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Tax Tips (22) – Dealing with International Tax Cooperation
A multilateral tax cooperation mechanism under the Belt and Road Initiative (BRI), the Belt and Road Initiative Tax Administration Mechanism (BRITACOM) which includes tax authorities from 34 countries and regions, was established on 18 April 2019. The reported aim of BRITACOM is to facilitate cross-border trade and investment along BRI routes by expanding tax dispute resolution activities, increasing transparency, streamlining compliance and digitizing filing. An office will be opened in Beijing to help facilitate these goals.

Since the BRI consists primarily of Chinese outbound investment in infrastructure projects in the participating countries, BRITACOM will likely function more in facilitating outbound Mainland Chinese entities’ local tax compliance and dispute resolution when engaged in such projects. BRITACOM will be different from the various anti-tax avoidance initiatives of the OECD and other international organisations.

International Effort in Anti-Tax Avoidance

The most well-known international effort against tax avoidance is the Base Erosion and Profit Shifting (BEPS) project. The 15 BEPS Actions issued in October 2015 challenge tax avoidance practices by large Multinational Enterprises (“L-MNEs”) by amending the global tax treaties, increasing disclosure and transparency, introducing new documentation in transfer pricing, countering harmful tax practices, lowering threshold of permanent establishment recognition, investigating into new form of taxation for digital services and toughening interest deduction rules. The primary aim of BEPS is to ensure that the international tax rules do not facilitate the shifting of corporate profits away from the real economic activity and value creation are taking place. Many of these Actions have been implemented already, the latest being the Economic Substance Law (with the BVI just issued the Draft Economic Substance Code).

In addition, the OECD has stepped up efforts in international cooperation on tax matters in recent years. Heads of tax administrations meet regularly at the Forum of Tax Administration (FTA). Cross-border tax avoidance intelligence is shared among tax offices under the Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC). The International Compliance Assurance Programme (ICAP) invites large MNEs to engage voluntarily with tax administrations from 17 jurisdictions (expanded from 8 when the pilot began in January 2018). Tax Inspectors Without Borders sends experience tax officials to train those in developing countries to perform tax audits on MNEs.

The United Nation, the World Bank, the International Monetary Fund, and the European Unions are also very active in introducing new initiatives in combating tax avoidance.

Large MNEs have Acted

Many L-MNEs have already started restructuring back in around 2013/14 in view of the disclosure requirements especially the Country-by-Country Reporting (CbCR). In the past, many L-MNEs housed the intellectual properties (“IP”) in tax haven jurisdictions earning untaxed royalties or have captive insurance companies there to provide insurance coverage to group companies in order to receive untaxed income while the group companies could take a tax deduction. Smart L-MNEs would have restructured early so that no tax office would have the opportunity to ask the sensitive questions. Their most immediate challenge to the L-MNEs would likely be dealing with the economic substance law in the tax haven countries, especially those that have been acting as funding vehicles.

Smaller MNEs – Act Now

L-MNEs have internal tax resources to help them manage tax risks in this rapidly changing tax environment. What about the Small and Medium Size MNEs (S-MNEs) that do not have in-house tax people? They obviously have to rely on external tax consultants. The key is to identify the right consultants to do the following two things:

1. Review the existing structure, operations and arrangements

The objective of such review is to identify tax risks and opportunities currently embedded in the group structure and operations. The author had seen a group missing out the 50/50 offshore claim in the Hong Kong profits tax filing on a contract manufacturing arrangement. In another case, a Hong Kong-based listed group devoted resources in Hong Kong to help the overseas affiliates in high tax countries to become highly profitable but they do not realise that they should recoup the costs incurred in Hong Kong via transfer pricing in order to align with the commercial reality and reduce the group’s effective tax rate. These can be dug out and properly addressed in order to create legitimate tax saving.

Some groups have not paid attention to documentation of decision making and thereby creating risks of being regarded as tax resident in jurisdictions unexpectedly. The old model of cost-plus remuneration of agents may now be exposed to permanent establishment risks. Some have ignored the documentation of substance. The impact of the Economic Substance Law introduced by the tax havens such as the British Virgin Islands (BVI) must be properly analysed with a set of action determined to address the issue.

To be a good manager, issues should be addressed and resolved upfront so that the expectation of shareholders and directors of the group/company is well-managed. The review should be conducted by professionals with solid technical and business experience. There are well-qualified tax advisors in the market to do the work at competitive rates and high efficiency to deliver substantial value to the groups.

Often the finance managers of the groups/companies prefer to stick their heads into the sand instead of dealing with the problems because they don’t want to take the blame for issues uncovered by the seasoned tax advisors. It is thus important for the directors or even the shareholders to realise what the current tax environment is like and take initiative in carrying out the review. At the end of the day, if the hidden tax exposures are not cleared before they crystalise, the group/company, the directors and shareholders would be badly hurt.

2. Seek on-going tax support especially on documentation

Having identified and dealt with past issues, it is important that no such issue will arise again in the future. This can be achieved by retaining the tax advisor to review transactions or documentation as and when required, just a family doctor caring for the health of the family. For example, sometimes the auditors, being unaware of the tax exposure created, may make disclosures in the audited financial statements that are unnecessary and sometimes even harmful to the tax arrangement of the company. For listed companies, they should be very careful in the disclosures in the annual reports.

Board papers are crucial. It is direct evidence of management and control which is one of the key factors in determining substance and tax residency. Tax advisors play an important role in advising who should be on the board of each company, location of board meetings and review the board papers.

Also, management should be made aware of tax law changes and new cases that affect their business. Questions they should ask, or proactively addressed by the tax advisor, include:
- What are the benefits of the new tax incentives introduced in Hong Kong such as the two-tier tax system to the group?
- Should something be done about intellectual property in view of the new Section 15F of the Inland Revenue Ordinance?
- What should the group do in view of the Beneficial Ownership rules in Mainland China to ensure that the benefits can be obtained?
- Is CbCR going to affect the group?
- The boss travels to Mainland China often, is he exposed to the Chinese Individual Income Tax on worldwide income?
- Is the loan financing of a foreign subsidiary compliant with transfer pricing or will it be challenged by the tax authorities?
- In view of the tax cases, can the Hong Kong company still lodge an offshore claim on its trading profits? How to ensure a successful claim?
- How to structure a new acquisition? Is the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (commonly referred to as the Multilateral Instrument) going to affect the group? Would all the new tax rules introduced bring higher tax exposures in a share deal and how to mitigate such risks?
The list of questions can be much longer.

Tax Tips

It is time for the smaller groups to gear up the tax risk monitoring and compliance, and ensure that structures are sustainable in the medium term. The BEPS Project is at the implementation stage and it will not be long before OECD reviews the achievement and point to the next target: the S-MNE groups. The time to act is NOW.

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Ref:

BRITACOM: http://www.chinatax.gov.cn/eng/n2367751/c4273658/content.html
May 7, 2019
Tax Tips (21) – No Tax Even If Stay in China for Over 183 Days?

The article “The Mysterious 183 Days” (10 September 2018 – Tax Tips 15) addressed the question “Is it true that there is no IIT liability if one stays in the Mainland for not more than 183 days?”. The Ministry of Finance and the State Taxation Administration of Mainland China issued two important notices on Individual Income Tax (“IIT”) on 14 March 2019, namely 《Determination of the Duration of Residence of Non-China-domiciled Individuals – Public Notice 2019 No.34》 (“PN34”) and the very complex 《Policies Regarding the Tax Treatment of Non-Residents and Non-China-domiciled Resident Individuals – Public Notice 2019 No.35》 (“PN35”), which set out a new way of calculating the days of residence in China and details of IIT computation for non-residents and non-domiciled resident individuals under different scenarios. Both Public Notices are effective on 1 January 2019. This article focuses on the implications of the new definition of days of presence in China.

The Relevant Articles on the Days of Residence

To help Readers’ better understanding of the issue, the Articles in the IIT Law and Detailed Implementation Rules relating to the days of residence are set out below.

Article 1 of the IIT Law

Individuals who are domiciled in China, or non-domiciled but resided in China for 183 days in aggregate in a tax year, are resident individuals. Resident individuals are subject to IIT on income from sources within and outside China.

Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in aggregate in a tax year, are non-resident individuals. Non-resident individuals shall pay IIT in accordance with this Law on income derived from sources within China.

Article 4 of the Detailed Implementation Rules of the IIT Law (“DIR”)

Individuals who are not domiciled in China and resided in China for 183 days in a year for a consecutive period of not more than 6 years, upon completion of filing procedures with the in-charge tax office, the foreign sourced income that is paid by foreign entities or individuals is exempt from IIT; whenever a single trip of more than 30 days is made in the year that the days of residence reached 183 days in aggregate, the accumulation of consecutive years would start afresh.

Article 5 of the DIR

Individuals who are not domiciled in China and resided in China for not more than 90 days in aggregate in a tax year, China sourced income that is paid by the foreign employer and is not borne by a place or establishment of the foreign employer located in China would be exempt from IIT.

PN34 – Days of Residence

Article 1 of PN34 clarifies what is meant by “resided in China for 183 days in a year for a consecutive period of not more than 6 years” as per Article 4 of the DIR of the IIT Law. The provisions are in line with the general expectation.

Article 2 is more impactful. The article states that: “the length of residence of a non-domiciled individual in China in a tax year shall be calculated based on the days of presence in China. A full 24 hours-day of presence would be counted as one day of residence. Where the presence is less than 24 hours in a day, that day is not counted as a day of presence”.

