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A South African perspective on resolving dual residence disputes

Tuesday, 19 January 2016   (0 Comments)
Posted by: Author: Ben Johannes
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Author: Ben Johannes (SAIT)

Expect little sympathy from tax authorities when dual residence is claimed due to lack of economic substance

Multinational companies may find they are simultaneously resident in  two countries under the domestic laws of each of the countries. Modern tax treaties contain tie-breaker rules to determine dual residence in these circumstances. The tie-breaker rule is essentially a test that enables the company to determine residency for tax purposes. 

The issue arises when place of incorporation and effective management differ, or where two countries are claiming effective management. The following example illustrates the operation of the tie-breaker rule: 

Company Z is considered a resident of Countries A and B under the domestic tax laws of the two countries as Company Z is effectively managed in Country A, and has effective management in Country B.  Z distributes a dividend to its 25 percent to shareholder X, which is a resident of Country B.  The relevant question is whether the Double Tax Agreement (DTA) between Country A and Country B applies, or whether the distribution is perceived as occurring solely within Country A.

The effective management (traditional box-ticking) tie-breaker test has previously been used as the main treaty test. Under this historic test, Company Z would automatically be viewed as a resident of Country B.However, under the Organisation for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (Beps) initiative, the automatic effective management tie-breaker will no longer be the main test.  Instead, the mutual agreement tie-breaker has been accepted as the main test (See OECD’s BEPS Action 6 final report).  Most companies prefer the place of effective management test, as the mutual agreement procedure can take more than six months to negotiate. Under the new test, the destiny of a company’s taxation jurisdiction is in government’s hands with the outcome dependent solely upon discretionary negotiation.

The use of the mutual agreement tie-breaker has led to considerable uncertainty and concern among multinationals which have their intermediary holding companies located in low tax rate jurisdictions. The mutual agreement tie-breaker is seen by many multinationals as a barrier to trade and investment. Many even consider it to be unworkable. However, SARS is of the view that in the "unlikely event” a mutual agreement cannot be reached, the section 6quat rebate permits tax relief for tax paid by a resident company in a foreign country. This will prevent double taxation from occurring.

In this article we consider the high-level implications of the use of a mutual agreement tie-breaker rule, assuming that no mutual agreement is reached. 

We also analyse the factors to determine dual corporate residence under the South African tax treaties when a mutual agreement tie-breaker decision must is required. 

Mutual agreement tie-breaker in South Africa’s tax treaties

The South African tax treaties with Belarus, Botswana, Bulgaria, Canada, China (PRC), Finland, India, Indonesia, Japan, Kuwait, Malaysia, Malta, Mauritius, Mexico, Nigeria, Norway, Poland, Singapore, Thailand, Turkey, Uganda and the United States of America contain OECD mutual agreement tie-breaker rules.  Most of these tie–breaker rules do not contain an obligation for the contracting states to resolve the dual residency dispute by reaching a mutual agreement, instead agreements are wholly discretionary.

The use of a mutual tie-breaker rule to resolve the question of dual corporate residence is by no means unique to the South Africa / Mauritius DTA recently discussed in the media. South Africa first adopted this approach in its tax treaties with Finland and Poland in 1995.  The rationale behind the mutual agreement tie–breaker rule seems to be to discourage the use of dual residence companies by penalizing such use with double taxation, which may only be avoided if the dual resident takes action itself. 

Most of the South African DTA mutual agreement tie–breaker rules contain the phrase: "the competent authorities shall endeavour to determine by mutual agreement …”. This creates an opportunity for the competent authorities to fail to agree upon a single country of residence. In this case, a company could find itself considered resident by both of the contracting states, and paying tax in both. 

The phrasing of a competent authority tie-breaker rule, as set out in the relevant provisions in the South African- Mauritius DTA residence Article 4 paragraph (3) is as follows: 

"Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both contracting states, the competent authorities of the contracting states shall by mutual agreement endeavour to settle the question and determine the mode of application of the agreement to such person. In the absence of such agreement such person shall be considered to be outside the scope of theagreement except for the provisions of Article 25.”

Thisdual-residence tie-breaker rule essentially follows the alternative test under paragraph 24.1 proposed by the commentary to the OECD Model Tax Convention.  If South Africa and Mauritius cannot agree on where the company is resident, the entity will be a resident of both countries and taxed on a residency basis in both.  It would be wise for taxpayers to plan properly by ensuring that the company’s structure is set up solely in one country or another.  There is no obligation on the contracting states are not required to resolve the double tax dispute if either country chooses not to act.

It appears that the onus is on the company that is considered resident in the contracting states to initiate the mutual agreement procedure in the DTA. There may well be tax advantages to dual residence, such as the right to set off the same loss in both contracting countries so as to duplicate a loss.  

Factors to determine dual corporate residence 

Interestingly, the South Africa tie-breaker provision does not provide determinant factors within tax treaty.  The determination is wholly discretionary under the narrow wording of the law. 

However, in an effort to make the processes more transparent, South Africa and Mauritius signed a Memorandum of Understanding (MoU) on 22 May 2015. It sets out the factors that both contracting states’competent authorities will use when entering into discussions to resolve the dual fiscal domicile of companies. (See Ben Nevis Holdings Ltd & Another v Commissioner for HM Revenue & Customs [2013] EWCA CIV 578, where the court held that it is in the interest of fairness to taxpayers that a MOU should be readily available as it may have an important bearing on the position of taxpayers.)

The determining factors detailed in the MOU are in line with amendments to paragraph 24 of the commentary on Article 4 suggested in theOECD’s BEPS final report and the UN Model Taxation Convention.  According to the MOU the following factors may be considered to determine corporate residence:

  • where the Chief Executive Officer and other senior executives usually carry on their activities;
  • where the senior day to day management of the person is carried on;
  • where the person’s headquarters are located;
  • which country’s laws govern the legal status of the person;
  • where its accounting records are kept;
  • any other factors listed in paragraph 24.1 of the 2014 OECD Commentary (Article 4, paragraph 3), as may be amended by the OECD/BEPS Action 6 final report; and
  • any such other factors that may be identified and agreed upon by the Competent Authorities in determining the residency of the person. 

The order in which the factors appear on the list is hierarchical, meaning those at the top of the list are more important. These factors focus on economic nexus to ensure that the economic substance in a contracting country is taken into account.

However, there is no indication in the MOU regarding the length of time it will take the relevant competent authorities to resolve any tie-breaker issues.  As a result, companies will potentially be subject to double taxation until competent authority resolution.  Lastly, SARS informally is of the view that dual claims stem from marginal substance.  Marginal substance stems from tax planning, so taxpayers should expect little sympathy if the effective management issue remains unresolved.

The South African – Mauritius tax treaty appears to be the sole direction for tie-breaker treaty clauses going forward in terms of South African tax treaty policy.  As a result, if dual residency exists, no relief can be expected by way of treaty or otherwise.  Tax planners will have to arrange their affairs with greater care going forward.  True substance backed by administrative proof will be the order of the day.

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This article first appeared on the January/February 2016 edition on Tax Talk.   



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