703 - Corporate tax residence by mutual agreement

Globally it is common practice for countries to determine the tax residence of a company by applying two primary tests. The first is that a company that is incorporated under the law of that country is tax resident in that country and the second is typically some form of management test. The two most common management tests applied are “management and (or) control” and “effective management” (collectively referred to as management test).

This means that a company incorporated in one country, being a tax resident of its country of incorporation, could also be tax resident in another country under the “management test” applied by that other country (dual residence). In most cases this would translate into worldwide taxation of that company in both countries unless a rule applies to prevent this.

The rule could be a local law rule (ie, a domestic tax law). By way of example, the tax law in Jersey states that a Jersey incorporated company that has its management and control outside of Jersey will not be a Jersey tax resident (subject to satisfying certain criteria).

In the alternative, the rule could be contained in a double tax agreement (DTA). In this regard, most DTAs, regardless of the model on which they are based (UN or OECD), contain a clause that deems the tax residence of a company to be in one of the contracting countries where dual residence arises. By way of example, the South Africa-USA DTA deems the company to be a resident of its country of incorporation, while the South Africa-Botswana DTA requires the competent authorities of each country to mutually agree on the residence of the company, considering various factors.

What makes the position tricky is that there is no uniform meaning of the “management test” and the meaning applied by a specific country may differ materially to that of the other country also claiming the company as a tax resident.

This article explores the following questions that are most pertinent to the residency test based on management:

- What is the meaning of “effective management” and “managed and controlled”, and are these two terms in reality the same?
- What factors should be considered when seeking to determine the place where a company is effectively managed or managed and controlled?
- What is required in terms of applying the mutual agreement procedure to establish the tax residence of a company under a DTA and how has the enactment of the multilateral instrument (MLI) impacted this?

WHAT IS THE MEANING OF “EFFECTIVE MANAGEMENT” AND “MANAGED AND CONTROLLED”, AND ARE THESE TWO TERMS IN REALITY THE SAME?

Effective management

The term effective management has long formed part of the text of the Organisation for Economic Cooperation and Development (OECD) Model Tax Convention. The reason for this will become clearer when the role of DTAs in resolving the dual residence mutual agreement procedure is examined. It is therefore common to consider the meaning per the OECD’s commentary when seeking to interpret this term.

The OECD commentary states: “The place of effective management 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 place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.”

The concept of effective management has also been considered by the courts. While most of these cases have taken guidance from the OECD commentary, they have further noted the following:

- Effective management implies the real, top-level, positive management of the company.
- The effective management of a company is typically conducted by, and therefore located where, the most senior executives that “call the shots” exercise their powers.
- When seeking to determine the place of effective management of a company, a detailed analysis of the facts must be performed. Judges tasked with expressing a view on the subject typically include several pages of detailed fact finding in their judgments.

One should therefore not automatically assume that a company’s place of effective management will be located where the board of the company meets to take decisions. This would only be the case where the board legitimately consists of the “shot callers” and they exercise their management function through the organ of the board. Where a board merely meets as a formality to rubber stamp decisions already taken, the board would not be considered as the organ responsible for the effective management of the company.

Further, the tax authority may place less emphasis on the role of the board and more emphasis on the actions of the senior executives of the company when assessing the company’s place of effective management. What is key is that consideration of all the facts will ultimately determine the finding of a revenue authority or court.

Managed and controlled

The seminal case on the meaning of “managed and controlled” is arguably De Beers Consolidated Mines Ltd v Howe 5TC198. This case was heard in the UK and considered whether a South African incorporated company was UK tax resident.

Management and control has been used as a residence test for many years by the UK (applying a central management and control test). The UK has largely been the trendsetter in determining the meaning of this concept, especially having regard to the principle espoused in the De Beers case.

Lord Chancellor (Loreburn) held that “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.”

This statement has been used by the UK Revenue Authority (“His Majesty’s Revenue and Customs” (HMRC)) to define (and in effect take as law) the test that they will apply to determine whether a company is managed and controlled from the UK. The HMRC confirms that it is first necessary to identify who, in law, has the right and duty to exercise the management and control over the company.

