, if you control them and they work primarily for your entity. Document oversight, KPIs, and exclusivity where possible.

Are co-working spaces acceptable?

For small teams, yes, if the space is dedicated and used regularly. Keep evidence. As you scale, move to a private office.

Do I need resident directors?

In many cases, yes, to anchor central management. More critical if treaty access or residency is claimed.

How many employees are “enough”?

There’s no magic number. It must be proportionate to activity and profits. A holding company may need minimal staff; a finance or IP company often needs specialized professionals.

Can outsourcing satisfy ESR?

Usually allowed, but the entity must direct and monitor the outsourced provider. Outsourcing DEMPE functions without control is risky.

Final thoughts from the trenches

Substance isn’t a checkbox; it’s a story about where your business lives. Authorities, banks, and counterparties read that story through your people, decisions, and records. The good news is that a right-sized approach—credible headcount, thoughtful governance, and clean documentation—typically costs less than a single failed audit or denied treaty claim.

If you’re building new, bake substance into your operating model from the start: don’t let tax drive the map more than the business can support. If you’re remediating, move decisively on high-risk entities and over-communicate your changes in board minutes and filings. In my experience, when the paper and the practice align, reviews become routine. When they don’t, even a beautiful org chart won’t save the day.