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Corporate Tax Residence and Substance

Basil Bielich

For many years businesses have relied upon “offshore” or non-resident structures to reduce or defer taxes and improve returns for their investors. How these structures are managed may, however, be taking a different turn. Tax authorities seem to be asking whether there is a business reason to set up a company in another jurisdiction.

The tax authorities are now looking at the substance of the business before they are satisfied that the business can qualify for tax non-residence and relief from local taxes. Tax authorities want reality and not the figment of a tax planner’s over-active imagination. Businesses have to demonstrate substance in that other tax jurisdiction before they can get the tax treatment they claim

The concept of “Substance” is a common concept used by taxation authorities and professionals. However, there does not seem to be a common definition of substance. In some countries, the incorporation and tax registration in the jurisdiction is adequate. However, in most countries the incorporation of a company is not sufficient to ensure that the company will be considered a resident company.

To demonstrate substance, there needs to be an active board of directors (and, as appropriate, employees), suitable financing, and office facilities. Using subcontracted staff and general office space of an administration company may be ignored when considering the test except in specific circumstances. But it gets more complex. The necessary level of economic activity and overall substance might even vary according to the business of the company or the type of tax involved. The rules for exemption from income tax often vary from the rules for capital gains tax.

The difficulty in demonstrating substance is that there is no perfect answer in the real world.

Therefore, what should a business consider doing when setting up a company in another jurisdiction? It is crucial to understand that enhancing substance always should be tailor-made. Any attempt to generalise would prove dangerous. Therefore, the suggestions below are only intended to point out the items to consider. It is in no way a ready solution.

1. Always get tax opinion before entering into a transaction or establishing a structure. Getting advice in advance will ensure that every transaction has undisputable economic substance. Get tax ruling where possible. It is important to remember that there is no standard approach to when sufficient substance has been achieved. 

2. Appoint qualified directors who have the ability to make decisions and understand the nature of business. They should be residents of the relevant jurisdiction and must  have the proper background. Avoid setting up a structure in which directors of a foreign company are the same as directors of the source company.

3. It is advisable to maintain an office presence.

4. Maintain business records: original minutes of board meetings and general meetings, emails, general administration, archive, filing and accounting should be kept at the seat of the company.

5. Make contracts/agreements through the Company, avoid powers of attorney to execution of contracts and decision taking.

6. Continually develop the company. It is essential to demonstrate economic substance throughout the company’s lifetime.

Companies operating subsidiaries overseas and benefiting from lower taxes in those countries should take note of new International guidelines on so-called substance requirements. These substance requirements are becoming important to tax authorities worldwide, and should therefore be high on the agenda of companies operating overseas, or thinking of doing so.

As part of the global fight against tax fraud and a crackdown on “treaty shopping”, companies are being challenged to show their overseas operations are genuine subsidiaries being run from the host countries – or risk losing the tax breaks.

In broad terms, this means companies must show that the management, control and day-to-day decisions concerning business activity are taken in the country where the subsidiary is based.

Peregrine Corporate Services Limited is licensed by the Isle of Man Financial Services Authority.