The shareholders of a company may have some control over the company and its board of directors, but in the main, the board of directors is considered the body most likely to be responsible for the company’s management and control (unless in practice the shareholders usurp such authority). The HMRC further requires an examination of the role played by any agents appointed by the board (including persons holding titles such as managing director) to assess that the central management and control has not been delegated to another person, or organ (eg, committee) of the board.

What is interesting is that the HMRC suggests that effective management is a concept distinct from management and control whereby effective management is “the place where the Head Office is: the Head Office in the sense of – not the registered office – but the central directing source. The place where one would expect to find the finance director, for example, the sales director and, if there is one, the managing director. The company records would normally be found there together with the senior administrative staff.”

This being a distinct test that considers who legally has the ability to manage and control the company, which they suggest would most likely be the board of directors. The HMRC goes on to say that a company with its head office (ie, effective management) in the Netherlands would not suddenly move its effective management outside of the Netherlands if it were to hold an occasional board meeting outside of the Netherlands.

We would suggest, however, contrary to the position adopted by HMRC, that the two concepts are becoming increasingly more aligned. This is because both seem to seek out who the real decision makers are, not only in law, but in substance as well. They both place significant emphasis on where the executives of the business (top management) carry out their duties of making strategic decisions. Most importantly, both seem to place reliance on the need to examine all of the facts of each case.

WHAT FACTORS SHOULD BE CONSIDERED WHEN SEEKING TO DETERMINE THE PLACE WHERE A COMPANY IS EFFECTIVELY MANAGED OR MANAGED AND CONTROLLED?

The following key factors should be considered when applying either of the above management tests.

- Nature of the business of the company: A pure holding company lacking material substance may find it difficult to factually prove compliance with the applied management test in the intended jurisdiction. This is especially so where the company is not able to demonstrate that the majority of its directors reside in that country and/or where it has no full-time senior executive(s) based in that country.
- Level of presence of the company in a particular jurisdiction: A company with minimal presence in a particular country and an absence of a functional head office in that country may find it difficult to demonstrate that its effective management is conducted in that country.
- Substance of the board: A company that appoints a board consisting, in the majority, of members that have no strategic involvement in the operations of the company, or are not suitably qualified or experienced to provide meaningful (real/positive) management to that company may fall short (this is typically the case when “paid for” directors are appointed).
- Subcommittees: The formation of subcommittees by the board may undermine an argument that the board is the organ responsible for the effective management of the company. The terms of reference of each subcommittee requires careful consideration to establish if the committee is factually the real/positive management of the company.
- Shareholder influence: It is perfectly understandable that in a larger multinational group the strategy for the organisation as a whole would be set by the ultimate shareholder. The need for a particular company to align with that strategy should not alone cause the company to be tax resident in the country of residence of the shareholder. However, where the shareholder effectively usurps the decision-making powers of the company so that the company’s executives are mere “puppets”, the company will most likely be regarded as tax resident where the shareholder operates.

From these considerations, it is obvious that the formal governance structure of the company (eg, makeup of the board, terms of reference, authority levels, authority delegation, etc) will play a fundamental role. These governance documents should be documented and followed in practice.

WHAT IS REQUIRED IN TERMS OF APPLYING THE MUTUAL AGREEMENT PROCEDURE TO ESTABLISH THE TAX RESIDENCE OF A COMPANY UNDER A DTA AND HOW HAS THE ENACTMENT OF THE MLI IMPACTED THIS?

Where a company incorporated in one country establishes its central management and control or effective management outside of its country of incorporation, it is likely to become dual resident.

A typical example is as follows: a South African group of companies decides to set up shop in the USA. The group obtains all necessary regulatory approvals (including exchange control approval) and incorporates a US corporation. Until such time that the group employs executives in the US and starts its operations, it appoints solely South African resident individuals to the board of directors of the US corporation. The board meets in South Africa, appoints a South African resident executive, working in the South African group, as the acting managing director of the US entity. The board delegates authority to this individual to take all steps necessary to set up the operations of the US company, hire the right staff (at executive level that will be based in the US), liaise with US customers until the business is functional and negotiate and sign all contracts for the US corporation, etc.

