How To Understand Company Tax Residency
Residency of a Company
In an earlier article, we mentioned the three pillars of residency.
What are the three pillars?
They determine what country gets to tax your income.
Why does this matter to you?
Well if you don’t want to pay taxes in a high tax country and instead want to pay it in a low tax country you need to understand how to shift the income there legally.
In following articles, we’ll discuss the other two pillars:
- Residency of the income
- Residency of the shareholders
But for now, let’s start at the beginning with a company.
Why Companies Rather Than Individuals?
Companies have this wonderful quality, which is they can move very easily at the stroke of a pen in many cases.
Individuals aren’t the same.
If you want to move somewhere new you’ve got to sell your stuff, physically move it, go someplace different, obtain a legal residency permit there (often challenging), set up new relationships, potentially new work, etc.
But a company — although it is a legal person — isn’t restricted in this way.
A company is basically just an entry in a ledger for a government.
Clients will sometimes come to me saying:
“I don’t know about having my company based in XYZ, it’s not politically stable…”
Here’s the thing… a company isn’t anything tangible in and of itself so political stability, corruption, etc. none of that really matters.
Only the applicable laws matter to us along with the associated costs.
Now you’re going to hate me in a minute because I’m about to make this whole thing much more complicated but for now just realize we can register a company anywhere and relocate it at the stroke of a pen with a small amount of money.
Lots of times you might want to shift your income to someplace lower tax, but might not want to relocate yourself.
This is one of the many reasons we use companies for international tax planning.
What Does It Mean For a Company To Be Resident?
In an earlier article, we discussed some of the factors involved in figuring out what jurisdiction to use so we won’t cover the subject again here.
Here, we’re interested in digging into the subject that catches more people than any other I’ve seen…
“What does it mean to be resident?”
Picture this extremely common scenario.
You’re me and someone calls you up to discuss an international tax set up.
They make some comment like, “I’ve got a Belize company and Belize doesn’t have any tax”.
Now, aside from the surface error that Belize actually does have tax, in fact they even tax revenue not profit — it’s true Belize probably doesn’t tax the IBC (International Business Company) you formed.
However, there is a big problem with the statement above.
IT IS IRRELEVANT THAT BELIZE DOESN’T TAX YOUR COMPANY BECAUSE YOUR HOME COUNTRY PROBABLY DOES.
Hopefully, I said that loud enough.
Yes, that’s right.
You’ve probably achieved nothing more than increasing your annual compliance costs by forming a Belize company rather than a local company.
Even worse if you’re in BVI or some other more expensive jurisdiction.
What am I talking about?
There is a vast difference between “registration” and “residency”.
Countries tax based on the residency of a company not the registration of the company — at least in many cases.
So, for example, if you’re from UK you could have gone to the Companies House, registered a new limited company for £15 and paid your normal British tax calling it a day.
Because you formed a Belize company or a BVI company or a Bahamas company or whatever else someone on the net told you to do — you’re paying probably upwards of $1000 and yet for UK tax purposes this is exactly the same as a UK company.
In fact it literally is a UK tax resident company.
What this means is your foreign registered company is FULLY taxable on its entire worldwide income in UK just exactly the same as if you’d formed the company in UK.
The whole income of a company is subjected to the tax rules of whatever jurisdiction it is deemed resident in (and in theory it can be resident in multiple jurisdictions or none).
What Determines Residency?
Now, if you aren’t familiar with this concept you’re probably thinking “what are you talking about Michael, I don’t get it?”
There are various different ways countries around the world determine if a company is resident there.
In most cases it comes down to one or a combination of:
- Jurisdiction of registration
- Where the “management and control” takes place
Now, I know I just told you the jurisdiction of registration isn’t the jurisdiction of residency and this is to get you thinking in terms of residency rather than registration.
It is true that some countries only use the jurisdiction of registration and if you’re dealing with one of those jurisdictions you’re fine on this pillar.
You can register a company wherever makes sense for your needs and move on to the next pillar.
However, most high tax jurisdictions where someone would care to do this sort of planning use the management and control standard.
Note, there’s all kinds of language such as “place of effective management”, “place of central management”, etc. the point is it refers to where the high-level decisions of the company are made.
There’s also rare occasions where they’ll use some sort of physical presence or operations test, but this usually isn’t a concern.
The important thing for you to realize is in the case of most — but not all high tax or westernized countries — at least part of the criteria they use is management and control.
