December 2010 (106) – Company Residence

Many people will be thinking about their gut this Christmas. I know that I always try to make sure that my trousers are no tighter than last year (with the amount of working out I do, they should really be much looser but they never seem to be). But this Christmas I would like to talk more about gut feeling than gut dimension.

The older we get, the more we should rely on our gut feeling, particularly in our areas of speciality – international tax and business structuring in my case. If I look back at my newsletters over the last decade, I note that I was deeply sceptical about the success of the Euro without political union. The differing political, economic and social requirements of the various European Union member states require flexible and variable mechanisms to maintain their economic equilibrium on the global stage. What has happened is that two of the major control mechanisms (exchange rates and interest rates) have been eliminated by a common currency and interest level, leaving only fiscal policy within the sovereignty of each member state. And cutting expenditure on social requirements such as health, education, law and order would have been deeply unpopular during an unprecedented recent period of global growth.

So as usual, political self interest has meant economic collapse in countries like Greece and Ireland with the contagion spreading to Portugal and Spain as I write this. If the Euro is to remain in existence, sovereignty over fiscal policy needs to be surrendered if the requirements originally stipulated in the Maastricht Treaty are to be adhered to. Alternatively, successful EU member states will have to put considerable sums to a fighting fund meaning, yes, a bail out by individuals already suffering from domestic cuts to shore up the economies of more profligate member states. Or of course, throwing out those countries who cannot maintain their fiscal policy within European Union guidelines, reverting to their original domestic currencies and possibly re-entering the Euro at some later date perhaps on new exchange rates equivalents – I cannot see this happening.

So my gut feeling no. 1?
The Euro dream will stumble along but the Euro will weaken and eventually become the common currency of a core number of countries who can maintain a fiscal policy commensurate with having their hands tied behind their back. But what happens when economic growth suffers and hits those comparably prosperous member states, as it inevitably will.  Eventually, the politicians will have to awaken from the Euro dream and realise it’s been a nightmare.

Since VAT in the UK will be increasing to 20% on 4 January 2011, I thought I would revisit the case for indirect taxation as opposed to direct taxation, particularly in the light of tax rises that were instigated by the Labour government in the dying months of their reign. I remembered that I had written a letter to Ken Clarke as Chancellor of the Exchequer in the Conservative government before their historic defeat to Tony Blair in 1997. I did start the letter “Dear Kenneth” (or Gordon in order to hedge my bets), and having re-read the letter I am attaching it to this newsletter. Click here since I believe it has as much relevance today as it did in 1997.  And not only for the UK, but even more importantly in those member states as explained above who only have fiscal policy as a means of regulating their economy. Although there is a common EU Directive for VAT, member states are able to determine both rates of VAT and relevant goods on which VAT should be charged. When will governments realise that increases in direct taxation are a disincentive to growth, whilst increases in indirect taxation on non essential items gives people a choice (as explained in my letter). At this cycle of economic depression, consumer spending needs to be stimulated and increases in VAT may not be the best way to facilitate this process, but I suspect the effect will not be that spectacular, particularly since retailers may well absorb some of the effect of VAT increases.

So my gut feeling no. 2?
During the next decade, forward thinking governments will revisit the complexity of tax laws created by successive governments for the past 50 years with lower top rates of personal direct taxation, significantly lower corporate tax rates and varied VAT rates depending upon the essential nature of product or otherwise (such as existed in France in the 1980s but for some reason were dispensed with as European integration proceeded). By the way, the attached letter to the Chancellor mentions potential changes to the non domicile regime in the UK which have been made, but in a piecemeal, disruptive and technically very confusing way.

The third area that I would particularly like to discuss in this newsletter is within the realm of tax avoidance. Not tax evasion, because this has been fairly well covered by money laundering legislation introduced worldwide since the terrorist attacks of 2001.  There has also been a general crackdown by Revenue authorities through Exchanges of Information (witness the proliferation of Tax Information Exchange Treaties during the Noughties). However, tax avoidance covers such a wide area of business structuring that appropriate structures designed to maximise returns for investors are tainted by media and government attacks on tax mitigation generally. Governments have to realise that there is a direct correlation between levels of taxation and returns available to investors/entrepreneurs, taking into account that their capital is totally at risk and may be lost if the business is unsuccessful.