A foreign incorporated company with its place of effective management in South Africa is a South African tax resident, unless a DTA states otherwise. In the above-contemplated scenario, the US company will have its place of effective management in South Africa. Oddly, however, in this scenario, the US company will remain US tax resident under the US-SA DTA. It may be viewed as having a tax presence in South Africa (commonly termed a permanent establishment), but it would not be regarded as a South African tax resident. No engagement with a tax authority is needed to confirm this position as the DTA rule is clear. (Note that the US-SA DTA contains a limitation on benefits clause, which may act to deny treaty benefits. The assumption in this situation is that the DTA would apply in the hypothetical scenario.)

If the same scenario were to take place with a UK-incorporated company, until recently, the UK company would have been viewed as a tax resident of the country in which it conducts its effective management. However, with the introduction of the MLI, this has now changed. The UK company will now be viewed as a tax resident of the country that is agreed between the competent authorities of the UK and South Africa. This is a significant change. Furthermore, it is not unique to the SA-UK DTA and could be the position for many other scenarios.

MUTUAL AGREEMENT

While the concept of mutual agreement has formed part of the South African tax landscape for many years, it was not widely used. The primary reason is that the South African DTA network contained very few opportunities for uncertainties to arise when dealing with developed nations. In the case of DTAs with developing nations, the process was considered cumbersome, lengthy and costly, and therefore most taxpayers elected to rather forfeit the benefit available under the DTA.

The MLI stands to change all of that.

The MLI empowers competent authorities of the relevant contracting states to endeavour to resolve cases of dual tax residence on a case-by-case basis through mutual agreement. A competent authority is generally the person who represents the State in the implementation of the relevant DTA, which would generally be the Minister of Finance or the authorised representative of the Minister. In the case of South Africa, there are SARS officials dedicated to this task.

A number of jurisdictions, including South Africa, have elected for the MLI to modify the tie-breaker clause contained in existing DTAs to “mutual agreement” from the previously widely used place of effective management.

A dual tax resident company may approach a competent authority of either country of residence to request a determination of its single residence through mutual agreement under the mutual agreement procedure article contained in the relevant DTA.

The mutual agreement procedure article contained in most DTAs sets out the mechanism for competent authorities to interact with each other outside the formal diplomatic channels and resolve international tax matters, such as the dual tax residency, by mutual agreement. The mutual agreement procedure is not litigation, but rather a process of consultation between the relevant competent authorities.

Most mutual agreement procedure articles provide for a company seeking a determination of its sole tax residence through mutual agreement to approach the competent authorities within a limited period (usually three years). Unfortunately, these provisions do not set specific timelines for resolving disputes nor do they compel competent authorities to reach an agreement or actually resolve the dispute.

This means that dual tax residency disputes may go on for years unresolved. Not only does this put the dual tax resident taxpayer at a disadvantage as the MLIs provide for such taxpayers to be denied tax relief until such time as a single country of residence has been determined; it may also give rise to double taxation as the taxpayer will continue to be regarded as dual tax resident in both states (and subject to tax accordingly). This makes it crucial for companies to take the necessary measures to ensure that they are not dual tax resident.

Companies that intentionally established themselves as dual residents, are advised to urgently assess if they should undertake a mutual agreement process to seek confirmation from the relevant competent authorities that the MLI changes do not impact their ability to continue to be treated as a tax resident of the country selected.

PRACTICAL NEXT STEPS

- All parties with multinational groups are urged to assess the current residence status of their existing operations.
- Where there are concerns that companies may be dual resident, the impact of implementing measures to address these concerns should be assessed bearing in mind that exit tax costs could be triggered where changes are enacted that have the result of the company ceasing to be a resident of a particular country.
- Companies that are deliberately established as dual resident, and previously applied the place of effective management tie breaker test to achieve this, should assess if they now need to implement a mutual agreement procedure to retain their current tax status.

Nhlamulo Maluka & Robyn Berger

Bowmans