Jul 06 2020
Policymakers around the globe introduced corporate residency criteria in order to tax their legal persons typically on their worldwide income, wherever arising. Unlike physical persons, where identifying where an individual resides is a straightforward process, corporate tax residency criteria are more problematic because legal persons, such as companies, are artificial persons and therefore determining where an artificial person resides is an oxymoron.
In particular, with the current technology environment, most board of directors’ meetings take place in an electronic form and decisions are often taken centrally by large corporate groups. In this context, countries use different criteria to tax their corporate residents, thereby leading to double taxation.
Double taxation could be eliminated if two states have concluded a tax treaty that includes a tie-breaker rule similar with the pre-2014 Organization for Economic Co-operation and Development (OECD) Model Article 4(3). Such a rule would solve the problem by providing for a single residency. Following the BEPS project, however, the new tie-breaker rule proposed by the OECD seems not to be a tie-breaker rule but rather a tax treaty anti-avoidance rule and thereby single tax residency may not be achieved.
Internationally, there are two types of test used by tax policymakers to determine when a company is resident under their domestic law. The first is the place of incorporation test and the second is the place of management test.
From a policy perspective, the place of incorporation is an objective test as it is simple, straightforward and difficult to manipulate, whereas the place of management is a subjective test and therefore does not provide tax certainty to taxpayers.
It is worth mentioning that countries, to a broad extent, use both tests under their domestic law in order to be able to exercise jurisdiction to tax on the corporations formed under their laws, as well as on foreign corporations that are managed and controlled from their country. It should be noted that just a few countries use solely one test under their domestic law. For example, Finland and the U.S. use the incorporation test solely and Singapore and Cyprus use the management and control test solely. Consequently, there are at least four tax planning opportunities.
First, companies can structure their activities in such a way in order for tax purpose to be “stateless” and therefore being taxed nowhere, for example, a company incorporated in Cyprus that has its management and control in the U.S.
Second, a multinational enterprise (MNE) can use corporate inversions to shift profits from a country that uses the incorporation test solely in its internal law, so that such a country does not have jurisdiction to tax according to the place of management test.
Third, an MNE could have access to the legal system of a reputable jurisdiction by incorporating a company there and at the same time not being taxed in that country, for example, by incorporating a company in Cyprus or Singapore and having its management and control elsewhere typically in a country with no or low tax.
Fourth and finally, as MNEs have the ability to make decisions using electronic means of communication, the place of management test can be easily manipulated. Thus, MNEs have the ability to transfer profits from a high tax jurisdiction to a low tax jurisdiction.
in light of this, we need to focus on the subjective test (i.e. place of management test), and the critical question here is where the place of management can be determined. There are at least two views. First, the common law countries, to a large extent, adopt the “central management and control” or “management and control” test. Such a test was articulated in the leading case of De Beers (De Beers Consolidated Mines v. Howe [1906] AC 455 (HL):
“In applying the conception of residence to a company we ought, I think, to proceed as nearly as we can upon the analogy of an individual. A company cannot eat or sleep, but it can keep house and do business. We ought, therefore, to see where it really keeps house and does business ... [A] company resides for purposes of income tax where its real business is carried on ... I regard that as the true rule, and the real business is carried on where the central management and control actually abides.”
As a result, the incorporation of a company is not decisive but rather the central management and control. The heart of the central management and control lies on the higher level of decision-making of the company. Normally, this would not be the day-to-day activities (as this is the case with civil law jurisdictions noted below). Instead, this would be the board of director’s decisions, and in case there is more than one board of directors then corporate residence will be assigned to the board of directors that effectively takes the higher decisions.
A case on this point is New Zealand Shipping Co (New Zealand Shipping Co Ltd v. Thew (1922) 8 TC 208 (HL), where a company formed under the laws of New Zealand had one board of directors in New Zealand and one in the U.K. The court decided that the U.K. board was effectively taking the decisions and not the New Zealand board as the latter was subject to the powers of the former. Consequently, it may be possible to find the central management and control in two countries.