Based on PN34, only a full 24-hours day of presence would be counted as a day of residence in China. This day of residence is relevant to the determination of “resided in China for 183 days” or “more than/not more than 90 days” under Article 1 of the IIT Law and Articles 4 and 5 of the DIR. The implication of this change is that it will be harder for individuals to be subject to IIT or become a Chinese tax resident, and easier to meet the conditions set forth in Article 4 of the DIR such that IIT liabilities would be reduced or even totally exempted. This is good news to non-China-domiciled Hong Kong individuals.

PN35 – Days of Work

Article 1 Para 1 of PN35 is about the determination of the source of wages and salaries. Para 1 stated that “The wages and salaries earned by an individual attributable to the working period in China are regarded as China-sourced wages and salaries. The working period in China shall be calculated according to days worked by the individual in China, which includes the actual working days in China and days spent inside or outside China for public holidays, personal vacations and training.

If the individual holds employment positions in both foreign and Chinese entities or is solely working for foreign entities, time spent in China that is less than 24 hours in a day would be counted as 0.5 days for the purposes of determining the number of days worked in China.

Why is this method of counting so different from that prescribed in PN34? Since non-China sourced income that is paid by foreign entities or individuals outside of China would be exempt from IIT, the determination of China and foreign sourced income is very important.

If a Hong Kong individual is only working for an entity in China, the days that are spent outside of China for vacation or training are all related to China employment and it is reasonable to include days spent outside of China as a working period in China, such that no days would be deducted from his China working period. On the other hand, if an individual is working for both China and foreign entities, it is reasonable that part of a day spent in China is counted for only 0.5 days as China working period.

The foreign working period is determined by deducting China working period from the calendar days of the month. The number of days worked in China and outside China would be inserted into the formulae prescribed in PN35 in determining the wages and salaries from sources in and outside China.

Double Tax Arrangement – Days of Presence

“The Mysterious 183 Days” mentioned that the exemption from IIT for individuals who visit China for not more than 183 days is an effective extension of Article 7 of the old Detailed Implementation Rules of the IIT Law. Article 5 of the new DIR has basically retained the same provision. Under Article 14 <Income from Employment> of the Mainland-Hong Kong Double Taxation Arrangement (“CN-HK DTA”), the period of stay is “extended” from 90 days to 183 days. A Hong Kong resident would be exempt from IIT if the three conditions in Para 2 of Article 14 are all satisfied. The three conditions are:

1. the recipient is present in the Other Side for a period or periods not exceeding in the aggregate 183 days in any 12-month period commencing or ending in the taxable period concerned;
2. the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side;
3. the remuneration is not borne by a permanent establishment which the employer has in the Other Side.

“The Mysterious 183 Days” also mentioned that in counting the actual number of days for condition 1, one should include all days spent in China, including days that are not the full day such as the day of arrival and day of departure, as well as weekends, holidays, and vacation etc spent in China before, during and after the employment. Does the relaxation of counting the days under PN34 cover the 183 days in the DTA?

Unfortunately, there is no relaxation for the purposes of the DTA (notwithstanding, relaxation can be attained under Article 5 of the DIR, as to be explained further below). The days referred to by PN34 is the “days of residence”, the days referred to in the DTA is the “days of presence”. The new definition applies to “days of residence” only. Thus the counting of 183 days under the DTA has not changed.

According to the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017, there is only one method of counting 183 days: the “days of physical presence” method, which aligns with what was mentioned in “The Mysterious 183 Days”.

PN35 listed out a number of old IIT circulars that are abolished with effect from 1 January 2019, which included the “State Taxation Administration Notice on Certain Issues in Relation to the Implementation of DTA and IIT Law for Non-China-Domiciled Individuals – GuoShuiFa (2004) No.97”. Article 1 of the circular stated that “for individuals who do not have a domicile in China, for the purposes of calculating the days of residence in China for the determination of IIT liabilities under the law or DTA, the actual physical presence days would be counted. The day of arrival, the day of departure, round-trip and multiple round-trips to and from China would each be counted as one day of presence”. The new definition of days under PN34 and the abolition of GuoShuiFa (2004) No.97 could lead some people to wonder if the method of calculating the days of presence under the DTA has also been amended.

Readers should also pay attention to the fact that Article 15 Para 2(1) of the circular “Interpretation of the DTA between China and Singapore and the Protocols – GuoShuiFa (2010) No.75” applies the same OECD method in computing the days of presence, and the article in this circular has not been abolished by PN35.

The IIT Law is More Favorable than Tax Treaty Provisions?

Assuming a Hong Kong resident who is not domiciled in China and only has employment in Hong Kong. His salary is paid by the Hong Kong employer in Hong Kong and is not borne a place or establishment of the employer in China (fulfilled the 3 conditions set forth in Article 14 Para 2 of the CN-HK DTA and Article 5 of the DIR). Starting in 2019, the individual visits China every week, Monday to Friday, and his weekly travel pattern is as follows:

Monday Hong Kong to Guangzhou
Tuesday Guangzhou to Hong Kong
Wednesday Day trip to Shenzhen
Thursday Hong Kong to Zhuhai
Friday Zhuhai to Hong Kong
Saturday Hong Kong
Sunday Hong Kong

According to CN-HK DTA, the individual stayed 5 days in a week in China, and he will reach 183 days in week 37 such that he will have to report and pay IIT for his China-sourced income for the past 37 weeks. However, the individual’s day of residence in China is zero. Is he subject to IIT?

The point to note here is that zero-day of residence does not mean zero-workday in China. Therefore, the individual is still required to apply the formulae in PN35 to determine the IIT calculation in this case.

Tax Tips

Whenever an employee is seconded to work in China or an individual chooses to be employed by a Mainland Chinese enterprise or even taking up positions inside and outside China, the IIT implications should be carefully assessed. The individual’s domicile, residency, employment inside or outside of China, the bearer of wages and salaries, the days of residence, work and presence would all affect the reporting and calculation of IIT.

Although under the new IIT law the tax rates have been reduced, more deductions are allowed and the grace period of avoiding taxation on global income has been extended, the complexity of the new IIT law has made it more difficult to comply, easier to make filing mistakes and result in increased tax risk.

On the other hand, the more relaxed days of residence calculation would encourage more people to stay in China for a longer period of time, which would make it easier for foreign enterprises to create a Permanent Establishment in China (discussed in details in “The Mysterious 183 Days”). The matter has to be handled carefully by both employers and individuals.

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(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 29 March 2019: https://manageyourtax.com/HKEJ Forum 21 )

Ref:

Public Notice 2019 No.34
http://www.chinatax.gov.cn/n810219/n810744/n3752930/n3752974/c4151944/content.html

Public Notice 2019 No.35
http://www.chinatax.gov.cn/n810219/n810744/n3752930/n3752974/c4151934/content.html

IIT Law
http://www.chinatax.gov.cn/n810219/n810744/n3752930/n3752974/c3970366/content.html

IIT Law Implementation Rules
http://www.chinatax.gov.cn/n810219/n810744/n3752930/n3752974/c3963364/content.html

CN-HK DTA
https://www.elegislation.gov.hk/hk/cap112AY!en-zh-Hant-HK?INDEX_CS=N&xpid=ID_1438402590626_001

Model Tax Convention on Income and on Capital: Condensed Version 2017
https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version-2017_mtc_cond-2017-en#page307

GuoShuiFa (2004) 97
http://www.chinatax.gov.cn/n810341/n810765/n812193/n812988/c1202708/content.html

China-Singapore DTA Implementation Notes
http://www.chinatax.gov.cn/n810341/n810765/n812161/n812547/c1085021/content.html

March 29, 2019
Tax Tips (19) – Ready to Hire Employees in the BVI?
The last issue of Tax Tips (The Final Days of Tax Havens – 10 December 2018) discussed the paper “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”) issued by the OECD Inclusive Framework on BEPS Action 5, and forewarned the changes ahead: tax haven companies will be required by law to hire an adequate number of full-time qualified employees and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in.

Tax Havens including the well-known Cayman Islands and the British Virgin Islands (BVI) have swiftly introduced economic substance legislation. Cayman Islands passed The International Tax Co-operation (Economic Substance) Law, 2018 on 17 December and the BVI’s Economic Substance (Companies and Limited Partnerships) Act, 2018 was passed into law on 19 December 2018. These laws have become effective on 1 January 2019.

The rush to pass these laws before the end of 2018 was due to the commitment made to the European Union (EU). The Cayman Islands and BVI, together with countries such as Bermuda, Guernsey, Jersey and Isle of Man were included in a list of countries whose tax policies and economic substance caused concern for the EU Code of Conduct Group (Business Taxation). These countries were given the deadline of 31 December 2018 to introduce laws (the “Economic Substance Law” hereinafter) to avoid blacklisting by the EU.

Economic Substance Law

The economic substance required by the EU is basically identical to those set out in the Paper. Although the Economic Substance Laws have been passed, the Tax Havens still need to wait for the EU to confirm that the EU requirements have been met. However, from the reports on the visit by the OECD representatives (including the Director of the Centre for Tax Policy and Administration Mr. Pascal Saint-Aman) to the Cayman Islands in early January 2019, it seems that things are on the right track. Although the legislation introduced by different countries are broadly similar, details are different and Readers using Tax Haven vehicles should study the specific legislation to analyse the impact.

Impact Assessment

Not all Tax Haven entities will be affected. Here are the general steps one could take to assess if a company shall comply.

Step 1: Is the company a “Relevant Entity”

The Economic Substance Laws generally apply only to entities that are not tax residents outside of the Tax Haven country (the Relevant Entities). For example, if a BVI company is registered to carry on business in Hong Kong, it will likely be regarded a tax resident in Hong Kong and thus out of scope for the BVI Economic Substance Law.

