Clarifying Corporate Tax Residency

16 October 2020

Australian based groups with foreign incorporated subsidiaries will be relieved to know that years of commercial uncertainty regarding the tax residency of foreign subsidiaries and unnecessary compliance burdens are proposed to end with the Government’s recent announcement.

In its 2020/21 Federal Budget, the Government has stated that it will provide a legislative fix to Australia’s existing corporate tax residency tests.  The proposed law change is intended to minimise commercial ambiguity and create better alignment with modern day corporate and board practices.

The reform will also reduce compliance costs and ensure that tax residency for corporates is appropriately “sticky”, such that Australian tax residency is not volatile and subject to short term changes.  The reform will also make it easier for businesses to operate and to do so with higher levels of assurity as to the Australian tax implications.

Why is a legislative fix required?

Following the decision by the High Court in the Bywater case, the ATO issued TR 2018/5, detailing its revised view on corporate tax residency.  Importantly, this ruling demonstrated a fundamental change in the ATO’s approach to previously accepted principles and practices regarding Australian corporate tax residency.

Specifically, the ATO’s view effectively ignored the location of the actual operations of the company (and its day to day management activities) and focussed instead on the physical location of the controlling mind of the company i.e. its directors.  Accordingly, where a company had its central management and control (CMaC) in Australia, it would effectively be a tax resident of Australia.

The ATO’s revised view caused considerable uncertainty for many entities and materially increased the risk that foreign-incorporated subsidiaries of Australian companies would now be considered Australian residents. 

Impact of COVID-19

The COVID-19 pandemic and the resultant impact on international travel has further served to highlight the practical issues associated with the ATO’s approach (i.e. the requirement that Australian directors physically fly to board meetings held in foreign jurisdictions) and reinforces that the current tests of residency are no longer relevant in the present environment.

Corporate tax residency review requested

In August 2019, the Government, in response to a high level of industry concern requested that the Board of Taxation (the Board) conduct a review of Australia’s corporate tax residency rules to ensure that the rules are operating appropriately in light of modern, international and commercial board practices and international tax integrity rules. 

The Board completed its report in July 2020, making several recommendations to the Treasurer that aimed to ensure:

  • that a company’s residency status is not volatile and subject to short term changes;
  • that a company’s residency status is not determined solely or predominantly on the basis of board meetings being attended in person, as opposed to meetings being attended via internet-based conferencing platforms;
  • that developments in modern corporate governance are accommodated;
  • Australian business growth is encouraged via the ease of operation and the removal of unnecessary red tape; and
  • that transitional and unintended tax impacts arising from any change in Australia’s corporate tax residency settings are minimised.

On 6 October 2020, the Government released the Board’s report and in its 2020-21 Budget adopted the Board’s key recommendation.

Proposed law as recommended

The CMaC test will be modified such that a foreign incorporated company will only be an Australian resident company if it has a ‘significant economic connection’ to Australia.

A sufficient economic connection will exist for these purposes where the company: 

  • conducts its core commercial activities in Australia; and 
  • has its CMaC in Australia.

As such, the existence of a company’s CMaC in Australia with no other Australian trading or operational presence will no longer be enough to satisfy the test of residency except in very limited circumstances (such as with certain holding companies).

It is expected that the revised tests of residency will apply in the following way. 

Reference: A Report to the Treasurer – The Board of Taxation

Core commercial activities – relevant factors

Whilst the Board has recommended that both the proposed law and the ATO provide guidance as to what circumstances will result in core commercial activities being conducted in Australia, the Board considers that the following factors will be relevant:

  • the nature of the business carried on by the company;
  • the location of staff and assets employed in the conduct of the core business activity of the company in both Australia and abroad;
  • the size of the company;
  • the sophistication of the company’s corporate governance practices;
  • any separation between strategic management and operational control of the business;
  • the composition of the company’s board and any additional roles held by directors; and
  • the distinction between activities that are core to the conduct of the business and those that are preliminary or ancillary, such as general support functions.

What won’t change?

The ‘voting power test’ will retained at this time.  As such, those companies that carry on business in Australia and that have 50% or more of voting power held by Australian resident shareholders, will be Australian resident companies.

Comparison of corporate residency outcomes

The legislative amendments will have the effect of reflecting the corporate residency position prior to the Bywater decision.

