The issue of corporate economic substance is high on the agenda of tax authorities globally, following recent developments to improve fairness and cooperation in international tax.
Following requests from the EU’s Code of Conduct Group (Business Taxation), the Crown dependencies have agreed to introduce legislation that will require resident companies carrying on certain specified activities to be able to prove that they have adequate economic substance in those jurisdictions. This will ensure the Crown dependencies do not feature on the EU’s list of non-cooperative tax jurisdictions.
Whilst each jurisdiction will have its own approach, here we highlight some of the key points tax authorities are expected to consider when determining whether a company has sufficient economic substance.
Determining where a company is tax resident is important as this will typically be the jurisdiction that has primary taxing rights over the company’s income. A company will generally be tax resident in the jurisdiction in which it is incorporated, but circumstances can arise where another jurisdiction also claims primary taxing rights.
In the UK, for example, case law has determined that a company that is not incorporated in the UK is tax resident in the UK if it is ‘centrally managed and controlled’ in the UKThe test applies to identify where the highest level of management and control over a company’s affairs is exercised (ie where the key strategic business decisions are made), as opposed to decisions over normal day to day operational matters.
Where more than one jurisdiction claims primary taxing rights and a double tax treaty applies, the treaty will typically require consideration of where such strategic decisions take place in determining the territory of residence recognised under the treaty. This will generally be where board meetings take place, but the location of such meetings is not necessarily conclusive and the facts of each case need to be considered on their own merits.
It is therefore important to ensure that management’s actions do not cause the company to unintentionally become tax resident in another jurisdiction. Being resident in more than one jurisdiction can give rise to unexpected tax liabilities and compliance costs, either through dual residence itself, or the need to claim relief from double taxation where available.
What factors will the tax authorities consider?
A number of factors will be taken into account by tax authorities when considering where control over a company is exercised, such as:
- the location of board meetings;
- how directors attend board meetings (eg in person or remotely via electronic communications);
- where the directors are tax resident; and
- whether the board meeting simply ‘rubber-stamps’ significant decisions made outside of the meeting.
As a minimum, therefore, board minutes should evidence key strategic decisions being made in the meeting held at the appropriate location. If the board of directors does not, in practice, make the key decisions, tax authorities will look to understand who does, and where.
New economic substance requirements for Crown dependencies
The tax authorities of Jersey, Guernsey and the Isle of Man have agreed to impose stricter substance requirements on resident companies carrying on ‘relevant activities’. Relevant activities include banking, insurance, fund management, finance and leasing and the holding of intellectual property.
Such companies will be required to demonstrate that there is:
- an adequate frequency of minuted board meetings held in the jurisdiction, involving a quorum of physically present directors with suitable knowledge and expertise to discharge their duties;
- an adequate number of qualified employees (whether employed by the company or another entity) in the jurisdiction, proportionate to the activities of the company;
- an adequate level of annual expenditure incurred in the jurisdiction, proportionate to the core income generating activities of the company; and
- adequate physical offices and/or premises in the jurisdiction for the activities of the company.
Where companies cannot prove they have adequate substance, they may be liable to penalties from the authorities of the Crown dependencies. Persistent non-compliance may give rise to further sanctions, such as the disclosure of financial information to foreign tax authorities.
Why it matters
Tax residence and corporate economic substance are ultimately matters of fact. However, it is important for companies to take necessary steps to ensure they do not inadvertently become tax resident in another jurisdiction.
With global corporate tax rates generally falling, there is likely to be pressure on jurisdictions to prevent the loss of tax receipts. This could therefore bring the topic of corporate residence even more to the fore as countries seek to protect their tax base.
For more information regarding corporate economic substance please get in touch with Ryan Broomfield.