RSM Australia

Australia broadens the tax ‘resident’ test for foreign incorporated companies

  • ATO gets a powerful new weapon, as Australia broadens the tax ‘resident’ test for foreign incorporated companies.
  • ATO issues draft ruling on central management and control (CM&C) of foreign incorporated companies.
  • Broader test adopted; more foreign incorporated companies likely to be caught as Australian tax residents. Foreign marketing hub companies may be amongst the first so challenged.
  • The draft ruling implements High Court decision in Bywater Investments, which upends the longstanding interpretation of the CM&C test.
  • Whilst unrelated to the OECD BEPS project, the reconceptualization of the CM&C test can be seen as inconsistent with the BEPS principles.
  • All corporate structures require review; in particular Australian-based outbound investors.

From time to time, court decisions are handed down which do more than simply ‘develop’ the law; they invert the conventional understanding of the law and leave both the Revenue and taxpayers in the world of uncertainty. The Australian High Court decision in Bywater Investments, handed down in November 2016, is such a case. The decision upends the accepted understanding of when a foreign incorporated company may nevertheless be an Australian tax resident, in circumstances where its ‘central management and control’ is located in Australia.


On 15 March 2017, the Australian Taxation Office (ATO) issued a draft tax ruling – TR 2017/D2 - setting out its “preliminary but considered view on how to apply the central management and control test of residency” following the High Court’s Bywater decision. The previous ruling on the issue – TR 2004/15 - was withdrawn on the same date. (The legislative tests remain the same; the changes arise from the High Court’s decision, and the ATO’s administrative response.)


What is the likely effect?


There are likely three. First, international groups having non-resident company connections with Australia, will need to review the implications of the Bywater decision and the new draft ruling to their circumstances. Second, there may be no adverse consequences, or consequences which can be accepted without structural change (e.g. potential double taxation, but exemption relief available). Third, unrelieved double taxation (or significant uncertainty as to tax consequences) leading to a corporate restructure. In all cases, there will need to be far greater attention paid to formal governance matters, which will likely have the effect of increasing operating costs. But, as discussed below, the role of ‘governance’ in modern multinational groups is increasingly divorced from the traditional view which underlies the CM&C test.


Who is affected?


Australian based groups with outbound operations are primarily affected. The changes result in a materially higher risk that foreign incorporated subsidiaries will now be classified as Australian tax residents, as well as retaining their tax resident status in their country of incorporation.


Foreign inbound investors will also need to review their structures, particularly if they have both ‘inbound to Australia’, and ‘outbound from Australia’ structures. They should also review Special Purpose Vehicle (SPV) entities established to operate only in Australia.


The consequences of the changes will vary depending on the country in which the foreign subsidiary is incorporated: whether in a country with which Australia has a comprehensive double tax agreement (DTA), or otherwise. For companies incorporated in a DTA country, the consequences will be affected by the terms of the specific DTA.


Australian tax law test for company residence


Under Australia’s domestic law, a company will be a ‘resident of Australia for tax purposes’ if:


  1. it is incorporated in Australia; or
  2. it is not incorporated in Australia, but it carries on business in Australia, and either:
    • its central management and control is in Australia; or
    • its voting power is controlled by shareholders who are Australian tax residents.

Bywater and TR 2017/D2 consider the application of the alternative ‘central management and control’ (CM&C) test for determining whether a foreign incorporated company is an Australian tax resident.


CLICK HERE FOR  BYWATER CASE STUDY 


TR 2004/15


This was the ATO’s earlier ruling on the application of the CM&C test of residence for foreign incorporated companies. It was generally considered that the ruling adopted a ‘generous’ (to taxpayers) approach, in that it adopted a two-step approach: first, as a matter of fact – was the company’s CM&C located in Australia? If yes, then there was a second enquiry – was it otherwise carrying on business in Australia (on the basis that simply having CM&C located in Australia did not constitute the carrying on of the company’s business). Given the High Court’s view that, by definition, the activity of CM&C constitutes the “real business” of a company, then by definition CM&C constitutes the carrying on of the company’s business.


The ruling was withdrawn on 15 March 2017.


TR 2017/D2


The new draft ruling follows closely the High Court decision in Bywater. The first point made, is the backflip over the relationship between a company’s CM&C, and the carrying on of its business -  “If a company has its central management and control in Australia, and it carries on business, it will carry on business in Australia within the meaning of the central management and control test of residency.”


