Bases of Taxation
i. Tax Residency
It is a common misconception that either a company or an individual can only be tax resident in one jurisdiction at any one time. Most countries will tax an individual who spends six months within their borders. As a simple example, an individual who spends six months in the UK and the other six months in the USA may be considered tax resident in both the US and the UK and therefore subject to tax on his worldwide income in both countries. Happily, the US and UK have signed a tax treaty to eliminate double taxation, such that credit will be given for tax paid in one country against the tax due on the same income in the other. However the individual would still be subject to the highest level of taxation applicable in either country.
A similar position can arise in respect of companies. Most countries consider any company that is incorporated within their jurisdiction to be tax resident there. Most countries also consider any company that is managed and controlled within their jurisdiction to be locally tax resident, even if it is incorporated abroad. A company is generally considered to be “managed and controlled” wherever its directors habitually meet and reside. Thus a company incorporated in the US that has a board of directors who meet and reside in the UK, could be deemed subject to both US and UK tax on its worldwide income. This “management and control” test means that it will rarely be the case that an individual residing onshore can safely act as the director of an offshore company without making that company liable to tax in his home jurisdiction. For this reason Sovereign often provides directors who manage the affairs of the offshore company from offshore.
ii. Anti-Avoidance Legislation
In simple terms, offshore companies can be extremely effective in avoiding tax if they are used to collect income. But sadly things are not always that simple. Many countries have enacted “anti-avoidance legislation” designed to reduce or eliminate the effectiveness of offshore structures in avoiding taxation. Each country has its own specific rules in this area but such legislation can be broadly categorised as follows:
a. Controlled Foreign Corporation Legislation
Controlled Foreign Corporation (CFC) legislation seeks to tax the profits of a foreign company as though they had been paid out to domestic shareholders, regardless of whether or not such profits are actually paid out. Where an owner holds only a portion of a foreign company then the percentage of the company’s profits allocated to him or her is equal to the percentage of shares held. If, for example, a UK resident owned 50% of an offshore company then they would be liable to declare their interest in the company on their year-end tax form. They would be taxed as though they had received 50% of the profits of that company calculated in accordance with UK rules, whether they had actually received them or not.
b. Transfer Pricing Legislation
All arrangements between companies that have any sort of common ownership must be at “arms length”, or open market, prices. If this is not the case, transfer pricing legislation enables the local revenue to adjust those prices. For example, if an offshore trading company was set up to buy goods from China and sell those goods to an associated company in the USA, then the price at which the goods were sold on must be the same price as the US company would be likely to pay on the open market. If the US company paid a higher than open market price to an associated company in a low tax jurisdiction – thereby artificially shifting profit to that company and reducing the US tax bill – then the US tax authority, the IRS, would be entitled to adjust the taxable profit to reflect the lower, open market price.
c. General Anti-Avoidance Rule (GAAR)
Most countries have introduced GAAR legislation – or have equivalent rules or case law – which states that if the primary purpose of an arrangement is to reduce tax then the domestic tax authority can ignore it and remove any tax advantage obtained. Thus, any arrangements that confer a tax advantage should also have a demonstrable commercial purpose and be set up, at least in part, for reasons other than tax planning.
d. Anti-Treaty Shopping Provisions
Treaties can be used to reduce withholding tax on dividends, interest and royalties but certain treaties may prevent non-residents of the treaty partner from benefitting. For example, the US withholds tax on royalties paid to nonresidents at a rate of 30%. The USA/Netherlands treaty reduces the withholding tax on royalties to zero but the treaty contains provisions that render the treaty inapplicable unless the beneficial owner of the recipient company is a bona fide resident of the Netherlands. A Hong Kong resident wishing to reduce withholding tax in the US could not therefore achieve this by setting up a Netherlands company to receive the income and then pay it on to Hong Kong because the beneficial owner would be a Hong Kong resident rather than a resident of the Netherlands. In September 2013, the G20 leaders agreed to adopt an OECD Action Plan for the prevention of base erosion and profit shifting (BEPS). The move is intended to close the gaps between national tax systems by re-examining existing international tax rules on tax treaties, permanent establishment and transfer pricing. All non-OECD G20 countries have now signed up to a BEPS project, through which they will develop proposals and recommendations for tackling the issues identified by the OECD (see section 6.4).
However, there will always be products or structures – such as life insurance or pensions – that are specifically provided for by statute and which can deliver great tax advantages. Likewise there will always be ways in which an operation may be structured so as to prevent it falling foul of anti-avoidance legislation. Simple offshore structures will rarely work. In most situations a more sophisticated structure will be needed, and the ongoing administration will have to be handled accurately and with skill if later problems are to be averted.