Step 2: Is the Relevant Entity conducting the “Relevant Activities”

Corporates and individuals use Tax Haven entities for various activities but only the “Relevant Activities” are subject to the substance requirements. Generally, the geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and the below Non-IP activities would be considered the Relevant Activities:
- Headquarters
- Distribution centres
- Service centres
- Financing
- Leasing
- Fund management
- Banking
- Insurance
- Shipping
- Equity holding
Relevant Entities will likely be required to file notices to inform the authorities whether they are conducting Relevant Activities or not. Those conducting Relevant Activities will then need to provide information covering items such as income, expenses, assets, premises, management, employees and physical presence. If the economic substance of the Relevant Entity falls short of the requirements, it will be asked to make an improvement. Persistent failure to fulfil the substance requirement may be subject to fines and even result in being struck-off.

Step 3: Meeting the Economic Substance Requirement

In general, a Relevant Entity conducting any of the above Relevant Activities complies with the economic substance requirements if:

(a) the Relevant Activity is directed and managed locally (i.e. in the Tax Haven);

(b) having regard to the nature and scale of the relevant activity:
1. there are an adequate number of suitably qualified employees in relation to that activity who are physically present locally;
2. there is adequate expenditure incurred locally;
3. there are physical offices or premises as may be appropriate for the core income-generating activities; and
4. where the Relevant Activity is IP business and requires the use of specific equipment, that equipment is located locally; and
(c) the Relevant Entity conducts core income-generating activity.

A pure equity holding entity, which carries on no Relevant Activity other than holding equity participations in other entities and earning dividends and capital gains, are subject to the reduced requirement and would be considered to have adequate substance if it:

(a) complies with its statutory obligations under the relevant company laws; and
(b) has adequate employees and premises for holding equitable interests or shares and, where it manages those equitable interests or shares, has adequate employees and premises for carrying out that management.

On the other hand, more stringent rules apply to high-risk intellectual property holding companies.

As to what is “adequate”, one has to wait for the details to be announced by each country. The Mauritius example mentioned in Tax Tips (18) would give some indications of what is to come.

Outsourcing of Core Income Generating Activities

The economic substance requirements generally allow for outsourcing of the core income generating activities to third-party within the jurisdiction. The Relevant Entity must, however, be able to prove that it is able to monitor and control the core income generating activities being carried out are conducted locally.

The below flowchart downloaded from the Jersey Government website is a good reference on how the laws work in general.

No-where Income

The Common Reporting Standard (CRS) and Economic Substance Laws are bringing tax residencies of companies and individuals into the limelight. Hong Kong businesses are faced with questions from their bankers that ask them to identify the tax residency of their Tax Haven companies which have bank accounts in Hong Kong. Thanks to creative tax planning advice Hong Kong businesses acted on in the past, many of them use the bank accounts in the following situations:
- There is a group company in Mainland China manufacturing goods for domestic sales. Orders of overseas customers are accepted in China and are shipped out without export declaration. The overseas customers pay to the Hong Kong bank account of the group BVI company, and some of the cash received would be used to pay Hong Kong suppliers who provide the raw materials in China. These sales and purchases would not be booked by the manufacturer in China.
- Services are provided in Hong Kong or China to overseas clients and they are asked to pay to the Hong Kong bank account of a BVI company. Income is booked in the BVI company while the costs of services are incurred in Hong Kong or China with tax deduction allowed unchallenged.
- IPs such as brands, trademarks, designs, rights etc are owned by BVI companies and earning hefty royalty income from group companies or unrelated parties, while the work related to the development, exploitation, maintenance, protection and enhancement of the IPs are carried out in Hong Kong, and the costs of such activities have been fully tax-deducted.
In the above examples, there would be under-reporting of income as profits have been shifted to entities that do not carry out value-creation activities. Once the tax offices in Hong Kong or China have become aware of the situations (which has become more likely these days with all the reporting and information exchange arrangements), they may, for example, treat the BVI companies as carrying on business in Hong Kong or managed and controlled in China, as the case may be, and assess tax on the under-reported amount and impose heavy penalties. On the other hand, from now on the groups in question also need to maintain substance of these BVI companies in the BVI or they risk the companies being struck-off. Things will become more complicated if the shareholders of the companies become Chinese tax residents by spending 183 days or more in China in a calendar year.

Tax Tips

As mentioned in Tax Tips (1), “Base Erosion and Profit Shifting” (BEPS) refers to the tax planning strategy of multinational groups (big or small) making use of differences and mismatches of tax rules across different countries and artificially transferring profits to low or no-tax jurisdictions with little or no economic activity. The pressure now felt by taxpayers is indeed the intended effect of OECD’s project against BEPS. At the same time, the compliance costs of Tax Haven entities are rising. Taxpayers should take action to restructure their operations and shift profits back to where the activities are. There will be an increase in tax burden, but a managed transition would help minimise the tax costs and avoid heavy penalties: tax offices like to punish aggressive taxpayers with the highest penalties.

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(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 24 January 2019: https://manageyourtax.com/HKEJ Forum 19)

Ref:

The Paper: http://www.oecd.org/tax/beps/resumption-of-application-of-substantial-activities-factor.pdf

Members of the Inclusive Framework on BEPS: http://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf

BVI Economic Substance Law:

https://eservices.gov.vg/gazette/sites/eservices.gov.vg.gazette/files/newattachments/Act%20No%2012%20–%20Economic%20Substance%20%28Companies%20and%20Limited%20Partnerships%29%20Act%202018-%20Revised%2017%2012%202018%20%28clean%29%20%281%29_0.pdf

EU Listing:

http://data.consilium.europa.eu/doc/document/ST-9637-2018-INIT/en/pdf

OECD visit to the Cayman Islands:

http://www.caymanfinance.gov.ky/portal/page/portal/pruhome/pressroom/2019/oecd-tax-policy-representatives-visit-cayman?fbclid=IwAR1QkTcf0gRS4dbBLEbba2lg0K8k9_AQhGUhI-n1xObKUeOGrl8P6P_GVH4

Bermuda Economic Substance Act:

http://www.royalgazette.com/assets/pdf/RG3964221217.pdf
January 24, 2019
Tax Tips (18) – The Final Days of Tax Haven
What would you do if every tax haven (e.g. BVI) company under your control is required by law to hire full-time qualified employees there and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in?

BEPS Action in action

In Tax Tips (13), the issue of tax residency of tax haven companies was discussed. Smart corporates will be able to ensure that the tax residencies of their tax haven entities are properly managed and thus would not create tax exposures. That does not necessarily mean that these companies can continue to book un-taxed profits with no substance. The BEPS machine is not stopping.

Last month, the OECD Inclusive Framework on BEPS: Action 5 issued a paper called “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”), which sets out the substance requirements for tax havens. To the tax havens around the world, this Paper could be the last straw on the camel’s back (incidentally, tax havens such as the BVI, Cayman Islands etc are members of the Inclusive Framework).

Background

The OECD issued the report “Harmful Tax Competition: An Emerging Global Issue” in 1998 (“the 1998 Report”) setting out a framework for approaching the perceived problem that certain no or only nominal tax jurisdictions (i.e., tax havens) and harmful preferential tax regimes “affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems”. The 1998 Report called this “harmful tax practices,” and built a framework to assess these practices. The aim was to deliver a level playing field between jurisdictions in a context where taxpayers can easily relocate their mobile activities in response to tax considerations.

The framework for assessing whether a jurisdiction is a tax haven is based on four criteria:

(a) whether a jurisdiction imposes no or only nominal taxes;

(b) lack of effective exchange of information;

(c) lack of transparency and

(d) the absence of a requirement that the activity be substantial.

Notwithstanding, in 2001 the Forum on Harmful Tax Practice decided to only determine whether or not a jurisdiction was considered uncooperative on the basis of the first three criteria, and focused on making them cooperative and transparent.

With the implementation of BEPS Action 5 and the peer review process to ensure tax breaks are only offered to substantive activities and only if they do not pose risks of harmful competition to others, the focus is now shifted to ensure that business activity does not simply relocate to tax haven in order to avoid the substance requirements. Against this background, the Inclusive Framework has decided to apply the Substantial Activities Requirements for tax havens.

The Scope of the Substantial Activities Requirements

The types of activities that are within the scope of the Substantial Activities Requirements are geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and Non-IP activities which includes headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping and holding companies.

What are the Substantial Activities Requirements

Non-IP-Related

For income from income not related to IP (“Non-IP Income), tax havens would be required to introduce laws to:

(i) define the core income generating activities for each relevant business sector;

(ii) ensure that the activities are undertaken by the entity (or are undertaken in the jurisdiction);

(iii) require the entity to have an adequate number of full-time employees with necessary qualifications and incurring an adequate amount of operating expenditures to undertake such activities; and

(iv) have a transparent mechanism to ensure compliance and provide an effective enforcement mechanism of the laws.

IP-Related

For income related to IP (“IP Income) derived from patents or similar assets, the core income generating activities would be the conducting of research and development activities with an adequate number of qualified full-time employees and adequate amount of operating expenditures. A similar requirement would apply where an entity is exploiting marketing IP assets such as trademarks, where the core income generating activities are branding, marketing, and distribution.

In other cases of IP Income, the entity would need to demonstrate that it is conducting strategic decision making, managing and bearing the principal risks relating to the development and subsequent exploitation of the IP asset, or carrying on the underlying trading activities through which the asset is exploited, with the adequate number of qualified full-time employees and an adequate amount of operating expenditures.

