Australia: A look at the changes to the corporate residency test
James Newnham of DLA Piper analyses the Australian government's interpretation of the ‘corporate residency’ test for non-Australian incorporated companies.
In its budget, released on October 6 2020, the Australian government announced changes that will clarify the ‘corporate residency’ test for non-Australian incorporated companies.
These changes will in effect require a ‘significant economic connection’ to Australia, as well as Australian central management and control, in order for the company to be regarded as an Australian resident.
The domestic tax rules, and in turn the understanding of situations that trigger Australian tax residency of a company, had been relatively settled for a number of years. More specifically, the Commissioner’s ruling TR 2004/15 outlined his views on the situations where a company that is not incorporated in Australia, would be treated as a resident of Australia for tax purposes. This ruling drew on previous case law including Malayan Shipping (see reference below) and stated at paragraph 19:
“Where a parent company exercises CM&C [central management and control] in Australia over a subsidiary (but does not conduct the day-to-day activities of the business…FCT.., the subsidiary would need to also be carrying on business in Australia for it to be a resident under the second statutory test.”
Following the High Court decision in Bywater Investments Limited & Ors v. Commissioner of Taxation; Hua Wang Bank Berhad v. Commissioner of Taxation  HCA 45; 2016 ATC 20 589 (Bywater Case), this position changed. The Commissioner’s decision impact statement (DIS) on this case stated:
“The approach the Commissioner took in TR 2004/15 in relation to the earlier High Court decision in Malayan Shipping can no longer be sustained… If a company carrying on business has its central management and control in Australia it will necessarily carry on business in Australia. That is so even when the only business carried on in Australia consists of that central management and control, and trading operations are conducted outside this country.”
These changes to the position in TR 2004/15 have created significant uncertainty in the international market as to whether a foreign-incorporated company, with some Australian presence, will be a resident of Australia for income tax purposes. As outlined above, to be an Australian tax resident (and thus be taxed in Australia on worldwide income), previously a company not incorporated in Australia needed to have central management and control in Australia and carry on a business in Australia.
Under the Australian Taxation Office’s (ATO) interpretation of Bywater, to be an Australian tax resident, where a company has its central management and control in Australia, this was interpreted as meaning that it is carrying on business in Australia and can be an Australian tax resident (and thus taxed in Australia on worldwide income). The ATO’s interpretation meant in principle that, in certain circumstances, the second limb of carrying on business was no longer separately relevant to being treated as an Australian tax resident.
As a result, it meant that companies that were previously sitting outside the Australian tax net could be drawn into the net. Where a company is a resident for tax purposes, broadly, it pays Australian tax on its worldwide income and has significant compliance obligations. As a result of the above change, company groups were subjected to different tax outcomes relating to, among others, the participation exemption on dividends, capital gains tax (CGT) exemptions and the application of the ‘significant global entity’ rules.
In addition, as a result of the above changes, board composition and behaviour needed to pivot to ensure Australian tax residency was not triggered. This included:
Australian directors of overseas companies travelling overseas to attend board meetings;
Australian directors not attending board meetings of overseas companies if they cannot attend in person;
Foreign directors of overseas companies not attending board meetings via video link, if they were in Australia at the time of the meeting; and
The number of Australian directors on boards being restricted, or prohibited.
The above interpretation caused significant inefficiencies and restrictions for Australia-based directors. As a result, the government asked the Board of Taxation to review the situation, and their initial review was released in December 2019.
Budget announcement and solution
As in the 2020-21 Federal Budget, the government will legislate a change in line with the Board of Taxation’s review, to ensure that a company will only trigger the residency test where it has a ‘significant economic connection’ to Australia. This connection will only occur where a company has central management and control here, as well as it having its ‘core commercial activities’ being undertaken in Australia. This effectively is a throwback to the two-limb test pre-Bywater, but replacing the ‘carrying on business test’ with a novel ‘core commercial activities’ test.
Another point that the Board of Taxation’s review made was that the definition of ‘central management and control’ was distinct from ‘carrying on a business’ and needed to be clarified. Importantly, taxpayers will have the option of applying these rules from March 15 2017.
The above changes, endorsed by the Board of Taxation’s further Report to the Treasurer (publicly released on October 6 2020), are welcome news for global corporate groups. However, it remains to be seen how ‘core commercial activities’ would be defined and interpreted. Hopefully the rules will also clarify whether or not the application extends to entities that are deemed to be a company under tax laws, such as limited partnerships.
At first glance these changes look like a concession which allows directors to ‘work from anywhere’. While it is true that a ‘work from anywhere’ policy for directors would be much less likely to lead a foreign company to be an Australian resident, the proposals are silent on the other great risk, that the directors (or indeed other employees) constitute a permanent establishment (PE).
It would be desirable if the new rules could embrace and enable a ‘work from anywhere’ approach, such that individuals working in Australia as employees of overseas companies would not give rise to a PE in Australia; but one thing at a time!
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