Finally, a more recent and interesting case is the Australian case—Bywater. In this case, it was decided that the decisions were not taken where the board of directors’ meetings were held (i.e. in Switzerland), but rather in Australia, because the board of directors simply followed the advice of an individual, namely Mr Goul, based in Australia. The main finding of the court was:
“a board of directors abrogates its decision-making power in favor of an outsider and operates as a puppet or cypher, effectively doing no more than noting and implementing decisions made by the outsider as if they were in truth decisions of the board.”
Turning to the civil law jurisdictions, in contrast to common law jurisdictions noted above, apart from the board of directors’ decisions one would typically adopt a day-to-day management test as well. Examples would be Switzerland and Germany. As a consequence, the difference in meaning between the common law and civil jurisdictions—and sometimes between common law jurisdictions themselves for example, the case noted above New Zealand Shipping Co—can lead to dual residence companies. The result would be that such a dual resident company is going to be taxed twice on its worldwide income, wherever arising.
This issue not only leads to international double taxation, but also to the unwanted scenario of increased international double taxation. To solve this issue, both the OECD and the UN Model provide a tie-breaker rule for non-individuals under Article 4 “Resident.”
In order to be able to apply the tie-breaker rule, a taxpayer needs first be considered a resident under Article 4 paragraph 1.
The importance of Article 4—in both the OECD and the UN model—is found in the personal scope of Article 1. That is, for a taxpayer to have access to a tax treaty, such taxpayer needs to be a “resident of one or both of the contracting states.” Further, the residency of the taxpayer is also important as it is used, to a large extent, in the all income article allocation rules. The first sentence of the positive definition of Article 4 paragraph 1 of the OECD reads as follows:
"[T]erm ‘resident of a Contracting State’ means any person who, under the laws of that state, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature…"
It can be argued that the OECD accepts that there is not an international consensus on what the residency criteria should be and therefore leaves this to be determined under the domestic law (i.e. “under the laws of that state”).
Countries are free to use any of the criteria provided, and further, the OECD provides with a swiping up provision for “any other criteria in similar nature.” Also, for a company to be considered resident, such company needs to be “liable to tax therein.” Unlike “subject to tax” that in general means that a taxpayer needs to effectively pay taxes, the term “liable to tax” is regularly understood to mean that generally a company falls within the scope of a state’s taxation.
The view of the OECD under the Commentary of Article 4 paragraph 8.13 is that fiscally transparent vehicles such as partnerships are not considered to be liable to tax and therefore cannot be considered a resident for tax treaty purposes. For example, a fiscally transparent entity such as a U.K. partnership or a Cyprus trust would typically not be regarded as liable to tax as they are not a tax subject. Further, with respect to “liable to tax” from an international perspective, there are at least two views:
In practice, in order for countries to provide a tax treaty benefit, they request from their foreign tax taxpayers a tax residency certificate. Typically, such tax residency certificate is issued by the tax authorities of the other contracting state, provided that they meet the corporate residency criteria of that state.
However, the country that would provide the tax treaty benefit and therefore give up its taxing right, remains at its discretion to accept or reject such a tax residency certificate. For example, the Netherlands provides a list of minimum criteria that taxpayers should meet in order to provide them with a tax residency certificate. In case the Dutch tax authorities noticed that a taxpayer who received such tax residency certificate for obtaining a tax treaty benefit failed subsequently to meet such criteria, then the Dutch tax authorities would normally inform their tax treaty partner in order to deny such a tax treaty benefit.
Paragraph 4 of Article 3 of both the OECD and the UN Model include a “tie-breaker” clause for dual resident companies, that is the place of effective management (POEM). From the first draft of the OECD Model in 1963 until 2014, Article 4 paragraph 3 reads as follows:
“Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the state in which its place of effective management is situated.”
It is worth noting that for the tie-breaker rule to apply the taxpayer needs to meet the definition of residence of Article 4(1), noted above, in both states.
Further, such clause is not limited to companies but instead it generally applies to all types of legal persons, such as partnerships and trusts. This is because it applies to persons other than an individual and according to OECD Model Article 3(1)(a) that would be a company and any other body of persons.