IP Income – Higher risk scenarios

Higher risk scenarios would be cases that involve related parties outside of the tax haven where (i) the entity has acquired the IP asset from related parties or through the entity funding research and development activities which took place outside the tax haven; and (ii) the IP asset is licensed or sold to related parties, or the exploitation is conducted by related parties outside the tax haven (e.g. foreign related parties are paid to develop and sell a product in which the intangible asset is embedded).

An entity in a higher risk scenario could meet the substantial activities requirements by providing evidence that there was, and historically has been, a high degree of control over the development, exploitation, maintenance, enhancement and protection (the DEMPE functions) of the intangible asset, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities in the tax haven. This would need to be demonstrated by providing additional information including:
- detailed business plans which demonstrate the commercial rationale for holding the IP assets in the jurisdiction;
- employee information, including the level of experience, type of contracts, qualifications,
  and duration of employment; and
- evidence that decision making is taking place within the jurisdiction, rather than
  periodic decisions of non-resident board members.
Ensuring Compliance

To ensure compliance, tax havens would need to:
1. Set up a mechanism to collect various information from entities including details of the core income generating activities, the amount and type of gross income and expenses, the assets and premises held in the course of carrying out the business, and the number of full-time, qualified employees.
2. Set up a sanction mechanism that is rigorous, effective and dissuasive to take action in the event an entity failed to meet the substantial activities requirements. Sanction mechanism could include striking an entity off the register. The tax havens would also need to continue enforcement efforts and remedy any shortcomings in the enforcement process.
3. For any entities that do not comply with the substantial activities requirements, tax havens would be required to spontaneously exchange all relevant information with the jurisdictions of residence of the immediate parent, ultimate parent, and ultimate beneficial owner.
The effectiveness of the information collection and exchange mechanism is to be reviewed in 2022.

What about Holding Companies?

As discussed in Tax Tips (13), tax haven company is the ideal type of vehicle for investment holding, i.e. holding equity participations and earn only dividends and capital gains. Such companies are recognised in BEPS Action 5 that they may not require much substance in order to exercise their main activity of holding and managing equity participations, and therefore is less of a concern from BEPS’ perspective. The Substantial Activities Requirements on investment holding companies are that they respect all applicable corporate law filing requirements and have the substance necessary to engage in holding and managing equity participation (for example, by showing that they have both people and the premises necessary for these activities).

The Mauritius Example

Mauritius imposes nominal tax on companies with Category 1 Global Business Licence (“Cat 1 GBL”, commonly used as holding companies with access to the Mauritius tax treaty network). In the recent months, the Mauritius authorities issued new rules to bring about changes with effect from 1 January 2019. Under the new rules, Cat 1 GBL will be replaced by a new licence called Global Business Corporation (“GBC”) and the licensing conditions for GBC include, inter alia, carrying out of its core income generating activities at all times in, or from, Mauritius by:
- Employing, either directly or indirectly, a reasonable number of suitably qualified persons to carry out the core activities; and
- Having a minimum level of expenditure, which is proportionate to its level of activities.
In addition, the regulations provided the indicative core income generating activities and the minimum annual expenditure and employees (direct or indirect). For an investment holding GBC, the indicative minimum annual expenditure is USD12,000 and there is no minimum employee specified.

The Mauritius rules could be an example of what is forthcoming in other tax havens.

Tax Tips

Subject to the actual regulations to be introduced by the tax havens, the requirement that the entities in tax havens should maintain “an adequate number of qualified full-time employees and adequate amount of operating expenditures” and the threat of information exchange is likely sufficient to kill most tax haven entities earning IP or Non-IP Income (except for investment holding companies). Corporates that have not already restructured the activities to “normal tax jurisdictions” should speed up their review process and take action.

As to investment holding, which probably is a major business activity of most tax havens, corporates should follow the development closely and react to that accordingly. It is foreseeable that the OECD may accept more lenient substance requirements in order not to hurt the economies of the tax havens too significantly. The introduction of requirements on annual minimum expenditure even full-time employees will reduce the attractiveness of tax haven. As these are real additional costs of setting up investment holding companies, corporates should consider consolidating the group holding structures to eliminate duplicated costs, if not pulling out completely. The days of letterbox and brass plate companies appear to be limited.

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(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 December 2018: https://manageyourtax.com/HKEJ-Forum-18)

REF:

The Paper: http://www.oecd.org/tax/beps/resumption-of-application-of-substantial-activities-factor.pdf

Members of the Inclusive Framework on BEPS: http://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf

Mauritius Circular CL1-121018: https://www.fscmauritius.org/media/67458/cl-on-substance-gb.pdf
December 10, 2018
Tax Tips (17) – Chinese Individual Tax Reform – The Dual-Residency Issue

With the extensive media coverage in Hong Kong and elsewhere, Readers should already be well aware that the revised draft Detailed Implementation Rules of the Individual Income Tax (“IIT”) Law of China (“Draft DIR”) released by the Chinese Ministry of Finance and the State Administration of Taxation on 20 October 2018 for public consultation has provided a generous relaxation on the IIT for non-domicile tax resident (please refer our Tax Tips (14) for background).

According to Article 4 of the Draft DIR, IIT would be imposed on China-sourced income only, provided that the non-domicile resident individual does not stay in China for 183 Days for 5 consecutive years, or, in case the individual has spent 5 consecutive years, he has made a single trip outside of China for more than 30 days during the said 5 years. In other words, the “5 Year Rule” of the existing DIR has been retained with a large degree of relaxation in the Draft DIR, such that the fear that foreign individuals (including Hong Kong individuals) would be subject to IIT on worldwide income for spending 183 days in China has been swept away.

However, when one looks closer at the provisions, there is an important issue that foreign individuals should pay serious attention to.

You Become A Chinese Tax Resident by Spending 183 Days in China!

Under Article 1 of the new IIT Law effective 1 January 2019, a tax resident is defined to include a non-domiciled individual who resides in China for 183 days in a fiscal year (there is no tax resident concept in the existing IIT Law). Article 4 of the Draft DIR mentioned above applies to such an individual. Therefore, a foreign individual who does not have a domicile in China but resides in China for 183 days would still be regarded as a Chinese tax resident under the IIT Law, and, upon meeting the requirements under Article 4 of the Draft DIR, he can be exempt from IIT on foreign-sourced income. [Update] The Public Notice 2019 No.34 issued on 14 March 2019 has an impact here. Please refer to Tax Tips (21) – No Tax Even if Stay in China for Over 183 Days? for details.

Accordingly, while the concern of IIT on worldwide income for foreign individuals has been eliminated, as they are regarded as Chinese tax residents, they will likely be considered tax resident of both their home jurisdiction and China. This dual-residency status creates two important issues:

1. Foreign Tax Credit Claim

The foreigner, as tax resident at his home jurisdiction, may be subject to home tax on the China-sourced income. In order to eliminate double taxation, the foreigner has to lodge a tax credit claim. However, unless domestic rules allow for other tax credit claim mechanisms, the tax credit shall be claimed on the basis of the relevant Double Tax Arrangement (“DTA”) signed with the Other Side for which the tax is suffered, which in this case is China.

For Hong Kong individuals, in the past, most would rely on the salaries tax income exclusion claim under Section 8(1A)(c) of the Hong Kong Inland Revenue Ordinance (“IRO”) to eliminate double taxation, instead of filing a tax credit claim. Unfortunately, the rule has just been changed. Claims under Section 8(1A)(c) of the IRO would no longer be accepted from 1 April 2018 (Year of Assessment 2018/19) onwards for Hong Kong taxpayers who have paid foreign tax of similar nature in other jurisdictions that have signed DTA with HK, which includes Mainland China. Instead, they have to claim relief of double taxation by tax credit under Section 50 of the IRO. Please note that Section 8(1A)(c) is still available in respect of tax suffered in jurisdictions that have not signed DTA with Hong Kong.

Technically, to claim a foreign tax credit under a DTA the individual shall be a tax resident of Hong Kong. If the individual is also a tax resident of Mainland China, the place of tax residency should first be established before a tax credit claim can be lodged in Hong Kong. How to determine the place of tax residency? According to Article 4(2) of the DTA between Hong Kong and Mainland China, when an individual is a resident of both Sides, his status shall be determined by the tie-breaker rules with reference to his “Permanent Home”, “Centre of Vital Interests” and “Habitual Abode”.

Details of the above tie-breaker rules have been discussed extensively in Tax Tips (14) so they will not be repeated here.

On the other hand, if a US tax resident is sent by his US employer to work in China for a period of time which exceeded 183 days in a year so that he has become a dual-resident for both the US and China, regardless of the dual-residency status, he would still be able to claim the foreign tax credit under the US domestic rules. The impact of dual-residency on double taxation for individuals from different home jurisdictions would therefore have to be determined on a case-by-case basis.

2. CRS Automatic Exchange of Information

If a foreign individual becomes a Chinese tax resident, he needs to be very careful in declaring his tax residency for anything related to the Common Reporting Standard (“CRS”). Under CRS, financial information of individuals will be automatically exchanged to the jurisdiction of the individual’s tax residency. As it may take time to confirm oneself as non-resident of China under the tie-breaker rules in the relevant DTA, individuals who do not want their information to be made available to Chinese tax authorities may want to avoid becoming Chinese tax residents, which could happen on 2 July 2019 the earliest, by leaving China, thereby potentially creating a talent drain.

What Can You Do?

Make your voice heard

Ideally, the Draft DIR should be amended such that individuals meeting the conditions under Article 4 of the Draft DIR would not be regarded as Chinese tax residents. They should file IIT as non-residents under Article 6(2) of the new IIT Law without the various new deductions available to resident individuals and at the same time, be entitled to the various IIT exemption on allowances currently available to foreigners for child education, language training, housing, meals, laundry, home visits, removal and deduction on Mainland social security contributions. This way, the transition to the new IIT Law would be stable and the stated policy objective of attracting foreign talents would be achieved.

