Rewrite of corporate residence test: More certainty in an uncertain world? - Wolters Kluwer CCH
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Income TaxTax

Rewrite of corporate residence test: More certainty in an uncertain world?

Cameron Blackwood, Partner, Richard Hendriks, Partner, Julian Pinson, Partner and Richard Vann, Consultant, Greenwoods & Herbert Smith Freehills

Following the delivery of the 2020 budget announcing the revision of the corporate residence test for taxation in Australia, the government has released the Board of Taxation’s report on which this announcement was based. This insight explores some of the effects of the changes and continuing uncertainties in the corporate residence area (particularly for offshore holding companies and SPVs).

The terms of the announced change to the corporate residence rule in the budget follows almost exactly the words of the board’s recommendation:

a company that is incorporated offshore will be treated as an Australian tax resident if it has a ‘significant economic connection to Australia’. This test will be satisfied where both the company’s core commercial activities are undertaken in Australia and its central management and control is in Australia.

So it seems that the board’s report is the best guide of what will happen at least until we get a consultation paper or exposure draft legislation.

Importantly the announcement does not clarify what core commercial activities in Australia means – all of them, most of them, some of them or at least one of them. The same ambiguity is present in parts of the board’s report but at least some of the discussion and more particularly example 4 in Appendix C make clear that it is not all and probably not most, leaving some or at least one core commercial activity as possibilities. The discussion in the report of the need for guidance on ancillary or incidental activities which do not qualify as core business (such as back office) may suggest any part of the core business in Australia is enough. The board provides a shopping list of things to consider without carrying the matter much further but does make clear that the Explanatory Memorandum (EM) should flesh out what is meant so that the ATO can then offer further guidance. The key distinction for companies with active businesses is between strategic management and operational management.

Both the budget announcement and the report make clear that the purpose of the change in practice in a broad sense is to restore the position as it was under the ATO’s now withdrawn ruling TR 2004/15. The report’s examples also make clear at least the plain vanilla cases where the budget change will reverse the position that the ATO takes in its current guidance (TR 2018/5PCG 2018/9).

The report recognises that the business environment has changed since the 2004 ruling in the form of governance practices, technological developments and the emerging post-COVID world and the EM should spell this out and the ATO take the hint down the track and not retreat from all of its general COVID guidance on corporate residence issues.

The most common questions that arose under the 2004 guidance were for passive holding companies and investment funds and at the extreme special purpose vehicles (SPVs) which in many cases just enter into one transaction during their existence. While rejecting a special statutory rule for holding companies the report does indicate that the treatment of holding and investment companies will remain the same as under the 2004 ruling and the investment example in that ruling is effectively elaborated in the report’s example 2 making clear that if an offshore investment manager makes the investment decisions while the Australian board just sets the investment strategy and appoints the manager, this will not amount to core commercial activities being in Australia. The same approach is applied to offshore regional holding companies within an active corporate group where a majority of directors of the holding company are in Australia but the operational activities of running the operating subsidiaries by the regional holding company occur offshore.

One important point made by the board is that whilst the intention is for the physical location of directors to assume less importance, for holding companies it is likely to continue to have greater weight in this context – given that the location of central management and control is indicative of where the company carries on business and vice versa (example 2(d)). In any event, given it is the ATO that is tasked with providing “administrative practical guidance” for holding companies, it will be important that the ATO administers the rules in a way that provides certainty for taxpayers and does not result in offshore holding companies of Australian multinationals being treated as Australian residents inappropriately.

For SPVs many taxpayers have operated on the basis that the strategic decisions (to sign the contract or make the investment) are also the core commercial activities and both have to be offshore to avoid both Australian residence and Australian tax on a source basis (unless treaty relief from source tax is available). These kinds of situations are likely to test the fact that not only has the commercial environment changed since 2004 but also the visibility of the residence issue with the ATO. After 2004 the ATO did not for many years devote audit resources to the residence issue (and even in the Bywater 2016 ATC ¶20-589 case, which has been the root of current uncertainties, the ATO used it largely it seems because of difficulties of discovering the underlying facts). Once the issue is out of the box, it cannot simply be put back in so SPVs may give rise to uncertainty at least until the new law settles down and the ATO offers hopefully helpful guidance.

The board also notes that residence should be “sticky”, so as to provide certainty and ensure that short term “fluctuations” do not affect residence.

Unfortunately neither the report nor the budget deals directly with another residence uncertainty arising from the removal of the place of effective management dual resident tiebreaker test from many of Australia’s tax treaties by the Multilateral Instrument (MLI). While the ATO guidance following Bywater exacerbated this problem, the removal of those uncertainties by the budget announcement does not deal with the fact that many countries have more than one residence test for companies and the other common test apart from management type tests is the place of incorporation. The budget change applies only to foreign incorporated companies and if they end up as resident in Australia under the revised rule they will generally be a dual resident and thus potentially lose treaty benefits (with flow-on domestic law consequences) under the MLI changes.

Buried in the budget “glossy” on tax cuts was an announcement that the post-COVID economic recovery strategy includes reinvigorating the Australian tax treaty negotiation program (which has produced only three full treaties apart from the MLI after 2010) through investigating treaty policy, priorities and processes followed by streamlined (and faster) progress on Australia’s treaty network. That is, however, a long way from saying that the significant problems created by the MLI change may be solved, and certainly the special solution with New Zealand of a very tightly circumscribed power for taxpayers to self-assess the issue in an SME context is no solution at all (though it is referenced by the board’s report).

The quick way to deal with some of the problem would be to withdraw Australia’s reservation under MLI article 4(3)(e) so that the competent authorities could at least give treaty reliefs without deciding the residence issue – we understand that the UK at least is not happy with Australia’s reservation. The next step going forward would then be to replace the MLI rule with the much better rule found in Australia’s 2009 New Zealand treaty and 2015 German treaty providing primarily for use of the place of effective management test and only falling back to competent authority determination in very limited cases, plus the possibility of relief without a decision on treaty residence in cases which still need competent authority agreement.

This article was originally published on the Greenwoods & Herbert Smith Freehills website and has been reproduced with permission.

Read about tax residency rules on the CCH iKnow Residency topic guide, and access commentary on the MLI in the International Tax module.