Founders often read about large multinationals paying little to no tax in Australia and think, “Why don’t I just incorporate a company overseas and run the business from here (in Australia)?”
Whilst it is possible to successfully “offshore” a business, there are some significant hurdles to clear in order to achieve the desired tax outcome, that is, Australia’s:
- corporate tax residence rules
- controlled foreign company (CFC) rules
Australian corporate tax residence
The starting point is the definition of an Australian-resident company.
Under Australian tax law, a company is an Australian tax resident if it is incorporated:
- In Australia
- Outside of Australia where
- It carries on business in Australia
- Either has its:
- Central management and control in Australia (CMC), that is, high-level strategic decision-making is made by director or other persons whilst physically in Australia; or
- Voting power controlled by Australian resident shareholders.
Therefore, Australian tax law adopts a two-pronged corporate residence test.
Traditionally, a foreign-incorporated company with operations ‘on the ground’ overseas was not taken to carry on business in Australia for present purposes even if high-level strategic decision-making took place in Australia.
However, in Bywater Investments Limited v Commissioner of Taxation; Hua Wang Berhad v Commissioner of Taxation  HCA 45 (Bywater), the High Court held that high-level strategic decision-making by individuals physically in Australia (whether formal directors or not) of itself constituted the carrying on business in Australia (at least in part). Therefore, although Australian corporate tax residence adopts a two-prong test, it can be satisfied by the same facts in particular circumstances.
In the aftermath of Bywater, the Commissioner:
- withdrew TR 2004/15; and
- issued TR 2018/5 and PCG 2018/9.
TR 2018/5 confirms that:
- whether a company is resident under the CMC rules is determined by reference to all the facts and relevant case law;
- relevant factors include:
- where CMC is exercised;
- where the governing body meets;
- where dividends are declared and paid;
- the nature of the business; and
- minutes and other documents recording where high-level decisions are made;
- it is not necessary for any part of the trading or investment operations of the business to take place in Australia as CMC itself forms part of the carrying on of the business;
- control and direction of a company is generally distinct from the day-to-day operations of the company;
- who exercises CMC is a question of fact and it is not limited to those formally occupying the office of a director of the company (referred to as ‘outsiders’);
- there is a critical distinction between:
- an outsider who is merely influential over formal decision-makers (but where such decision-makers ultimately exercise independent judgement) – see Esquire Nominees Ltd v FCT (1973) 129 CLR 177; and
- circumstances in which formal decision-makers merely rubber stamp outsiders’ decisions – Bywater;
- the nature of the business activities may dictate where its key decisions are made – North Australian Pastoral Co Ltd v FCT (1946) 71 CLR 623; and
- CMC is determined by where it is exercised, not the tax residence of the director(s) (although the latter may be relevant in certain circumstances).
PCG 2018/9 focuses on the practical, evidentiary issues in substantiating Australian corporate tax residence and:
- where a company has kept board minutes:
- the ATO will accept them as prima facie establishing where the company’s CMC is located; and
- provided that they represent a true and accurate account of the location of the decisions by the relevant decision-makers, will generally be conclusive evidence of CMC;
- where a company has not kept board minutes, or not all high-level decision-making occurs at board meetings, other evidence will be considered in determining CMC such as circulars, emails and other correspondence evidencing decision-makers’ deliberations on such high-level matters.
The ATO then provides various examples involving a number of different scenarios.
In terms of the ATO’s ongoing compliance approach, it will not normally apply resources to review or seek to treat a foreign-incorporated company as an Australian tax resident merely because part of the company’s CMC is exercised in Australia on the basis that directors regularly participate in board meetings from Australia using modern communications technology in certain circumstances. However, this is limited to subsidiaries of an Australian public group, a listed holding company of a foreign public group or a wholly-owned subsidiary of a foreign public group in certain circumstances.
Therefore, Australian resident founders of an ordinary private company fall:
- outside this administrative blind spot; and
- squarely within the ATO’s compliance sights.
Impact of Double Tax Agreements
Where a foreign-incorporated company is taken to be a tax resident under the domestic tax laws of both the incorporation country and Australia, then relief may be available under an applicable Double Tax Agreement (DTA).
A DTA is a bilateral agreement between Australia and another country aimed at eliminating double taxation (or double non-taxation of income).
Australia’s DTAs are incorporated into domestic law.
Many DTAs have corporate residency tie-breaker rules which are intended to assign sole tax residence to one country or the other for the purposes of the DTA.
DTAs are broadly based on a Model Tax Convention (MTC), although there is considerable divergence in many instances.
The Organisation for Economic Cooperation and Development (OECD) provides commentary on the MTC (Commentary) as a guide to interpretation and the ATO provides additional guidance in this regard in TR 2001/13.
With limited exceptions, the provisions of a DTA override domestic tax law to the extent of any consistency, therefore, if:
- The ATO took the view that a foreign-incorporated company was an Australian tax resident;
- The company was also a tax resident under the domestic tax law of a foreign country;
- Australia had a DTA with the other country;
- The DTA had a corporate residency tie-breaker; and
- The corporate residency tie-breaker operated to assign sole tax residence to the other country,
Australia would have to give up its right to tax the company as an Australian resident for DTA purposes.
The MTC requires the relevant countries to work together to determine a company’s sole tax residence based on its place of effective management (POEM).
The Commentary indicates that there is considerable overlap between:
- the domestic concept of CMC;
- the MTC concept of POEM; and
- the concept of “managed an controlled” in many of Australia’s DTAs.
(Domestic) changes on the horizon?