If Article 4 of Draft DIR remains unchanged in the final version, in order to avoid the foreign tax credit and CRS issues mentioned above, many foreign individuals working in China will need to prepare for the determination of tax resident status as soon as reaching 183 days of stay. As mentioned in Tax Tips (14), it is likely that the Chinese tax offices have handled very few cases of resident determination in the past and when such cases begin to surface next year, the volume and technicality of the cases could be very challenging for the Chinese tax officers. The competent authorities may need to be involved too. One possible way of reducing the magnitude of the problem is to amend the DTA between Hong Kong and China to make it easier for Hong Kong individuals to be recognised as Hong Kong tax residents.

The other option is, of course, avoid residing in China for 183 days each year.

[Update on 23 Dec 2018] The new IIT DIR has been released. There is no change to the rules regarding tax residency so the concerns expressed above have, unfortunately, become real.

Tax Tips

Companies and individuals are recommended to closely follow the development of the Draft DIR in order to ensure that human resources issues are managed well and the employees’ concerns are addressed. For Hong Kong individuals who ordinarily reside in Hong Kong, they should consider applying for the Certificate of Resident Status with the Hong Kong Inland Revenue Department as supporting of tax resident status. Affected individual and companies should talk to knowledgeable tax consultants as soon as possible for advice on managing tax exposure.

The Author would like to thank US Individual Tax expert Ms. Virginia La Torre Jeker J.D. for her comments on the US tax implications in the example mentioned in this article. Please visit https://us-tax.org/ for more information about Virginia.

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(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 5 November 2018: https://manageyourtax.com/HKEJ Forum 17)

Ref:

New IIT Law: https://baike.baidu.com/item/%E4%B8%AD%E5%8D%8E%E4%BA%BA%E6%B0%91%E5%85%B1%E5%92%8C%E5%9B%BD%E4%B8%AA%E4%BA%BA%E6%89%80%E5%BE%97%E7%A8%8E%E6%B3%95/1289974?fromtitle=%E4%B8%AA%E4%BA%BA%E6%89%80%E5%BE%97%E7%A8%8E%E6%B3%95&fromid=4307817

Public consultation: http://yjzj.chinatax.gov.cn/hudong/noticedetail.do?noticeid=1701567 (this link may not work after 4 November 2018)

November 5, 2018
Tax Tips (15) – The Mysterious 183 Days

The Amendments to the Individual Income Tax Law of the People’s Republic of China (“the Amendments”) discussed in the last issue of Tax Tips was promulgated by the National People’s Congress on 31 August. Included in the Amendment, as expected, is the adaptation of the tax resident person concept into Article 1 of the law.

Around one week before the Amendments were passed, the topic of Hong Kong people who enters the Mainland for more than 183 days will be subject to Individual Income Tax (“IIT”) liabilities of up to 45% on income earned outside of the Mainland started to heat up in the Hong Kong media.

On 31 August, according to Hong Kong media reports, Mr. Tam Yiu-Chung, member of the Standing Committee of the National People’s Congress, claimed that Hong Kong and Macau residents would have a five-year grace period, such that they would only need to pay IIT on income earned outside of the Mainland after the year 2024.

The introduction of tax residency concept would indeed have a huge impact on Hong Kong and Macau residents due to their close ties with Mainland China. It can be imagined that for residents from countries such as Japan, the United Kingdom and the United States who visit China for 183 days or more, as they would unlikely buy properties in China, they would likely maintain their home and economic ties in their home countries, and their home tax authorities would have much experience in tax residency determination, their tax residency status should be relatively clear-cut. If what Mr. Tam said is implemented, Hong Kong people can put the issue aside for the next five years.

A potential big loser to the Amendments is Taiwanese individuals. The Mainland and Taiwan signed the Cross-Strait Agreement for the Avoidance of Double Taxation and Strengthening of Tax Cooperation in 2015 (contents are similar to a standard double taxation agreement) but the Agreement is not yet in effect. In 2019 when Taiwan individuals become Mainland tax residents by staying in the Mainland for 183 days, they may need to pay IIT on income derived from inside and outside of the Mainland. If the individuals are also subject to Taiwan income tax on the same income, a double taxation situation will arise which cannot be resolved through a double taxation agreement (the tie-breaker discussed in the last Tax Tips). Nevertheless, as tax policies are designed to serve the economic and political needs, it is possible that the five-year grace period may include Taiwan individuals. At this moment, the only thing that can be done is wait-and-see.

Originally, this issue of Tax Tips would discuss how should Hong Kong companies manage the upcoming challenge in IIT. However, as the issue may be put to bed for 5 years, Hong Kong companies may not be interested in it anymore. Readers should watch the development closely in the coming months. This issue would instead discuss the so-called “183 Days Rule”, which has been given a new meaning by the Amendments: Is it true that there is no IIT liability if one stays in the Mainland for not more than 183 days?

The 183 Days Rule

Many Hong Kong people who frequently travel to the Mainland would have heard that IIT would be imposed if one stays in the Mainland for more than 183 days. Is it true? When one reads Article 1 of the IIT Law, whether the existing one or the amended version, it is clear that a non-domicile person who resides in China for less than 183 days are required to pay IIT on income derived from sources within China:

Current version: “Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside for less than one year in China, shall pay individual income tax in accordance with this Law on income derived from sources within China.”

Amended version: “Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in a tax year, are non-resident individuals. Non-resident individuals shall pay individual income tax in accordance with this Law on income derived from sources within China”.

So, is one liable to IIT if one stays in China for not more than 183 days?

The exemption from IIT for individuals who visit China for not more than 183 days is an effective extension of Article 7 of the Detailed Implementation Rules of the IIT Law (“DIR”, which is also subject to corresponding amendments to be announced). Under Article 7 of the DIR, “Individuals who are not domiciled in China, but stay in China continuously or in aggregate for not more than 90 days in a tax year, would be exemption from IIT on income derived from sources within China that is paid by the foreign employer and is not borne by a place or establishment of the foreign employer located in China”. In principle, when an employee enters China and performs services, the income would be regarded as derived from sources within China. Provided that the employee does not stay in China for more than 90 days in a tax year (continuously or in aggregate), and the income is paid by the foreign employer which is not borne by any place or establishment of the foreign employer, no IIT would be imposed. Under Article 14 <Income from Employment> of the Mainland-Hong Kong Double Taxation Arrangement (“CN-HK DTA”), the period of stay is extended from 90 days to 183 days; the relevant provisions in Para 1 and 2 are as follows:

“1. Subject to the provisions of Articles 15 [Director’s Fees], 17 [Pensions], 18 [Government Service], 19 [Students] and 20 [Other Income], salaries, wages and other similar remuneration derived by a resident of One Side in respect of an employment shall be taxable only in that Side unless the employment is exercised in the Other Side. If the employment is exercised in the Other Side, such remuneration as is derived therefrom may be taxed in that Other Side.

2. Notwithstanding the provisions of paragraph 1 of this Article, remuneration derived by a resident of One Side in respect of an employment exercised in the Other Side shall be taxable only in that One Side if all the following 3 conditions are satisfied:
(1) the recipient is present in the Other Side for a period or periods not exceeding in the aggregate 183 days in any 12-month period commencing or ending in the taxable period concerned;
(2) the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side;
(3) the remuneration is not borne by a permanent establishment which the employer has in the Other Side.”

The most important point is that all 3 conditions in Para 2 shall be satisfied in order to enjoy the 183 days exemption, otherwise the individual may fall into Article 1 of the IIT Law and liable to IIT on income derived from sources in China. Although the rules have been in existence for a long time, many people are still unaware of Condition 2 and 3, and they believe that simply avoid staying in China for over 183 days would be good enough to get away from IIT (and they may not even know how the days are counted).

How to Count 183 Days

The first important point is how to calculate 183 days. “Any 12-month period commencing or ending in the taxable period concerned” denotes two concepts, namely, that the number of days of presence may straddle over 2 years, i.e. the days of presence can be calculated continuously or in the aggregate irrespective of the year; and that a floating calculation method may be adopted. The 12-month period can commence or end at any day within the taxable period concerned. In counting the actual number of days, one should include all days spent in the Mainland, including days that are not the full day such as the day of arrival and day of departure, as well as weekends, holidays, and vacation etc spent in the Mainland before, during and after the employment.

[Update] The Public Notice 2019 No.34 issued on 14 March 2019 has an impact here. Please refer to Tax Tips (21) – No Tax Even if Stay in China for Over 183 Days? for details.

Who is the Employer

Some may think that Condition 2 “the remuneration is paid by, or on behalf of, an employer who is not a resident of the Other Side” is easy to satisfy, by simply having the Hong Kong employer bears all the employment costs without charge-back to the Mainland entity that the employee works in. It is not that simple. The “employer” is the party who owns the work product of, is responsible for, bears the risk of, and assess the performance of the individual. If the Mainland entity owns the work product of the individual, is responsible for his well-being, bears the risk of his acts, and assess his performance, the tax authority would regard the Mainland entity to be the real employer, and the income of the individual would be subject to IIT on the part performed in the Mainland.

The tax authority would consider the following factors in assessing the employer-in-substance:

(1) Does the Mainland entity direct the work of the individual;
(2) Does the Mainland entity determine and is it responsible for the working location of the individual;
(3) Does the Mainland entity provide the tools and materials to the individual in performing his duties;
(4) Does the Mainland entity determine the quantity and requirement of the position?

The above are common factors considered in determining if the master-servant relationship exists. Hong Kong entities sending employees to the Mainland should pay attention to such details and ensure there is documentary evidence to support the master-servant relationship. Mainland tax authorities will take the substance-over-form approach in assessing the identity of the real employer.

