Having a registered address in a low tax jurisdiction may satisfy the incorporation requirements, but it does not necessarily mean that the company will be tax resident, profits will be taxed in that country and that it will qualify for any treaty benefits. This has become an increasing concern for multinational groups, holding companies and entrepreneurs who have an international presence.
While not a new issue, as governments continue to share financial information and understand who owns the company and what transactions are taking place, having a company incorporated in one country does not necessarily mean it will be seen as tax resident in that country. A company will be tax resident in the country where it is effectively managed. Even if a company can be proven to be tax resident, if there isn't any real business activity within the company, this can cause issues with claiming any lower rate of withholding tax or exemptions.
When structuring companies across the United Arab Emirates, Europe, Asia and Offshore Financial Centres, it is no longer enough to simply set up a legal structure, you must be able to prove that the company is doing what it says on the tin.
Tax Residency is Not the Same as Incorporation
Incorporation will provide a company with a legal existence in that country. However, tax residency will be dictated by the laws of that country and any agreement between countries.
Depending on the country, the company may be tax resident based on incorporation or if the central management and control is located elsewhere. Some countries will require the company to show that key decisions are made in that country. Therefore, there can be conflicting opinions on where the company will be tax resident, if the company is incorporated in one country, the management, directors and shareholders are in another country.
This can be a real issue for holding companies. While the company might have been established to own shares in operating companies, receive dividends, provide finance to the group or hold IP, this can be a legitimate business activity even if there is a small number of staff. However, depending on the laws that apply to the company, the type of income and if the structure meets the requirements for substance, this can impact on how the company is taxed.
A certificate of incorporation or tax residency certificate may help with proving a company's position, but it cannot be guaranteed that all tax authorities will accept this. They can investigate the facts, purpose and how decisions are made.
Where Effective Management is Made
Often the key issue will be where the company is effectively managed. Tax authorities can investigate where the directors meet, who has overall approval for major transactions, where decisions on financing are made and whether the board have any independent judgment.
If the company only has minutes to prove that decisions were made in a certain country, this may not be enough. If there are emails or other correspondence showing that the decision was not made in that country but approved, then this may cause issues. Directors may also be appointed locally to comply with local requirements, but if they are not heavily involved in the company, this could be questioned.
It doesn't necessarily mean that all decisions have to be made physically in the country of incorporation. Many international companies will have remote management, regional directors and travelling directors. However, the key issue is how the laws of that country will impact on where the company is resident.
Having clear lines of delegation, properly constituted board meetings, commercial justification for major decisions and ensuring directors have access to the right information can all help to reduce any uncertainty. The documents should show genuine governance and not an administrative process to ensure the company falls into the desired tax position.
However, if the founder or parent executive is overseas and making all material decisions for the company, despite it being an independent subsidiary, this can cause an issue. If the local directors aren't heavily involved in the company, this could be a problem.
Corporate Substance
Corporate substance is often a hot topic. While having an office, staff and spend can be a factor, it depends on what the company is doing and the laws that apply.
If the company is trading and has a lot of front facing activity, then it will likely have a very different structure to a company that holds investments or receives dividends. If the company is providing finance, it may need to have staff or external expertise to manage the credit risk, liquidity and lending decisions. If the company is holding IP, then there may be questions around who is developing, improving, maintaining, protecting and exploiting the IP.
The amount of local presence required will depend on what the company is doing, what risks it is taking and what decisions it is claiming to be making. Just because the company has a large office, doesn't mean it is genuinely managed there. Likewise, if the company is lean, this does not mean it is artificial.
In the United Arab Emirates it is important to understand the difference between regulation and tax. Companies incorporated in a free zone will often have additional licensing, reporting and substance requirements. To qualify as a Free Zone Person and receive the relevant corporate tax treatment, companies must comply with the requirements set out in the UAE corporate tax regime. This includes substance requirements. Having a company in a free zone does not mean it will be exempt from corporate tax.
In other countries, there may be different requirements due to the economic substance laws, local anti-avoidance rules and international requirements.
Beneficial Ownership
Tax authorities and financial institutions are increasingly looking to understand who the ultimate natural owners/ controllers of the company are. This is to improve transparency of the company structure and understand whether they are compliant with tax requirements, financial crime risks etc.
A company may be owned by another company, which is owned by a trust, foundation or multiple entities. While this can be legitimate for succession planning, holding assets and investment management, it can cause issues if the ownership cannot be explained, proven and matches with the company's stated activities and tax position.
