The Bywater Decision and the impact on New Zealand Incorporated Companies
The Australian Tax Office (ATO) was successful before the High Court in the case of Bywater Investments Limited & Ors v FCT; Hua Wang Bank Berhad v FCT  HCA 45 (“the Bywater case”) with regard to the tax residency of foreign corporates. This decision will impact a large degree of New Zealand incorporated companies that are Australian owned and/or managed. Boards of Directors will need to ensure they are aware of how their decision-making processes may impact on the Australian tax residency of such New Zealand incorporated companies.
Setting the Scene
For Australian tax purposes, there are three alternative tests in the corporate residency definition under section 6(1)(b) of the Income Tax Assessment Act 1936 (ITAA 1936):
- Incorporation in Australia (the incorporation test);
- Carrying on business (CoB) in Australia and central management & control (CM&C) in Australia (the second statutory test); and
- Carrying on business in Australia and voting power controlled by shareholders who are residents of Australia (the third statutory test).
It is the second statutory test that was put under the spotlight in the Bywater case. This is a two limb test, i.e. CoB in Australia and CM&C in Australia. The “nature of the business” of a foreign incorporated company was key in determining corporate residency under the second statutory test. Historically, the Commissioner drew a distinction between two types of companies:
- Where a company was operational such as trading, provision of services, manufacturing or mining activities, the location of the company’s business would be where the main operational activities took place, not necessarily where the CM&C was located; and
- Where activities consisted of passive dealings, such as investment management, the location of the company’s business would be where major decisions were made, i.e. often where the CM&C was located.
The ATO historically rejected the approach that the mere exercise of CM&C would itself constitute the carrying on of a business. Consequently it was always considered that where a New Zealand incorporated company carried on business in New Zealand, it was not considered Australian tax resident even though its CM&C may be located in Australia. The Bywater case is a U turn on the previous ATO position.
The taxpayers involved in the case were four private companies, all of which were incorporated outside Australia. However despite that, the ATO were seeking to assess income tax on the companies’ share trading activities.
The companies argued they were not residents of Australia for income tax purposes as their “central management and control” was not in Australia. The directors of the companies resided outside Australia and gave evidence that they were the decision makers of the companies. The ATO argued that it was the Australian resident accountant who actually controlled the companies. Further they argued it was he who actually made all the commercial decisions about the share transactions entered into.
The directors stated the Australian resident accountant was just an advisor and not the person that made the final decisions. In addition to this, the companies also argued that what determines corporate residency is the place where the company’s decisions are formally made, not a place from which informal influence may emanate.
After an examination of the evidence, the primary judge in the Federal Court found that there was a deliberate attempt to conceal the role of the Australian resident accountant’s true role and that the directors exercised no independent judgment. Instead they merely carried into effect the accountant’s instructions. It was concluded by the Court that the companies’ place of CM&C was within Australia.
The decision went through the appeal process. Eventually the High Court held that, as a matter of long-established principle, the residence of a company is a question of fact and degree to be answered according to where the CM&C of the company actually abides. The High Court drew a distinction between a board of directors that actually meets and makes independent judgements and a board whose meetings are mere window dressing comprised of rubber-stamping decisions actually made elsewhere by others.
The High Court then unanimously held that the CM&C of the taxpayers was within Australia.
Of note is that this is a substantial shift from the Commissioner’s previous stance. ATO rulings have consequently been updated. In Taxation Ruling (TR) 2004/15, the ATO view was that for a company to be a resident under the second statutory test in section 6, two separate requirements had to be met. The first was that the company must carry on business in Australia and the second that the company's CM&C must be in Australia.
A good two years on from this verdict, and the ATO have now finalised TR 2018/5 to assist with the application of the CM&C test.
What does TR 2018/5 say?
At the same time as finalising TR 2018/5, the ATO also released Practical Compliance Guideline, PCG 2018/D3 that provides guidance in relation to the application of TR 2018/5.
In brief, the ATO states:
“If a company carries on business and has its central management and control in Australia, it will carry on business in Australia within the meaning of the central management and control test of residency.
It is not necessary for any part of the actual trading or investment operations of the business of the company to take place in Australia. This is because the central management and control of a business is factually part of carrying on that business. A company carrying on business does so both where its trading and investment activities take place, and where the central management and control of those activities occurs”.
The key message for taxpayers going forward, is to focus on assessing where CM&C will be located rather than a mechanical consideration of where a company may carry on its business. TR 2018/5 states as “a starting point” the ATO will consider where the directors of a company will exercise CM&C. The ATO will also consider amongst other factors:
- where the governing body of the company meets;
- where the company declares and pays dividends;
- the nature of the company’s business and whether it dictates where CM&C decisions are actually made in practice; and
- evidence such as minutes or other documents recording where high-level decisions by the company are made.
Importantly, exercise of CM&C by the directors of a company looks at real decision making not merely the implementation or rubber stamping of decisions made by others.
PCG includes examples of variable situations such as:
- a high-level decision vs a decision relating to day-to-day management of the company;
- a person who is ‘merely influential’ vs a ‘real decision maker’; and
- decisions made in one location vs decisions made in multiple locations.
Whilst some useful examples are included in PCG 2018/D3, most are simple and of limited utility. As the ATO itself says, the examples and guidance in PCG 2018/DC are “general in nature” and foreign incorporated companies are encouraged to approach the ATO on a case by case basis to discuss their specific circumstances.
Impact for New Zealand incorporated companies
New Zealand incorporated companies, particularly those with parent companies in Australia, need to be certain they are meeting the CM&C test by ensuring that high-level decisions of these companies are undertaken in New Zealand.
The supporting draft Practical Compliance Guideline provides an example.
An Australian parent company owns a subsidiary abroad. While the Australian parent company can be highly influential to the foreign subsidiary, even share some board members, the foreign company’s board must demonstrate that it acts with a degree of independence and makes its own high-level decisions. The foreign company’s board members should make judgments on the merits of proposals for the business, engaging independent consultants where necessary, and show they have the relevant knowledge to make the required decisions.
A company’s board minutes, as an example, have been identified as a matter most likely to influence the court’s decision. Through detailed and complete records of board minutes, a company should be able to provide evidence of all high-level decisions and those involved in the decision making. The Commissioner should be left with no doubt about who made the decisions and where they were made.
A transitional period applies until 13 December 2018 in which the ATO will not apply its resources to review the non-resident company’s residency status provided that during the transitional period the non-resident company:
- changes its governance arrangements so that the CM&C is exercise outside Australia by the end of the transitional period;
- does not commence carrying on business in Australia (other than because its CM&C is exercised in Australia); and
- does not enter into any artificial or contrived arrangements to affect the location of its CM&C, or, any tax avoidance scheme whose outcome depends on, in whole or in part, on being a non-resident.
Corporate groups for which these changes have implications should contact their regular RSM adviser as a matter of urgency to arrange for a health check of their current structure.