Permanent Establishment

Condition 3 is related to Permanent Establishment (“PE”) which is a relatively complex area. Some basic understanding of what constitutes a PE is required.

When an employee is sent to work in China at a place or establishment that is relatively fixed and lasting, that place or establishment could be regarded as a PE. Conceptually it is like an unregistered branch of a foreign entity. If the employer is a Hong Kong entity, the CN-HK DTA shall be referred to in determining whether a PE exists.

According to Article 5 of the CN-HK DTA, the term “PE” means a fixed place of business through which the business of an enterprise is wholly or partly carried on, including a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extraction of natural resources, as well as:

(1) a building site, a construction, assembly or installation project or supervisory activities in connection therewith, but only if such site, project or activities last more than 6 months;

(2) the furnishing of services, including consultancy services, by an enterprise of One Side in the Other Side, directly or through employees or other personnel engaged by the enterprise, but only if such activities continue (for the same or a connected project) for a period or periods aggregating more than 183 days [NB] within any 12-month period.

Many people can understand sub-paragraph (1) above but not sub-paragraph (2).

When a Hong Kong entity sends employees to a fixed location in the Mainland to work in a project or connected project within any 12-month period, and from the first day of arrival to the project completion day the period of stay (continuously or in aggregate) exceeds 183 days, the fixed location is a PE of the Hong Kong entity unless exemption under CN-HK DTA applies. The number of days is counted based on all employees of the entity who work in the Mainland at different times for the same project, and each day is only counted once when more than one employee is present at the same time. For example, if a Hong Kong entity (Company A) sends 10 employees to work for the same project at the same time for 3 days, the aggregate days in China is 3 days and not 30 days. However, if another Hong Kong entity (Company B) sends 1 employee to work for a project in the Mainland for 100 consecutive days, and then sends another employee to the Mainland for the same project soon afterwards, PE would be created when the second employee stays more than 83 days, creating Corporate Income Tax liability for Company B.

Condition 3 of Article 14 Para 2 requires that the employee remuneration is not borne by a PE or fixed place of the employer located in the Mainland. If a Hong Kong individual is sent to perform services at a PE of the employer in the Mainland, or the employees themselves have created a PE of the employer through the carrying out of a project or contracted work, their remuneration is deemed to be borne by the PE no matter the length of time of their services and where the remuneration is actually paid. This rule, however, does not apply to individuals who visit the PE for inspection, review or provide temporary assistance for the head office.

In the above example, the two employees of Company B are both liable to IIT even though each of them stays in the Mainland for not more than 183 days.

Lastly, if one of the employees of Company B stayed in the Mainland for more than 183 days, would he be considered a Mainland tax resident and subject to IIT on his worldwide income (assuming that there is no five-year grace period)? What information is needed to make the determination? The answer is for the Readers to work out.

Tax Tips

183 days can be the difference between paying or not paying IIT, or the triggering point from paying IIT on China sourced income to worldwide income, and each situation has to be studied on a case-by-case basis to determine how should the rules be applied. The different ways of counting 183 days (less than or not more than 183 days, and over which period) for different purposes can often create confusion. From experience, many Hong Kong enterprises are not aware of the issue, and some of them even print the Mainland address on the name cards of the Hong Kong employees, which becomes a useful clue to the tax authority and create tax risks. Enterprises facing such issues should review the operating structure and staff secondment arrangement to manage their tax exposure.

NB: CN-HK DTA Second Protocol Article 3

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(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 10 September 2018: https://manageyourtax.com/HKEJ Forum 15)

Ref:
Final version of IIT Law amendments:
http://www.npc.gov.cn/npc/xinwen/2018-08/31/content_2060151.htm

HK news report on 5 year grace period:
https://www.881903.com/Page/ZH-TW/newsdetail.aspx?ItemId=1027694&csid=261_341

CN-TW DTA:
http://www.chinatax.gov.cn/n810341/n810770/c1794734/part/3360344.pdf

Current IIT Law Implementation Rules:
http://www.chinatax.gov.cn/n810341/n810765/n812156/n812479/c1186518/content.html

September 10, 2018
Tax Tips (14) – My Worldwide Income will be subject to IIT if I stay in China for 183 days?
The month-long public consultation of the Draft Amendments to the Individual Income Tax Law of the People’s Republic of China ended on 28 July 2018. According to the website of the National People’s Congress (“NPC”, www.npc.gov.cn), more than 67,000 people have submitted over 130,000 comments on the Draft Amendments. Through the increase of standard deduction, widening the lower tax bands and introducing specific deductible items, the Individual Income Tax (“IIT”) burden on individuals is expected to reduce. The NPC website reported that the IIT payable by an individual making RMB10,000 a month drop by 74%.

However, if the Draft Amendments are passed as they are, starting next year, when a foreign individual resides in China for 183 days or more in a year, his foreign earnings may be subject to IIT. This is particularly worrying for Hong Kong individuals, many of them work for Multinational Enterprises based in Hong Kong, who travel to the Mainland frequently to carry out their employment duties.

The last issue of Tax Tips was about tax residency of companies. Thanks to the timely introduction of tax residency into the IIT Law, this issue of Tax Tips discusses tax residency of individuals, which will have a profound impact on Hong Kong businesses and individuals.

The Current Rules

Article 1 of the current IIT Law reads as follows:

“Individual income tax shall be levied in accordance with the provisions of this Law by individuals who have a domicile in China, or though without domicile but have resided for one year in China on their income derived from sources within and outside China.

Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside for less than one year in China, shall pay individual income tax in accordance with this Law on income derived from sources within China.”

What is domicile, not domicile, reside for one year or less than one year? According to the Detailed Implementation Rules of the IIT Law (“DIR”, which is also subject to corresponding amendments to be announced), the term “individuals who have domicile in China” means individuals who by reason of their permanent registered address (HuJi), family or economic interests, habitually reside in China. The DIR did not define what is “not domiciled in China” but generally it refers to individuals who do not fall into the definition of domicile in China. In practice, as long as the individual does not possess HuJi in China, that person would be a Foreigner and regarded as not domiciled in China.

The term “resided for one year in China” means to have resided within China for 365 days in a tax year. That does not mean that only those who live in China every day in a tax year would become what is commonly referred to as “One Year Taxpayer”. According to the DIR, no deduction of days would be considered for “temporary departure”, which is defined as absence from China for not more than 30 days in a single trip, or not more than a cumulative total of 90 days over a number of trips, within the same tax year. In other words, in order to avoid being considered a One Year Taxpayer and pay IIT on income sourced in and outside China (i.e. worldwide income), the individual shall either travel outside of China for more than 30 days in a single trip, or more than 90 days cumulatively, in a tax year. As long as the individual is not domiciled in China and is not a One Year Taxpayer, only income sourced in China is subject to IIT.

Having said the above, many Foreigners who station in China with temporary departures are not paying IIT on their worldwide income. This is because Article 6 of the DIR provides that: for individual not domiciled in China and resides in China for more than one year and less than five years, subject to the approval of the tax authorities-in-charge, IIT may be paid on only that part of income which was paid by companies, enterprises or other economic organisations or individuals in China. Individuals who reside for more than five years shall, commencing from the sixth year, pay IIT on the whole amount of income derived from sources outside China.

The effect of this Article is that Foreigners would only be subject to IIT on worldwide income on the sixth year if they become One Year Taxpayer for five consecutive years. Therefore, many Foreigners who have stationed in China for four years would, on the fifth year, make a single trip out of China for more than 30 days, or spend more than 90 days cumulatively outside of China, in order to restart the five-year-count. As such, it should be very rare that any Foreigners would be paying IIT on their worldwide income.

The Draft Amendments

The concept of tax resident has been introduced by the Draft Amendments to replace One Year Taxpayer. Article 1 of the IIT Law will be replaced by:

“Individuals who have a domicile in China, or though without domicile but have resided in China for 183 days or more in a tax year, shall be a resident individual and subject to individual income tax in accordance with the provisions of this Law on their income derived from sources within and outside China.

Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in a tax year, shall be regarded as a non-resident person, and pay individual income tax in accordance with this Law on income derived from sources within China.”

If the above is passed into law, assuming that the definition of “domicile in China” is unchanged, Foreigners (including Hong Kong individuals) would be regarded as Chinese tax residents by residing in China for 183 days in a tax year, and their worldwide income would be subject to IIT. As a result, Foreigners may easily become dual-residents – resident of both their home jurisdiction and China. Unless the to-be-amended DIR contains provisions relaxing the requirements (similar to the provision in Article 6 discussed above), the period of stay required for IIT to be imposed on worldwide income shall be reduced from five years to 183 days!

It is understood that the Draft Amendments will be passed in August this year, and the revised IIT Law will be effective 1 January 2019. From 1 October 2018 to 31 December 2018, IIT on salaries and wages may be calculated by applying the new monthly standard deduction of RMB5,000 and the new tax rates (for consolidated income), without deducting the additional deduction (previously available to Foreigners).

What kind of Foreign Income is subject to IIT?

All income items covered under the IIT Law shall be subject to IIT at the applicable new rates, as follow:
1. Consolidated income (salaries and wages, labour services, author’s remuneration, royalties) at progressive rates from 3% to 45%;
2. Business income at progressive rates from 5% to 35%;
3. Interest, dividend, gains, property leasing income, property transfer income, occasional income and other income at a rate of 20%.
That is to say, if a Hong Kong individual becomes a Mainland tax resident, the above kinds of income earned in Hong Kong, including the potentially substantial amount of income from property transfer, could be subject to IIT. The Mainland tax authorities would have the taxing right even on income that is subject to Hong Kong tax, such as property rental income.

