It has now become crucial that actual substance is infused into the operations of international business Companies in order to safeguard their tax residency. This need has arisen from the worldwide financial crisis that has led Governments to seek for mechanisms to protect or increase their tax base outside their jurisdictions by disputing the tax residency of companies in countries that are considered as low tax jurisdictions.
In this publication, we shall examine in depth the reasons why considering substance has become more crucial; what are the common mistakes made by the foreign investors whereby rendering the tax residency of their companies open to attack by foreign jurisdictions; and what additional protective measures are to be considered in order to have a tax viable and beneficial structure for many years to come.
B. SUBSTANCE IS CRUCIAL
The worldwide financial crisis has led Governments to seek for mechanisms to extend their tax base outside their jurisdictions. This trend is evidenced by various multinational instruments and national legislation with one thing in common: the attack on aggressive tax planning and most importantly the attack on the so-called “conduit” or passive entities.
In other words, structures that are mere vehicles for rerouting profits for that purposes or are only established for the sole reason of taking into advantage a low tax jurisdiction or double tax treaty without a corresponding real physical presence in the country of its tax residence.
Notably the international investor is now faced with:-
The USA FATCA (Foreign Account Tax Compliance Act)
Russia’s De-offshorisation law
Ukrainian Law Regarding Identification of the Ultimate Beneficial Owners of Legal Entities
OECD’s (organisation for Economic Co- Operation and Development) initiative for multilateral automatic exchange of information,
The upcoming BEPS (Base Erosion and Profit Shifting) Action Plan of the OECD.
The adoption in all renewed Double Tax Treaties (DTTs) of article 26 of the OECD regarding the exchange of information.
The adoption of a broad interpretation of article 5 of the OECD Model DTT in what constitutes a Permanent Establishment.
The effect of the abovementioned legal instruments is that they give the foreign tax authorities the means and tools to scrutinize and dispute the declared tax residency of an entity. This is done both by examining the effective management and control of the entity in question, as well as the location and even the underlying essence of such entity’s activities.
C. RISK FACTORS AFFECTING TAX RESIDENCY
As it is well known, the location of effective management and control of an entity will be the decisive factor establishing the entity’s tax residency. With regards to Companies, management and control is carried out by the Directors subject to the provisions of the articles of association.
Additionally though there are other important locations that will be examined below that might impact the management and control of a Company.
I. The Directors not exercising Management over the Company
The first factor affecting the tax residency of a Company is the tax residency of its Directors. The current practice with regards to management and control by the directors, is usually deficient: whilst the directors appointed would be tax residents in the country of the company’s tax residency, the effective management of the Company is transferred to non-tax residents rendering the Directors as agents of the beneficiaries. Instruments that have this effect, amongst others, include:
General and wide powers of attorney.
Agreements between the ultimate beneficial owners and the directors removing any discretion from the directors and rendering the directors as mere nominees with no powers.
Excessive reserved powers in the Memorandum and Articles to the favour of the shareholders.
Written instructions given to the directors in the form of orders rather than suggestions.
Management of bank accounts by non-tax resident third parties.
Any other instrument or behaviour that has as an effect the limitation of the powers of the director of the Company.
It is therefore crucial, that in order to ring-fence the tax residency of the company, the directors would actually manage and control the company without abandoning or abdicating their authority or discretion in favour of third parties.
In this respect there is a real and substantial need for the international investor to really look into the way the directors of his Companies manage the affairs of such Companies and make necessary changes.
This position is further illustrated if one takes into account the requests of foreign tax authorities based on article 26 of the DDTs. Questions usually posed include:-
Who signed a specific agreement and whether any POAs were used.
What are the payment details (i.e. Location of bank account) for a specific transaction, or in general including who are signatories of a specific bank account.
Whether the Company is receiving management services from a service provider.
II. Physical Presence as Proof of Tax Residency
It must be noted that other factors have also began to visibly affect the tax residency of a company as indicators of external management and control. Most importantly the nonexistence of a physical presence in the case of a Company is increasingly having an adverse effect on attempts by the management of the Company to persuade as to its tax residency. Specifically, “letterbox” companies are the most likely candidates for attack by the foreign tax authorities as such companies cannot demonstrate sufficient legitimacy in their tax residency. This can be rectified by:
Renting or acquiring a real office for the Company
Employing qualified personnel
Sufficiently remunerating appropriate and knowledgeable Directors
Considering converting the Company into a public Company and listing its shares in the Emerging Companies Market (ECM) of the Cyprus Stock Exchange.
In this respect it has now become important for companies to pursue a real presence in the place of their tax residency in order to avoid being tagged as a letterbox Company.
III. Other Indicators of Tax Residency
Further, national CFC legislation of countries such as Russia show what other factors will be considered by the authorities to have an impact on the tax residency of the companies:
The location where the meetings of the Board of Directors take place;
The location where the executive management of the company takes place. The executive management may include strategic development of the company, budget and other financial matters, the management of the bank accounts and others. It follows that the actual residency of the persons performing these functions, i.e. the Chief Executive officers or the signatories of the bank accounts has become extremely crucial;
The location where bookkeeping and accounting is performed;
The location where the Company’s archives, including minutes resolutions or certificates are archived.
It is now evident that foreign tax authorities shall look in depth whether the conduct of the Company is in line with its declaration that management and control is effected from Cyprus and that dynamic tax planning restructuring may be necessary in order to safeguard the tax residency of the Company in question.
D. COMMON MISTAKES AND POSSIBLE SOLUTIONS
As stated above, it is crucial for international business Companies to avoid pitfalls or dangers that may render the Company vulnerable and open to attack by foreign tax authorities.
It is imperative, in this respect, that the international investor reexamines their mode of operation concerning their structure in order to make such structures withstand the scrutiny of foreign authorities. Common mistakes and possible solutions may be found in the table that follows:-
The risks and challenges to maintaining tax residency in the case of international business Companies are important yet manageable. Every international investor must urgently proceed to an audit of the practices and mode of operation of their international structures. It is our opinion that taking an integrated approach with regards to such structures and implementing sound and informed solutions will have as an effect of not only ring-fencing the management and control of the Companies but even to an extent counteracting the effects of the age of increased transparency.
F. HOW KINANIS LLC CAN ASSIST
Consulting on ring-fencing solutions
Introduction to eligible directors
Setting up a physical office in Cyprus
Accounting and Payroll Services
Recruitment Services and HR Consulting
Introduction to eligible directors
IT Services (domain registration, server hosting, electronic filing software and online access to archives etc.).
G. DEDICATED PUBLICATIONS
Our firm regularly publishes dedicated publications regarding subjects of interest to the International Investors. Please visit www.kinanis.com for an exhaustive list of our publications. Relevant publications regarding the subject are:
Listing on the Emerging Companies Market in Cyprus
Criteria and Conditions for Naturalization by Exemption of Foreign Investors/Businessmen
Cyprus Permanent Residence Permits
Substance Fee Schedule
Cyprus International Trusts Reborn
Russian Deoffshorisation Law – The Cyprus Perspective Analysis of possible Actions
This publication has been prepared as a general guide and for information purposes only. It is not a substitution for professional advice. One must not rely on it without receiving independent advice based on the particular facts of his/her own case. No responsibility can be accepted by the authors or the publishers for any loss occasioned by acting or refraining from acting on the basis of this publication.