Turning to the interpretation of the POEM, this test would not typically be interpreted according to the domestic law meaning but rather needs to be interpreted autonomously, i.e. independently of domestic law because the tax treaty POEM purpose is to assign single residency and thereby resolves the bilateral issue of dual residence. It is worth mentioning that the POEM does not solve the issue if the POEM is found in a third state. According to the pre-2014 OECD Commentary of Article 4 there is only one POEM at any one time.
Further, to determine the POEM one must examine all relevant facts and circumstances, and it would be 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.
Importantly, the POEM is not determined only where the high-level decisions are made. Instead, one must also look at the day-to-day management. Thus, the OECD approach could be argued to resemble the civil law jurisdiction approach as compared to the common law approach noted above.
The OECD position is that it is possible for a legal person to be found to be dual resident (e.g. one state attaches importance to the registration and the other state to the POEM) although this would be rare in practice. However, taxpayers are structuring their activities with the purpose of being a dual residence in order to reduce their tax paid.
For example, a dual resident start-up company that is facing losses in the early years of incorporation, would typically, under certain circumstances, be able to use such losses twice (so-called double-dip). As a result, the OECD decided to replace Article 4 paragraph 3 and adopt a new tie-breaker rule that effectively single residency may be assigned by the tax authorities at their discretion. Article 4 paragraph 3 reads as follows:
“Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavor to determine by mutual agreement the Contracting State of which such person shall be deemed to be a resident for the purposes of the Convention, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by this Convention except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting States.”
Notably, the competent authorities (normally the tax authorities) are obliged to endeavor, i.e. seek to resolve the case in a fair and objective manner but not to achieve a result. Accordingly, the OECD moves to a new case-by-case solution that the tax authorities are only required to do their best to find a solution, and if they are unable to resolve the dual residence issue this is explicitly acceptable. In other words, a taxpayer is left at the discretion of the tax authorities to resolve the problem without being obliged to assign single residency. Such issues, however, were resolved by the POEM. As a consequence, increased double taxation is likely to arise and would therefore not be eliminated.
One is left wondering whether this rule is a tie-breaker rule that follows the purpose of a tax treaty, that is to eliminate double taxation. Interestingly, this is arguably an anti-avoidance provision in order to deter taxpayers or their tax advisers from planning their activities by using dual-residence companies. This “tax treaty threat” rule can be seen as a weapon in the arsenal of the tax authorities against abusive tax planning.
However, not all tax treaties include such a provision, as this new rule was included in the OECD Model in the 2017 update. Nevertheless, the OECD is trying to speed up the process as it has included this provision in the multilateral instrument (MLI).
As of today, the MLI covers 94 jurisdictions and entered into force on July 1, 2018. However, numerous countries did not opt into this provision as it is not a minimum standard. It is worth mentioning that the US is more aggressive on this area as the 2016 U.S. Model does not provide any tie-breaker rule for companies. As a result, a dual resident company would not be able to claim a tax treaty benefit as it would automatically be considered as not resident for both contracting states.
In light of the above, taxpayers doing cross-border business should revisit their structures and ensure that their tax burden is not at risk.
First and foremost, taxpayers should ensure that they comply with the domestic tax law criteria in order to be able to obtain a tax residence certificate if they would need a tax treaty benefit. Failing to do so, countries will not be inclined to provide them with a tax residency certificate and the source state (that would normally provide for the tax treaty benefit) may not accept such a certificate and eventually deny the tax treaty benefit.
Second, they need to ensure that their business structure would not trigger any corporate tax residency criteria of another country. Consequently, when designing their substance requirements, care should not only be taken by taxpayers on the jurisdiction where the company is a resident. Taxpayers should also consider the jurisdiction that such a company has connecting factors via its business there.
Finally, taxpayers should ensure that they avoid entering into tax planning schemes by using dual resident companies as the new tie-breaker rule is effectively an anti-avoidance rule in this regard.
Christos Theophilou is a Tax Partner at Taxatelier, Cyprus.
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