In most cases countries use management and control as well as registration.
This means “if the company is formed in this country it’s automatically taxed here, but if it’s formed somewhere else and managed from here it’s also taxed here”.
Some examples of these countries would be:
- New Zealand
- Hong Kong
- South Africa
Ireland only uses management and control, not registration, though there are some recent amendments following Apple and other countries exploiting this loophole.
Noteworthy countries who don’t use a management and control standard are US, Brazil, Thailand, a bunch of eastern European countries, etc.
What Does “Management & Control” Mean?
This is the really crux of the issue.
What is meant by “management and control” or “place of effective management” or “central management and control”?
Let’s start with the bad news — there is no definitive measure.
What it loosely tends to mean is this is where the high-level decisions are made for the company.
Historically, coming out of UK law this is where the board decisions were made.
However, this doesn’t mean that day to day operations can take place in UK… then once a quarter the board members can hop on a plane, fly to Bahamas, make some decisions and leaves.
Nor does it mean you can hire some people in Jersey or Isle of Man as directors, tell them what to do and have them formalize those decisions outside the country.
So where do we begin?
Well, as usual it’s jurisdiction specific so it helps to start with the particular jurisdiction in question.
Some jurisdictions are more helpful and some are less helpful in their guidance.
It also helps to understand management and control is what we call “a matter of fact” in law and therefore something a court will determine after looking at the available evidence.
To start understanding the principle, simply imagine yourself managing and controlling the highest-level decisions of your company.
What roles and functions do you take on?
Imagine the board of directors for a large public company. What roles and functions do they take on?
This is more or less what you want to emulate.
Digging a little deeper the Australian Tax Office (ATO) provides what I consider some of the most useful and specific language on the matter.
Keep in mind, this is technically specific to Australia, but because the subject is logical and the governance of companies is more or less the same, it’s a useful reference point for other jurisdictions as well:
“13. The second statutory test focuses on management and control decisions that guide and control the company’s business activities. This level of management and control involves the high level decision making processes, including activities involving high level company matters such as general policies and strategic directions, major agreements and significant financial matters. It also includes activities such as the monitoring of the company’s overall corporate performance and the review of strategic recommendations made in the light of the company’s performance.
14. Possession of the mere legal right to exercise central management and control of a company is not, of itself, sufficient to constitute CM&C of the company. Someone who has the ‘mere legal right to CM&C’ is a person with the legal right to make these decisions involving CM&C but who for one reason or another does not exercise this right. However, a person with the legal right to CM&C may participate in the CM&C of the company even if they delegate all or part of that power to another, provided that they at least review or consider the actions of the delegated decision maker before deciding whether any further or different action is required.”
That’s some beautiful language right there.
Let’s start with the second paragraph to draw out the important points here:
“Possession of the mere legal right to exercise central management and control of a company is not, of itself, sufficient to constitute CM&C of the company”
Perfect, ok so having someone in the position of say director doesn’t matter they’ve actually got to practice it.
“a person with the legal right to CM&C may participate in the CM&C of the company even if they delegate all or part of that power to another, provided that they at least review or consider the actions of the delegated decision maker before deciding whether any further or different action is required”
Ok, so the key point here is they don’t actually have to make the decisions.
Board members often have advisors and people they delegate or defer to.
What is important is they demonstrate evidence they are actually reviewing the actions and decisions prior to approval.
In other words, no hired gun who rubber stamps everything.
If you’re the director of the company and the person exercising central management & control do you demonstrate evidence you’re reviewing what’s going on?
Do you demonstrate evidence you’re actually providing discernment, pushing back against and sometimes vetoing suggestions, etc?
To take a tangent for a moment, here you might be wondering how this is demonstrated?
It will be primarily through correspondence and is a great reason to ensure you properly document regular director’s meetings to show what went on and how decisions were made.
Let’s circle back to the first paragraph to see some of the specifics of what areas we’re talking about reviewing and exercising discernment around:
“This level of management and control involves the high level decision making processes, including activities involving high level company matters such as general policies and strategic directions, major agreements and significant financial matters. It also includes activities such as the monitoring of the company’s overall corporate performance and the review of strategic recommendations made in the light of the company’s performance.”