In the aftermath of Bywater, the withdrawal of TR 2004/15 and the issue of TR 2018/5 and PCG 2018/9, the Board of Taxation submitted a report to the Treasurer reviewing the Australian corporate tax residence rules in July 2020 (Report).
The Report highlighted:
- Bywater fundamentally altered long-established practices;
- residency rules are over 90 years old and no longer fit for purpose;
- issues such the COVID-19 pandemic gave rise to a risk of companies ‘flipping in and out’ of Australian residence (which can give rise to the deemed disposal of assets on exit); and
- there is too much emphasis on the physical location of directors or other key decision-makers notwithstanding that this is less and less relevant in modern business practices.
After canvassing various options for reform, the Board of Taxation made the following recommendations:
- CMC should be retained but modified to ensure that a foreign-incorporated company requires a sufficient economic connection to Australia to be an Australian resident;
- sufficient economic connection will require the company’s core commercial activities to take place in Australia and have its CMC in Australia; and
- the scope and meaning of the phrase, ‘core commercial activities’ should be outlined in legislation and extrinsic materials supplemented by administrative practical guidance.
The government has yet to implement any changes in this regard but the aim appears to be to essentially legislate the previous administrative position under TR 2004/15 but with a lesser emphasis on the physical presence of directors or other key decision-makers.
Controlled foreign company (CFC) rules
The CFC regime is aimed at preventing Australian residents from parking tainted income in low or no tax jurisdictions.
It is an accruals regime, meaning that where it applies, the relevant Australian resident shareholders are taxed directly on their share of the income derived by the relevant foreign company (even in the absence of an actual dividend)!
Broadly, the CFC rules apply where:
- there is a foreign company sufficiently owned or controlled by certain Australian resident shareholders
- the CFC fails the active income test (i.e., has 5% or more of its turnover as tainted income).
Tainted income includes passive income, but also includes tainted sales income and tainted services income (see below).
Where a CFC satisfies the active income test, there is no attribution.
Where a CFC fails the active income test and is resident in:
- a listed country (Canada, France, Germany, Japan, New Zealand, UK and US) – generally only a limited class of income known as eligible designated concession income is attributable (e.g., income subject to concessional taxation or exempted in the otherwise comparably-taxed listed country); and
- an unlisted country – its income is attributable (calculated as if it were an Australian resident).
It is important to understand that even if a CFC carries on an active business, it can still generate tainted income and, therefore, fail the active income test for CFC purposes, for example:
- tainted sales income includes income from sales made by a CFC to an associated entity in Australia; and
- tainted services income includes income from services provided to unassociated (i.e., third party) Australian residents.
Where the CFC rules apply to attribute income directly to Australian resident shareholders, the actual payment of dividends from the CFC are tax-free to avoid any double tax issues.
Do DTAs override the CFC rules or vice versa?
The Commentary highlights that domestic CFC legislation does not conflict with DTAs, for example, CFC rules do not conflict with:
- Article 7 of the MTC (Business Profits) – as the relevant CFC is taxed in the overseas jurisdiction whereas the Australian resident shareholder is taxed under CFC rules (with a credit for the overseas tax paid by the CFC); and
- Article 10 of the MTC (Dividends) – as the provision relates to source taxation and has no bearing on how the residence country (i.e., Australia) seeks to tax its residents.
Therefore, DTAs and domestic CFC rules are interpreted such that:
- there is no conflict between them; and, therefore
- Neither overrides the other.
Interaction with shareholder issues
Australian corporate residence often arises in conjunction with personal tax residence issues relating to founders when looking to:
- ‘flip-up’ to an overseas parent; or
- otherwise, relocate overseas.
However, Australia has an exit tax, that is, when an individual, company or trust ceases to be an Australian tax resident:
- they are deemed to dispose of their capital gains tax assets (with limited exceptions for a narrow class of assets known as ‘taxable Australian property’, most notably, real property in Australia); and
- Although individuals can elect to defer the taxing point until actual disposal, doing so means:
- the relevant CGT assets remain in the Australian tax net (although this is subject to the overriding provisions of an applicable DTA); and
- Individuals and trusts otherwise entitled to the general 50% CGT discount will no longer be entitled to the full 50% concession going forward.
Therefore, if an Australian resident individual incorporates a foreign company in anticipation of moving overseas, they can inadvertently either:
- trigger exit tax in relation to the shares (if held personally); or, if they make an exit election to defer the taxing point in this regard,
- keep the shares in the Australian tax net going forward.
The international tax framework has its genesis in the work of the League of Nations after World War I.
Broad principles have developed over the decades, giving rise to myriad bilateral DTAs, however, the world is completely different to the one the international tax framework was developed to govern and the pace of change is slow compared to that of technology and globalisation.
When seeking to expand overseas, it is not simply a matter of incorporating a company in a foreign jurisdiction and running transactions through it. Rather, specific advice should be sought as to:
- the relevant jurisdiction;
- the type of business;
- how you intend to operate;
- whether Australia has a DTA with the jurisdiction;
- if Australia has a DTA with the jurisdiction, what does the tie-breaker corporate residence rule state;
- even if the tie-breaker corporate residence rule assigns sole tax residence to the other jurisdiction, do the CFC rules apply;
- if the CFC rules apply, do you pass the active income test; and
- if you fail the active income test:
- is the other jurisdiction a listed or unlisted country; and
- do you have attributable income.
Mosaic Tax Legal assists other law firms and accounting firms on a trusted adviser or white-label basis to deliver tax advice across multiple industries on a State, federal and international basis. We also provide direct-client services.
If you or your clients have any questions on expanding overseas or other international tax issues, please feel free to contact our office.