OMG, what should I do?

Before knowing how the DIR is to be amended, taking action now would seem immature. Notwithstanding, there is no harm in thinking possible solutions.

The simplest solution is to avoid staying in China for 183 days or more. That would not be easy for Hong Kong people who need to daily commute to nearby Chinese cities, and it may be harder in the future under the Greater Bay Area Initiative being promoted by the Hong Kong and Mainland governments.

A more complex and troublesome way is to re-allocate foreign assets and earnings so that the income generated would not be considered the income of the Foreigner. This is a somewhat palliative measure that should be considered only as the last resort.

A better solution is to dig deeper into the tax rules to find the way out.

Definition of “Resident” in Double Tax Agreement

Whenever tax issues between two tax jurisdictions arise, the Double Tax Agreement/Arrangement (“DTA”), if available, should be consulted. For Hong Kong individuals, the DTA between Hong Kong and the Mainland (“HK-CN DTA”) would be relevant. According to Article 4 – Resident of the HK-CN DTA, the term “resident of One Side” (for the part relating to individuals) means:

“(1) in the case of the Mainland of China, any person who, under the laws of the Mainland of China, is liable to tax therein by reason of his domicile, residence … or any other criterion of a similar nature. This term, however, does not include any person who is liable to tax in the Mainland of China in respect only of income from sources in the Mainland of China;

(2) in the case of the Hong Kong Special Administrative Region:

(i)an individual who ordinarily resides in the Hong Kong Special Administrative Region;
(ii)an individual who stays in the Hong Kong Special Administrative Region for more than 180 days during a year of assessment or for more than 300 days in 2 consecutive years of assessment one of which is the relevant year of assessment…”

In case an individual who ordinarily resides in Hong Kong becomes a Mainland tax resident under the new IIT Law, he would be regarded as a resident by both Sides. Not a situation that anyone would like to be in.

How to Decide Which Side the Individual a Resident of

It is not uncommon for a tax jurisdiction to treat a Foreigner a tax resident if he resides 183 days or more in that jurisdiction. The proposed amendment to Article 1 of the IIT Law is an alignment with the international norm. From the perspective of China, such an amendment is reasonable and perhaps long overdue. Since such a change practically has no impact to local Chinese nationals, it is likely that very few of the 130,000+ comments on the Draft Amendments would argue against the change. Therefore, it is expected that Article 1 will be amended as proposed.

As it is the international norm, it should be common for two Sides to dispute on the tax residency of an individual from one Side residing in the other Side. One of the main purposes of the DTA is to prevent double taxation and thus such disputes can be resolved by the DTA. Most, if not all, of the DTAs would contain rules to settle residency issue, which can be a direct negotiation between the competent authorities of the two Sides, or they go through the tie-breaker rules contained in the DTA first and only resolve by mutual agreement when the case goes into a deadlock. According to Article 4(2) of the HK-CN DTA, when an individual is a resident of both Sides, his status shall be determined by these tie-breaker rules:

(1) he shall be deemed to be a resident only of the Side in which he has a permanent home available to him; if he has a permanent home available to him in both Sides, he shall be deemed to be a resident only of the Side with which his personal and economic relations are closer (“centre of vital interests”);
(2) if the Side in which he has his centre of vital interests cannot be determined, or if he does not have a permanent home available to him in either Side, he shall be deemed to be a resident only of the Side in which he has an habitual abode;
(3) if he has an habitual abode in both Sides or in neither of them, the competent authorities of both Sides shall resolve by mutual agreement.

There are three technical terms here: “Permanent Home”, “Centre of Vital Interests” and “Habitual Abode”. Returning readers of Tax Tips would know that elaboration of these terms may be found in the Commentaries to the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017 (“the 2017 Model Tax Convention”), as extracted below:

Permanent Home

The residence is that place where the individual owns or possesses a permanent home, meaning that the individual must have arranged and retained it for his permanent use as opposed to staying at a particular place that is intended to be of short duration (travel for pleasure, business travel etc).

Home can be a house or apartment belonging to or rented by the individual, but the permanence of the home is essential; this means the individual has arranged to have the dwelling available to him at all times continuously. A house owned by an individual cannot be considered to be available to that individual during a period when the house has been rented out and effectively handed over to an unrelated party so that the individual no longer has the possession of the house and the possibility to stay there.

Centre of Vital Interests

If the individual has a permanent home in both Sides, it is necessary to look at the facts in order to ascertain with which of the two Sides his personal and economic relations are closer. Regards will be had to his family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property etc. The circumstances must be examined as a whole, but it is nevertheless obvious that considerations based on the person acts of the individual must receive special attention. If a person who has a home in one Side sets up a second in the other Side while retaining the first, the fact that he retains the first in the environment where he has always lived, where he has worked, and where he has his family and possessions, can, together with other elements, go to demonstrate that he has retained his centre of vital interests in the first Side.

Habitual Abode

It requires a determination of whether the individual lived habitually, in the sense of being customarily or usually present, in one of the two Sides but not in the other during a given period. It is a notion that refers to the frequency, duration and regularity of stays that are part of the settled routine of an individual’s life and are therefore more than transient. The length of time to look at in determining where an individual habitually abodes should be sufficiently long, and the relevant period of time will not always correspond to the period of dual-residence.

Other than the 2017 Model Tax Convention Commentaries, readers may also refer to the “Interpretation of the DTA between the People’s Republic of China and Singapore and the Protocol” issued by the State Administration of Taxation of China under Circular GuoShuiHan (2010) 75. The interpretation contained therein would also be applicable to other DTAs signed by China and other jurisdictions where the provisions are identical. The interpretations adopted are basically a simplified version of the 2017 Model Tax Convention Commentaries.

The Practice

It is good to have rules set out in the DTA to help determine which Side the tax residency of an individual belongs to. However, what happens in practice? This is the key problem. The current IIT Law does not determine the chargeability to IIT based on residency, and a Foreigner would only be subject to IIT on worldwide income when he resides in China for five consecutive years which is a position that can be easily avoided. Therefore, it is likely that the Chinese tax offices have handled very few cases of resident determination. When such cases begin to surface next year, numerous Foreigners would face a substantial increase in IIT if the tax officers do not have a good understanding of how to determine tax residency. As employers are unlikely willing to bear the additional IIT exposure, many employees especially Hong Kong people may refuse to work in the Mainland.

Tax Tips

IIT affects the well-being of every individual and deserves high attention. The above discussions should be helpful to readers in planning ahead of the changes. Companies are recommended to closely follow the development of the Draft Amendments and the upcoming changes to the DIR in order to ensure that human resources issues are managed well and the employees’ concerns are addressed. For Hong Kong individuals who ordinarily reside in Hong Kong, they should consider applying for the Certificate of Resident Status with the Hong Kong Inland Revenue Department as supporting of tax residency. Affected individual and companies should talk to knowledgeable tax consultants, such as us, as soon as possible for advice on managing the tax exposure.
Contact Us
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 8 August 2018: https://manageyourtax.com/HKEJ Forum 14)

Ref:

NPC reports:
http://www.npc.gov.cn/npc/xinwen/lfgz/lfdt/2018-07/09/content_2057484.htm

IIT Amendment Bill:
http://money.163.com/18/0629/11/DLFD41VJ00258105.html

OECD Model Tax Convention: https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version-2017_mtc_cond-2017-en#.WmNWKqiWYdU#page32

Guo Shui Fa (2010) 75:
http://hd.chinatax.gov.cn/guoshui/action/GetArticleView1.do?id=109865&flag=1

HK Tax Resident Certificate – Individual – Mainland:
https://www.ird.gov.hk/eng/pdf/ir1314a_e.pdf
August 8, 2018
Tax Tips (13) – What is the Tax Residency of Your BVI Company?
The global crackdown on tax avoidance and money laundering at both individual and corporate levels have brought about a substantial increase in disclosure in the financial world. Anyone who has the experience of trying to open a bank account for a company would know, as part of the bank’s Know Your Client (KYC) procedure thanks to FATCA and the Common Reporting Standard, that there will be questions on the beneficial owner and tax residency of the company. If one is lucky enough to have to file the Country-by-Country Report (“CbCR”, see Tax Tips 3), tax residency of every Constituent Entity in the group shall be reported. There could be serious consequences of incorrectly reporting the tax residency.

Tax residency of a company would be relatively straight-forward if it is incorporated and filed tax returns in a jurisdiction where there is income tax or profits tax. What if the company is incorporated in a jurisdiction that does not impose income tax (commonly referred to as an “Offshore Company”), such as Tax Havens like the British Virgin Islands (BVI), Bermuda, Western Samoa? Many people think that Offshore Companies are not subject to tax anywhere…is it really the case?

Becoming Taxable in Another Jurisdiction

Business profits of a company (say “Co A” located in Country A) could be subject to tax in another jurisdiction (say Country B) under two situations: (1) Co A has become a tax resident in Country B; or (2) Co A is a tax resident of Country A and has created a Permanent Establishment (“PE”) in Country B. The difference between the two is that as a tax resident of Country B, Co A may be subject to tax in Country B in full. On the other hand, if a PE is created, only the business profits attributable to the PE is subject to tax in Country B.

A company can also be taxable in a foreign jurisdiction without tax residency or PE. That would be the case on capital gains or passive income such as dividend, royalties and interests derived from that foreign jurisdiction.

This article focuses on business profits situation one: under what circumstances would a company become a tax resident in a foreign jurisdiction.