The following examples highlight the journey of the residency tests over the past few years and highlight the differences in residency outcomes under these tests.

Example 1: The majority of directors of the foreign incorporated company (with foreign operations) are always in Australia at the time Board meetings are conducted.

Example 2:A foreign incorporated investment company buys and sells shares.  All investment decisions are made offshore, while all strategic decisions regarding the investment mandate of the investment company are made in Australia.  As the majority of the directors are always in Australia at the time the Board meetings are conducted, the company’s CMaC is considered to exist in Australia. 

Example 3: A foreign incorporated company is a holding company for internal investments (such as shares in foreign subsidiaries).  The majority of the directors are always in Australia at the time Board meetings are conducted.  Strategic investment decisions are made during these meetings.

Next steps

The Government will amend the law, with the proposed change to have effect from 1 July after the date of Royal Assent of the enabling legislation, however companies will have the option of applying the new law from 15 March 2017 (being the date on which the ATO withdrew TR 2004/15).

Clarity still needed

Whilst the changes will provide greater certainty to many companies, it will be important that the technical amendments are well supported both from a legislative and administrative perspective.  In this regard, additional clarity and guidance will be required, particularly in respect to the following areas:

  • The meaning of the term CMaC in Australia in the context of modern corporate board practices.
  • The meaning of core commercial activities and what will constitute incidental or ancillary activities (for example, whether Australian back office functions (i.e. accounting and regulatory compliance) would be considered ancillary to core commercial activities).
  • The treatment of holding companies.
  • The application of the Multilateral Instrument (MLI) for dual residents.

Holding companies

The residency status of holding companies was previously addressed in the now withdrawn TR 2004/15, which broadly stated that the location of a holding company’s CMaC is indicative of where the company carries on its business.  Given the test of residency will consider core commercial activities, it will be important for the ATO to provide administrative guidance regarding the application of the amended law to companies with only investment activities , being the typical profile of holding companies.

Multilateral Instrument/ Tax treaties

The MLI overlays the tax treaties Australia has with those countries that have opted to also apply the MLI, with the MLI modifying the application of the relevant treaty in various ways.

Where two countries claim a company as a tax resident under their respective domestic tax laws, the ‘tie-breaker’ provision in the residency article of the tax treaty between those countries becomes relevant.  The ‘tie-breaker’ provision has the effect of deeming the company to be a tax resident of only one country. 

The application of the MLI, however, requires both countries to now mutually agree on the tax residency of the company.  Given the likelihood that such a process will be lengthy and no doubt costly, this is an unwelcome prospect for affected companies. Without a residency determination, benefits under the treaty are lost and this can result in significant financial costs and uncertainty.

Neither the Budget announcement nor the Board’s report discusses an administrative fix to this issue.

Actions for entities affected by TR 2018/5 and the new rules

For those companies that made changes to the makeup of their Board of directors and the location of Board meetings to ensure that the foreign subsidiaries remain non-residents:

  • Wait and see – the proposed legislation has not yet been released.  Cooper Partners will provide an update on further announcements.

For those companies that have treated foreign subsidiaries as Australian tax residents and dealt with the tax implications as a result, but will now be considered foreign tax residents:

  • Wait and see – to date, the ATO has not released guidance regarding the treatment of those affected companies that became Australian tax residents due to TR 2018/5 but which under the proposed law will now no longer be Australian residents. Consideration might be given to:
    • Amending tax returns – where the company chooses to retrospectively apply the proposed law from 15 March 2017.
    • Reviewing the tax implications of a changing residency e.g. potential deemed disposals for capital gains tax purposes, exiting tax consolidated groups and withholding tax .

Where we can assist you

If you would like to understand in further detail what these new announcements to corporate tax residency means for you please contact our Leaders in Corporate Tax, Marissa Bechta or Rachel Pritchard, on 08 6311 6900.

This newsletter is current as of 16 October 2020, however, please note that announcements and changes are being made by the Government and the ATO regularly, and we expect that the tax and business-related responses will continue to evolve.  Before acting upon the content of this newsletter, please contact us to discuss how the above applies to your specific circumstances.

This information is general advice only and neither purports, nor is intended to be advice on any particular matter.
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