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The 2020-21 Federal Budget announced an intention to change the definition of resident company for Australian income tax purposes. The proposal is to implement a recommendation by the Board of Taxation in its July 2020 report to the Treasurer on this issue.

The review of the residence of companies arose because of disquiet, particularly among multinational enterprises, about the interpretation of the current definition in Taxation Ruling TR 2018/5 issued following the decision of the High Court in Bywater Investments Ltd v Commissioner of Taxation[2016] HCA 45.

The current definition of resident company and the Board of Taxation’s recommendations

The current definition of resident company for income tax purposes is contained in Income Tax Assessment Act 1936 s6(1) and has been unchanged since its introduction in 1930.

Currently a company will be an Australian resident if:

The principal recommendation for change made in the Board’s July 2020 report is to modify test (b)(i)  to ensure that ‘for a foreign incorporated company to be an Australian tax resident there needs to be sufficient economic connection to Australia’.

The Board recommended that usually ‘sufficient economic connection’ is best demonstrated when both the company’s core commercial activities and its central management and control are in Australia.

Governance and communications developments making the definition problematic

The Board’s 2020 report pointed to developments in corporate governance and communications technology that made the operation of the central management and control test problematic. Powers are frequently delegated to committees of executive management and communications technology enables meetings to be held on-line with participants being resident in a number of different jurisdictions when logging in. Notably, the COVID19 pandemic has highlighted the significance of developments in communications technology.

Longstanding concerns with the definition and questions of construction underpinning them

Concerns with the ‘central management and control’ test date back at least to an earlier 2003 report of the Board of Taxation which recommended its replacement with a ‘place of incorporation’ test of corporate residence. In response the ATO issued Taxation Ruling TR2004/15 which regarded carrying on business in Australia as being, in most cases, a separate and additional requirement from the presence of central management and control (the ‘dual requirement’ view).

In Bywater Investments Ltd v Commissioner of Taxation[2016] HCA 45, the High Court reaffirmed earlier authority that the location of central management and control is a question of fact that is not necessarily determined by where the formal requirements of corporate law (such as board meetings) are carried out. The issue in Bywater Investments was whether several companies incorporated in foreign jurisdictions were Australian residents on the basis that they were centrally managed and controlled in Australia. All the taxpayers had conceded before the primary judge (Justice Perram) that their share trading activities on the ASX amounted to carrying on business in Australia.

The concept of central management and control dates back to the 1876 Exchequer Court decision in Calcutta Jute Mills and the 1906 House of Lords decision in De Beers Consolidated Mines v Howe which included statements that the ‘real’ business of a company was carried on where it was centrally managed and controlled. Both cases were referred to with evident approval by the plurality in Bywater Investments.

The presence of the apparently dual requirement dating from the introduction of the test for corporate residence in 1930 is thus curious. In Malayan Shipping Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156, Justice Williams explained the dual requirement as evidencing  a legislative intention that mere trading in Australia in the absence of central management and control would be insufficient to make a company an Australian resident.

The Explanatory Notes issued when the definition was introduced do appear to establish that the ‘mischief’ sought to be overcome by the definition arose where the sole or principal business of a foreign incorporated company was in Australia but this, of itself, does not resolve the uncertainties of construction as, on one view, the presence of central management and control could be regarded as an indicator of where a company’s main business was.

The Board’s list of factors to be considered

In the 2020 report, the Board saw sufficient economic connection with Australia as being demonstrated where both the company’s core commercial activities and its central management and control were in Australia. The former would be assessed by reference to factors such as:

  • The nature of the business carried on by the company
  • The location of staff and assets employed in the conduct of the core business activity both in Australia and abroad
  • The size of the company
  • The sophistication of the company’s corporate governance practices
  • The separation between strategic management and operational control of the business
  • The composition of the company’s board and any additional roles held by directors; and
  • The distinction between activities that are core to the conduct of the business and those that are preliminary or ancillary, such as general support functions.

The Board recommended that the ATO produce administrative guidance to align the term ‘central management and control in Australia’ more closely with modern business practice taking into account factors such as:

  • The composition of the board and any additional roles directors may hold
  • Any impact of the ultimate ownership of the company
  • The impact of regulatory requirements
  • The residency and/or physical location of directors in exercising their duties

Arguably, many of the factors listed as being relevant in determining ‘core commercial activities’ go to issues of strategic management and hence arguably fit within what the courts have traditionally regarded as the core feature of central management and control. Hence, there appears to be circularity in the Board’s recommendations as the factors it considers relevant in determining core business activities overlap with those that courts could conceivably take into account in determining the existence and location of central management and control.

The Board’s examples of current problems

The Board’s report included several examples where the TR2018/5 interpretation of the central management and control test was problematic. The Board considered the result in these examples undesirable and favoured stable and predictable rules. A sub-text in the Board’s consideration of the examples was a view that it was inappropriate to regard as an Australian resident a foreign incorporated company that did not have any productive or trading operational activities in Australia.

This would be consistent with current Australian policy on taxation of foreign active income of Australian resident companies. Profits of foreign branches that pass an active income test are non-assessable non-exempt income to an Australian resident company as are dividends received from foreign subsidiaries that pass an active income test. Given these rules it would make little sense to regard a foreign incorporated company with only active foreign business operations as an Australian resident.

The need for conceptual coherence in any redrafted definition

Any legislative reform of the definition of resident company will need to take into account:

  1. the need for increased operational certainty and administrative workability;
  2. the need to protect the integrity of the Australian corporate tax base; and
  3. the need for conceptual coherence.

The Board was clearly aware of the need to address the first two considerations. Introducing a factors based approach to determining the core commercial activity of a company should assist in meeting these two needs. This approach, however, will not necessarily produce conceptually coherent legislation. The requirement that a company have its core commercial activity in Australia and then, in addition, be managed and controlled in Australia risks a conceptual inconsistency between the notion that the ‘real’ business of a company takes place where it is centrally managed and controlled and the proposed legislative requirement that the core commercial activity of the company be carried on in Australia before any need to consider central management and control arises.

The solution might be as simple as altering the order in which the central management and control requirement and the core commercial activity requirement appear in the legislation and reconsidering and rephrasing the factors to be taken into account. If a company were defined as being resident in Australia if it is centrally managed and controlled in Australia and has additional, specifically identified, significant business activities in Australia then the conceptual inconsistency disappears. Mere trading would not make a company an Australian resident but central management and control coupled with a specified level and type of business activity would. Central management and control without the specified level and type of business activity would not make a company an Australian resident. The specifically identified activities could take account of particular types of business structure such as holding or mere investment companies.

Conceptual inconsistencies would leave room for litigation and uncertainty. Simple reordering of requirements and reformulating factors might just remove it.

 

This piece is based on a forthcoming TTPI Policy Brief.

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