It is important to understand that beneficial ownership should not be confused with legal ownership or management. The company may be owned by a shareholder, but not have full powers. Or someone may not be a shareholder but have control due to contractual rights, voting rights etc. The definition and disclosure requirements depend on the laws that apply.
If there are discrepancies between the company register, bank details, tax returns and information shared between authorities, this can cause issues. If there are hidden controllers, nominee arrangements or ownership changes around key events, this can cause issues.
Companies should have clear ownership information and a reason for the layers of ownership. If there are trusts or foundations, the roles of the founder, trustee, protector, beneficiary and any other controllers should be understood. There are varying requirements for transparency and just because the company has disclosed to one authority, this doesn't mean they will be compliant with all.
Cross Border Payments
Corporate substance can be an important issue when there are payments between related parties in different countries. Depending on the laws of the country, dividends, interest, royalties, management fees and service payments may be subject to withholding tax, transfer pricing requirements or other restrictions.
To qualify for relief under a treaty, the company may need to prove that it is a resident and entitled to the benefit. Tax authorities may also want to understand if the company is the beneficial owner, there is substance to the arrangement and if there are any anti-abuse provisions.
Beneficial ownership can be a key point, especially with passive income. If an intermediary is receiving the dividends or interest but is contractually or practically obliged to pay to another party, it may be hard to prove it has the income in the way intended. However, this depends on the wording of the treaty, local laws and facts.
Many treaties influenced by the OECD multilateral instrument include a principal purpose test. If one of the principal purposes of the arrangement was to obtain the benefit, this can limit the benefit received. Other treaties will have their own limitation of benefits provisions or anti-abuse provisions.
Transfer pricing can also cause issues. Charges within the group will need to be analysed to see if they are commensurate with the functions performed, assets used and risks taken. If the company is receiving high management fees or royalties but does not have appropriate staff or decision making processes, this could cause issues. Whilst it is important to have the right documentation and wording in place, this cannot replace evidence of economic activity.
Increased Information Sharing
With increased international collaboration, companies will find it harder to hide behind information gaps. The OECD Common Reporting Standard enables automatic sharing of financial account information between countries that participate. Country by country reporting means that tax authorities will have information to understand how a multinational groups income, tax and business activities are distributed globally.
While this will not necessarily mean the company is non-compliant, it means tax authorities can compare information from different sources.
Tax authorities will also have information from local filings, beneficial ownership registers, banking information (under the relevant legal processes), transfer pricing documentation and treaty information. If there is a mismatch between profits and where staff, assets or management are, this could cause issues. However, this needs to be viewed in the context of the company.
For multinational groups, if there are any disputes, this can cause additional tax, interest, penalties, lengthy investigations and litigation. There may also be double taxation if both countries are claiming. Whilst there may be relief available via local processes, mutual agreement procedures in tax treaties or other processes, it can take time to resolve and there is no guarantee.
Creating a Solid International Structure
Start by understanding why you need an entity. What role will it play? What risks is it taking? How does it fit into the wider group? This should influence why you are choosing that country.
Ensure the governance matches what the company is responsible for. Directors should have the right powers and access to information. Major decisions should be properly documented. If key executives are working from another country, the group should consider whether they will have an impact on where the company is resident.
Consider substance in relation to transfer pricing, beneficial ownership disclosure, treaty eligibility and licensing requirements. Consider whether your banking, contracts, accounts and tax returns are all consistent.
Don't just look at incorporating or setting up a new operation. If there are any changes in leadership, key executives moving, acquisitions, new finance arrangements or changes in where business is being carried out, this could impact on the tax analysis. Something that was appropriate when setting up may need to be reviewed.
Corporate Substance is Now a Strategic Consideration
While international tax planning is a legitimate part of structuring your business, countries will always try to attract investment by providing predictable regulation, infrastructure and access to markets. However, there is increased focus on ensuring that arrangements are not trying to plan tax in a way that does not reflect the economic reality.
Investors will want to ensure that the legal structure, management, ownership and activities of an entity supports the tax position.
A registered address will be required in many countries, but this alone will not help with any of the issues around residency, control or tax benefits. As there is increased transparency and enforcement across borders, having a solid structure with a commercial purpose and real activity will be more beneficial.
Dr. Sunil Ambalavelil is the Global Executive Chairman of Kaden Boriss, an international law firm specialising in franchise and business agreements. A seasoned legal adviser, he has advised and supported the international growth of numerous global brands, helping them navigate the legal complexities of cross-border expansion.
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