Determination of Tax Residency

For Hong Kong, the concept of tax residency does not attract too much attention because of the territorial concept of taxation. A foreign company would be taxed in Hong Kong just like a local Hong Kong company when it carries on a trade, profession or business in Hong Kong and derives Hong Kong sourced profits therefrom.

However, in many residency-based tax jurisdictions, a foreign company would be subject to income tax in full if it is regarded as a tax resident and carries on business in the jurisdiction. What determines tax residency? Using Australia as an example, a company is a resident of Australia under Subsection 6(1) of the Income tax Assessment Act 1936, if:
- it is incorporated in Australia, or
- if it is not incorporated in Australia, it carries on business in Australia and has either:
  - its voting power controlled by shareholders who are resident of Australia (the voting power test of residency), or;
  - its central management and control in Australia (the central management and control test of residency).
For a company incorporated outside of Australia, the test, essentially, is to lift the corporate veil and see in substance whether the company is really managed and controlled in Australia, just like a company incorporated in Australia.

Tax residency is also highly relevant in determining if a Double Taxation Agreement/Arrangement (“DTA”) is applicable to the company or not. Using the DTA entered into between Hong Kong and Mainland China (“HK-CN DTA”) as example, a resident in Hong Kong, for a company, is defined under Article 4(1) of the HK-CN DTA as “a company incorporated in Hong Kong, or if incorporated outside Hong Kong, being normally managed or controlled in Hong Kong”. Under Article 4(3), when “a person other than an individual is a resident of both Sides, then it shall be deemed to be a resident only of the Side in which its place of effective management is situated”. The place of effective management (“POEM”) is the tie-breaker in determining which Side should the company be regarded as a resident of. Readers should note that in the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017 (“the 2017 Model Tax Convention”), the tie-breaker clause has been revised such that the two sides shall agree on the matter with due consideration of the place of effective management, place of incorporation and any other relevant factors. It is however up to the contracting sides to adopt the previous tie-breaker clause, which reads exactly like Article 4(3) of the HK-CN DTA mentioned above.

Not only is tax residency relevant to Hong Kong under DTAs, the concept is also being introduced under the transfer pricing rules in the Inland Revenue (Amendment) (No.6) Bill 2017 (“the Bill”) which was enacted on 4 July 2018. “Hong Kong resident person” is defined to mean “a person who is resident for tax purposes in Hong Kong”, and “resident for tax purposes”, for a company, means “a company incorporated in Hong Kong or, if incorporated outside Hong Kong, normally managed or controlled in Hong Kong”.

The Place of Management and Control

Among the three terms came across above: the normal place of management and control, the central place of management and control, and the place of effective management (POEM), it appears that the “normal” place of management and control is a comparatively relaxed definition, and thus it may be easier for companies to be considered a tax resident in such case, which may or may not be a good thing. Legal experts will be able to better differentiate the three terms.

From a practical standpoint, what corporates would like to avoid, in most situations, is to be regarded as a tax resident unexpectedly. There will not be a One-Size-Fits-All guidance on what characteristics of management and control would make a company a tax resident of a foreign jurisdiction. For the purpose of this article, the search is, therefore, for general guidance on The Place of Management and Control (“TPMC”) that corporates can follow to help lower the chance of their Offshore Companies inadvertently become tax residents of residency-based tax jurisdictions.

Guidance on TPMC

OECD would be a handy resource to look for an answer. With the change in the Article 4(3) of the 2017 Model Tax Convention, the Commentary (of the Condensed Version) no longer provides an explanation to POEM. To understand OECD’s view on the matter, one may go back to the Commentary to the previous version of the Model Convention (Model Tax Convention on Income and on Capital 2014 (Full Version)), which says: “The POEM is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the POEM. An entity may have more than one place of management, but it can have only one POEM at any one time”. This definition is helpful but not in sufficient details for companies to follow and act on.

A good reference to offshore companies would be the Tax Ruling TR 2018/5 Income Tax: Central Management and Control Test of Residency issued by the Australian Tax Office (ATO) on 21 June 2018 (with an effective date of 15 March 2017). The three questions related to Central Management and Control are: What is it? Who exercises it? Where is it?

(1) What does central management and control mean?

Per TR 2018/5, the key element in the control and direction of a company’s operations is the making of high-level decisions that set the company’s general policies, and determine the direction of its operations and the type of transactions it will enter. It is different from the day-to-day conduct and management of its activities and operations, which is not ordinarily regarded as an act of central management and control. However, for small companies, their day-to-day conduct and management of a company’s operations might also be an exercise of central management and control.

What is “decision making”?

A person, or group of people, make a decision if they actively consider and decide to do, or not do something based on it being in the best interests of the company. It does not include the mere implementation, or rubber-stamping, of decisions made by others.

Acts of central management and control

Exercising central management and control of a company can involve setting investment and operational policy including buying and selling of stock or significant assets, appointing company officers, overseeing and controlling those appointed to carry out the day-to-day business of the company, and matters of finance, including determining how profits are used and the declaration of dividends.

Matters of company administration such as keeping a company’s share register, accounts, payment of dividend, are not acts of central management and control.

(2) Who exercises central management and control?

Identifying who exercises central management and control is a question of fact. It cannot be determined solely by identifying who has the legal power or authority to control and direct a company. The crucial question is who controls and directs a company’s operations in reality.

Normally, where a company is run by its directors in accordance with its constitution and the company law rules applicable to that company, which give its directors the power to manage the company, the company’s directors will control and direct its operations. It follows that ordinarily it is a company’s directors who exercise its central management and control.

When determining who exercises a company’s central management and control, all the relevant facts and circumstances must be considered. Facts and circumstances to be considered include the role of anyone who assumes the directors’ role in managing and controlling the company’s affairs or has a role in the decision-making processes or governance of the company. Therefore, mere legal power or authority to manage a company is not sufficient to establish an exercise of central management and control. On the other hand, the ATO would also examine who tacitly control and regularly exercise oversight of the affairs of the company. As such, legal authority or power is not necessary for a person to exercise central management and control. If an outsider actually dictates or controls the decisions made by the directors, the outsider will exercise central management and control of the company.

The directors’ knowledge of the business is also relevant. A lack of knowledge of the business sufficient to enable them to make decisions, suggests they are not the real decision makers and are more likely rubber-stamping or implementing decisions already made by others.

(3) Where is central management and control exercised?

A company will be controlled and directed where those making its high-level decisions do so as a matter of fact and substance. It is not where they are merely recorded and formalised, or where the company’s constitution, bylaws or articles of association require it be controlled and directed if, in reality, it occurs elsewhere. This will not necessarily be the place where those who control and direct a company live.

Multiple places of central management and control

Control and direction of a company may be undertaken by those controlling a company in multiple places. This means a company’s central management and control may be divided between more than one place. However, a company’s central management and control will only be exercised in a place for the purpose of the central management and control test if it is exercised in that place to a substantial degree, sufficient to conclude the company is really carrying on business there.

Residence of directors vs residence of a company

Where a company’s central management and control is exercised is not determined by where the directors, or other persons, who control and manage it, are resident or live. What matters is where they actually perform the activities to control and direct the company.

Summary

TR 2018/5 is a good reference because it is newly issued guidance which presumably has taken into account the latest court cases and BEPS. According to the ruling, in summary, TPMC is the location where the making of high-level decisions that set the company’s general policies, determine the direction of its operations and the type of transactions it will enter into, are made in substance.

The Offshore Company

Many individuals and corporate groups have set up companies in Offshore Tax Havens such as the BVI for various purposes. Many tax offices around the world see them, understandably, as tax avoidance vehicles because some of these companies book large amount business income from trade, services or intellectual properties. These individuals or corporate groups are not based in the offshore paradises but in the onshore commercial centres of the world, and often the directors of these offshore companies are the individual themselves or the senior management of the corporate groups. Even if local residents are appointed as directors, they would be acting as nominee only and tax offices will see-through them. Therefore, if not structured and maintained properly, TPMC of these Offshore Companies would be in the onshore commercial centres where the decisions are made, and the tax and penalties exposures could be significant. In the past, they could be hidden from sight but in the new transparent world, they will be exposed.

Offshore Companies are, on the other hand, the ideal type of vehicle for investment holding. They are inexpensive to maintain, useful in organising the group structure, aligning the financial results with management responsibilities, ring-fence risks, and offer great flexibility when a particular arm of the business is to be disposed of: the transaction can be done quickly without burdensome governmental administrative process. Although there may not be tax avoidance motive behind such a structure as the income of holding companies, namely dividend and capital gains, are often not taxed in many jurisdictions, corporates with such offshore holding companies should also be mindful of the issue of tax residency to avoid surprises, because these days tax offices are all trying to tax untaxed income.

Tax Tips

As the world is getting more transparent, corporates with Offshore Companies in the group structure should revisit the tax residency of such companies based on each company’s facts and circumstances and the applicable tax rules. One should note that having established TPMC is not necessarily the end of the risk analysis: the requirement of carrying on business is also relevant in many jurisdictions in determining tax residency. With the information in hand, corporates can decide what to do: make the necessary changes, perform tax filings, or prepare documentation for future defence as appropriate. No corporate can avoid exposures to tax but by knowing the risks and actively managing them would help win half of the battle. Corporates should review their organisational structures at once.

(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 12 July 2018: https://manageyourtax.com/HKEJ Forum 13)

Ref:

OECD Model Tax Convention: https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version-2017_mtc_cond-2017-en#.WmNWKqiWYdU#page32

OECD 2014 Model Tax Convention: https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-2015-full-version_9789264239081-en#page192

ATO TR 2018/5: https://www.ato.gov.au/law/view/document?DocID=TXR/TR20185/NAT/ATO/00001&PiT=99991231235958
July 12, 2018