The draft ruling considers what CM&C means – it “...is the key element in the making of high level decisions that set the company’s general policies, and determine the direction of its operations and the type of transactions it will enter. The control and direction of a company is different from the day to day conduct and management of its activities and operations. The conduct of the company’s day-to-day activities and operations is not an act of central management and control. Nor is managing those activities under the authority and supervision of higher level managers or controllers.”


However, a majority shareholder with the power to appoint a company’s board, does not of itself mean the shareholder controls or directs the company’s operations at the higher level.


The draft ruling emphasises that it is a question of fact in all the circumstances to determine who it is that actually exercises central management and control of a particular company. It also confirms there is no presumption that the board of directors will exercise central management and control in the absence of evidence to the contrary. (In other words, the burden of proving the board of a subsidiary does exercise CM&C rests with the subsidiary; it must be proven as a fact; there is no presumption.)


 The draft ruling addresses other issues which have come up through the various court decisions: CM&C is to be determined by reference to substance over form; the level of legal authority required to constitute CM&C; the distinction between an ‘outsider’ to the board being merely influential, as distinct from actually usurping the board’s role and exercising CM&C; the importance of formal documentation; and other relevant matters.


Unfortunately, at this point, the draft ruling does not include any worked examples, which was a most helpful addition in the earlier ruling, TR 2004/15. Hopefully, some examples will be added when the draft is issued in its final form.


Some practical observations


For Australian outbound groups, the incorporation of foreign subsidiaries has always presented ‘challenges’, but those challenges have been magnified by the Bywater decision, and confirmed by the tone of TR 2017/D2.


To be fair, the ATO has a tough task – it must police the tax law as written, but it must do so in a manner which is both efficient and consistent, and permits a high degree of certainty in Australia in a self-assessment environment.


The CM&C test of company residence is particularly challenging because of the interaction between ‘form’ on the one hand (ie the Board of Directors as the proper body for controlling a company), with ‘fact and substance’ on the other (how control is actually exercised). The case of a subsidiary company is complicated by the reality that its high-level direction has generally been set by the parent company, leaving limited scope for the subsidiary board to exercise “higher level authority” beyond mere compliance with administrative and statutory formalities.


The denial of any presumption that a properly constituted and operating board will satisfy the CM&C test in the absence of evidence to the contrary, places the burden of proof fairly on the subsidiary to prove its case. Inability to satisfy that evidentiary burden will result in the foreign incorporated company being treated as an Australian tax resident, by default – if the subsidiary’s board does not exercise CM&C, then it must be the Australian parent which does.


Having regard to the reality of international structures, and the barriers to trade and commerce wrought by double taxation (e.g. a company being treated as tax resident in more than one country), the ATO’s now withdrawn ruling set out a workable framework which allowed confidence in structuring, but left the ATO with sufficient scope to apply the CM&C test in appropriate circumstances, e.g. Bywater. But the tone of TR 2017/D2 is much less accommodating, and significantly increases the challenges faced by Australian foreign subsidiaries in satisfying the threshold test.


The task is made even more difficult because the test of CM&C is rooted in ‘traditional’ conceptions of board decision-making and control of companies, which are at odds with the way modern MNC groups are actually managed. Decision-making is now commonly done along business/product lines (vertical integration across national boundaries) rather than by reference to the constraints of a corporate entity. At best, the statutory minimum requirements are satisfied at the corporate entity level by its governing board, but with the absence (in many cases) of a company secretary, and the increasing adoption of remote/centralised corporate control, even maintenance of minimum statutory governance obligations can be a stretch in practice. The email has in most cases replaced the board minute.


Against this reality, proving the board of a foreign subsidiary does exercise CM&C is becoming more difficult. Nevertheless, to ignore the issue leaves the subsidiary open to characterisation as an Australian tax resident. The nettle must be grasped, and in doing so there is the practical question of ‘how’ in a self-assessment environment. Is the issue deferred until it is raised at some point (if at all) by the ATO, with non-Australian resident status maintained in the interim? Or should there be a positive engagement with TR 2017/D2 and a realistic attempt to determine resident status within the confines of self-assessment? (Consider the preparation of a statement of reasonably arguable position.) And in this context, at what point might this become a potential statutory audit issue?


The High Court decision in Bywater, together with the ATO’s consequential draft ruling, has rewritten the law (and upended the practice) on the application of the CM&C test for foreign companies having a business connection with Australia. Whilst the draft ruling is not yet final, it is not expected to vary much, given the clarity of the High Court’s reasons.


All corporate groups which have a foreign company in their structure with an Australian connection, should contact your regular RSM tax adviser to arrange for a ‘health check’ of your current structure.

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