Economic substance refers to the economic reality of a transaction or business activity, as opposed to its legal form. In other words, economic substance focuses on the actual economic impact and benefits of a transaction or business activity, rather than just its legal structure or tax implications.
For example, if a company sets up a subsidiary in a low-tax jurisdiction solely for the purpose of reducing its tax liability, without any real economic activity or substance in that jurisdiction, then the transaction may be considered to lack economic substance.
The concept of economic substance is important in tax law and is used to determine the tax treatment of certain transactions and activities. In some jurisdictions, tax laws require that a transaction or activity have economic substance in order to be recognized for tax purposes.
Economic substance tests may be applied to determine whether a transaction or activity has sufficient economic substance. These tests typically look at factors such as the purpose of the transaction, the economic benefit to the parties involved, and the level of economic activity and substance in the jurisdiction where the transaction takes place.