Ok, so let’s break down a list here:
- General policies — these would include broad far reaching policies concerning how the company is run for example there might be a policy of requiring board approval on any financial decision
- Strategic directions — day to day decisions will obviously get made by front line personnel and their supervisors, but high level strategic direction such as entering into new markets, key executive hiring decisions, succession planning, etc. should have board involvement
- Major agreements — again a company will engage in hundreds of thousands of small agreements routinely but what of agreements with a massive impact on the overall company? A key joint venture involving a lot of personnel and resources, a major licensing deal especially exclusively for a territory, etc.
- Significant financial matters — this might include mergers and acquisitions, investments over a certain dollar value, possibly matters of executive compensation, etc.
- Monitoring the company’s overall performance — is the board reviewing financials and digging deep into performance, areas of strength and weakness? Is the board examining the effectiveness of high level executives to hold them accountable?
- Review strategic recommendations in light of performance — based on the performance of the company led by the executive team is the board are they asking questions? Are they probing and applying pressure? Are they holding the team accountable for a direction change or timelines if the current strategy isn’t working?
These are great examples of the facts behind management and control.
In other words where are these actions and decisions taking place in the world?
Where are the people making those decisions located?
Often, we include control over bank accounts in this category.
After all, how can you consider yourself in control of the company if you don’t have signing authority on accounts?
Really, the process is quite logical, if you actually are taking a real active role at the highest level in controlling a company what would you do?
Now, whoever is doing those things where are they?
This is likely where the central management and control of the company is located.
Of course, some courts have ruled more in one direction and others have ruled more in another depending on when and depending on jurisdiction.
Canadian courts more on the side of form and less on the side of substance.
What we always suggest is err on the side of caution. It is better to be clearly on the right side of the line than risk it on the wrong side in the event of review.
Now, be aware in some cases the language and application of the language differs.
For example, in the case of Denmark the language isn’t “central management and control” but rather “day to day management”.
Whatever jurisdiction you’re dealing with dig in and make sure you’re compliant.
A Company Could Be Double Resident or Double Non-Resident
Keep in mind, residency isn’t one size fits all.
This is why I explain to people who state that a Hong Kong company shouldn’t get taxed in Hong Kong because XYZ that: “Of course not, but that’s not the problem. The problem isn’t Hong Kong it’s your local country”.
Let’s say you’re in Canada and you’ve got a foreign company set up in Panama.
Canada might well decide to tax the Panama company.
What’s worse, both Canada and Panama might decide to tax the company, which is where Double Tax Agreements (DTAs) come into play.
Often two countries have no such agreement in force.
In Double Tax Agreements (DTAs) there’s generally a tie breaker clause for if a company or person is considered tax resident in both jurisdictions how is it resolved?
In some cases it’s based on place of effective management, in others place of registration and still others it’s left to the “competent authorities”.
This is potentially useful.
In some cases as I’ve noted in examining some of Canada’s tax treaties as the tie breaker clause overrides the management and control standard generally used for Canadian tax and thereby make it much less onerous to form companies there.
The opposite to double residency can also take place though the so called double non-tax resident.
How does this work?
Let’s look at how Apple applies it with two of their Irish subsidiaries.
Ireland uses only a management and control standard.
The US uses only a registration standard.
So, they form companies in Ireland then manage and control them from the US. When the Irish tax authorities call they say, “we’re not tax resident in Ireland we’re managed and controlled in the US”.
When the US tax authorities call they say, “we’re not tax resident in the US we’re registered in Ireland” then claim no tax residency anywhere and have gone years without filing any taxes at all.
This is quite common in cases with other company types.
For example, the famous CV/BV structure in Netherlands exploiting some nuances in how a partnership is categorized.
Or potentially a US LLC owned by Canadian shareholders.
A US LLC doesn’t exist for US tax purposes — it’s a transparent or “disregarded” entity.
But because Canada doesn’t have LLCs they treat it as a corporation and you get a mismatch of tax laws between the two countries.
Of course, this can backfire depending on the functional operations of the company in question and the countries but it opens up interesting possibilities.
The bottom line is you absolutely must pay attention to the tax residency of the company and the applicable residency rules for each jurisdiction who might lay claim.
If you’re spending a lot of time living in a particular country and running a foreign business from there, be aware they might claim tax residency over the company.
It all depends on the rules.
It is possible to genuinely shift the tax residency of the company and gain substantial tax advantages in doing so, but if it was as easy as registering a foreign company everyone would be doing it rather than registering locally and high tax countries would be out of business.