The issue I will address in this newsletter is that there is still a wholesale misconception as to the use of companies or other entities in particular jurisdictions which are created specifically for a tax advantage, but which have no other purpose, nor any commercial substance. It is true that court cases over many decades have preserved the separate legal personality of particular entities to prevent the corporate veil being lifted. And I have previously discussed the need to establish such entities as being beneficially entitled to whatever income or profits they may receive. In this newsletter, I have prepared an article on company residence, the understanding of which I believe will be fundamental to tax planning in the next decade.

So my gut feeling no. 3?
Tax administrations will introduce legislation if it doesn’t already exist treating foreign entities as resident domestically under the ‘effective management’ concept. Where such legislation does exist, as indeed it does in most countries, court cases will be fought not in order to lift the corporate veil, nor even to establish beneficial ownership.  Instead, the cases will demonstrate that ‘shadow directors’, domestically resident, effectively manage any foreign entities that are engaged in real business activities within any structure. Alternatively, if no real business is undertaken by these entities, then to show that they are clearly conduit vehicles and should be ignored for tax purposes.

I hope you enjoy reading the following article on company residence which I believe is fundamental to tax planning in the coming decade – but even more, I hope you enjoy a quiet, stress free and joyous end of year, a merry Christmas and a happy, healthy and successful 2011.

Company Residence

Imagine a fausty Dickensian office in the heart of the City of London in 1905. A document arrives by ship from South Africa, which the South African local management advises its UK based board of directors to sign and return to them in connection with financing an African subsidiary operation. The board of directors of this South African company discusses the merits of the business as recommended by the local management and decide to approve the new venture. They try and phone local management in South Africa to discuss this but alas, the operator cannot connect them.  So they take out their quill pens and sign on the dotted line, sending the document back on the next boat to South Africa. Such is the background to the De Beers judgement decided in 1905 where the Court decided that the South African company was resident in the UK because that was where its controlling board of directors physically exercised its powers. The Court decided that the “real business” was carried on where “central management and control” abides.

A later case in 1959, Bullock v Unit Construction Co Ltd, endorsed the De Beers ruling and held that African subsidiary companies incorporated and trading in Africa were resident in the UK by reason of the degree of management and control over their businesses exercised in the UK by the parent company. This concept of attributing tremendous importance to the location where the board of directors meet and take their decisions may have been fundamental when communication between locations distinctly separated the functions required to make business decisions. Indeed, one could almost say that the De Beers judgement created the basis of the tax avoidance industry using offshore companies within business structures; all one had to do was to ensure that contracts were signed by the board of directors in their offshore locations, and hey presto, management and control had been accomplished.

Although it has been a slow process, tax authorities and practitioners are awakening to the reality of 21st century business. This time, imagine say Cayman Islands based directors receiving a contract from a US law firm to acquire a new real estate development project in southern Europe. The offices are luxurious with a wonderful sea view, and instead of the contract arriving by ship, it ‘pings’ up on the screen of the director’s latest iMac. This contract has also been sent to the shareholder of the Cayman Islands company, an individual based in Spain. Less than an hour later, the iMac ‘Pings’ again. The Spanish resident individual has sent back both to the US lawyer and to the Cayman Islands director his tracked changed version of the contract including his material, decision making, amendments. The director presses ‘Accept all’, prints out the contract, signs it, scans it and returns it to the US lawyer. He then prepares minutes of the meeting he is supposed to have held with his co-directors in the next office and lo and behold, he has created Cayman Islands management and control in respect of this transaction. And looking at the word “control”, he has indeed voluntarily signed the document without which the company would not be committed to the transaction, so to that extent he has indeed controlled whether the company commits to the transaction or not.

In my opinion, this illustration goes to the core difference between interpretation of management and control in the UK, and similar concepts in continental Europe. The history of UK tax schemes is based largely on semantics, where precise wording of legislation has been manipulated to create a variation to the purposive intention of the legislation. It is then up to the Courts to make sense of what the legislature initially intended.

Certainly, the latest string of cases in the UK such as the Wood v Holden judgement in 2006 demonstrated that the Court was prepared to look at the issue of control taking into account the entire arrangements, distinguishing between the case where real control over a company was conducted by persons other than members of the Board. The even later case of Laerstate BVdecided in 2009 summarised the issues decided in earlier case law. The judgement indicates that the Courts are now abandoning the formalistic approach taken in De Beers, looking far more at factual evidence taking all factors into account.

