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.
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.
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)
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