The first step therefore is to demonstrate that control actually vests with the Board. The directors should therefore be individuals who possess the necessary skills and experience to make informed decisions. Certain responsibilities can be clearly documented and vested with them. For example, the directors may have the power to maintain the company’s debt/equity ratio, ensuring that the company has the relevant working capital; they may receive and examine accounts of subsidiaries; they may also attend Board and shareholder meetings of subsidiary companies instead of simply providing general powers of attorney which deny them the opportunity to have any real input at these meetings. In other words, instead of relying on the word “control”, residence would rely on the place of effective management (commonly referred to as POEM).

Where a company is considered resident for tax purposes in two countries which have signed a double tax treaty between them, it is the POEM that creates the tie-breaker provision to determine which country has taxing rights over the company for the purposes of the treaty. It is therefore interesting to look at the OECD Commentary to Article 4 to consider how the POEM is arrived at, and some practical recommendations to ensure this creates corporate residence in the desired jurisdiction.

The Commentary, while reflecting the general opinion on the subject of a company’s POEM, contains its own recommendations. It advises against using a purely formal criterion like the place of registration, but instead importance should be attached to the place where the company is actually managed (para. 22.) This is defined as the place where key management and commercial decisions that are necessary for the conduct of the company’s business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the POEM. A company may have more than one place of management, but it can have only one POEM at any one time (para. 24.)

The Commentary further lists examples of the factors that tax authorities may consider when deciding on the company’s POEM on a case-by-case basis. Such factors certainly include where the meetings of its board of directors or equivalent body are usually held, but go much further and suggest the POEM may be where the chief executive officer and other senior executives usually carry on their activities, or even where the senior day-to-day management of the company is carried on (contrary to the De Beersjudgement).   It also suggests that the POEM should take into account where the company’s headquarters are located, which country’s laws govern the legal status of the company, and where its accounting records are kept.

It also states that when determining that the company is a resident of one of the Contracting States but not of the other for the purpose of the Convention, if this carries the risk of an improper use of the provisions of the Convention (para. 24.1.), then the POEM should not be considered the principal factor.  This last sentence is interesting, since if the title of the double tax treaty includes the term “for the avoidance of double taxation and the prevention of fiscal evasion” as many of them do, the creation of a corporate entity in a particular jurisdiction in order to avoid taxes in the other jurisdiction may not necessarily entitle the company to treaty benefits even if the POEM criteria are adopted. However, fiscal evasion is a term which is far more seriously considered by tax administrations than tax avoidance or tax mitigation, and therefore for most business structures, corporate residence will be accepted in the jurisdiction where the POEM is located, despite this last sentence of the Commentary.

Finally, we need to address the situation where there is no applicable double tax treaty, or where there is a double tax treaty but the POEM is in another location in a third country. Thus for example an individual resident in say Monaco may create a Dutch company to invest in a Spanish subsidiary, taking advantage of the Spanish/Dutch double tax treaty. The Spanish tax administration may have to accept that there is no effective management in Spain, and clearly the Dutch authorities will assess the Dutch company to Dutch corporate income tax since it is incorporated there. Should treaty benefits therefore be applicable?

In my view, if domestic legislation were to utilise the phrase “effective management” (in its full meaning as described above) to determine whether a foreign entity is resident in the relevant jurisdiction by virtue of this criterion, and to incorporate this requirement within its treaty provisions, this would deny the benefits of the Dutch/Spanish double tax treaty in the above example if the Dutch company were effectively managed by the Monegasque resident.

If clients wish to have longevity in their business structures and avoid the necessity of restructuring with all of its tax and legal complexities, it would be wise to anticipate the trend towards imposing the criterion of effective management when considering corporate residence, not only under domestic legislation but also as regards treaty definitions.  There have been many court cases surrounding the concept of beneficial ownership of income by companies interposed for treaty advantage, and limitation of benefits provisions have been introduced in the last 15 years to counteract the use of companies established solely for treaty benefits. Including the requirement under domestic law that a company in any jurisdiction must be effectively managed there to maintain exemptions under domestic or treaty law is not a difficult next step for governments to take.  Current court cases are indeed anticipating this.