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Remedies for dual residence of companies in tax treaty situations
The significance of tax residence is important for the determination whether a company is subject to residence-based taxation (worldwide taxation) or source based taxation (territorial taxation). Tax residence may also determine whether the company will be subject to gross taxation (usually levied on non-residents) or net basis taxation and whether there is a possibility to further claim double tax relief. Determining tax residence and later resolving any residence conflicts plays therefore a crucial role in determining which set of "rules" are applicable to a company.
Residence taxation of companies requires the application of a test (nexus) for connecting a company within a certain taxing jurisdiction. In that respect, many tests have been developed. Amongst the formal tests, one may highlight the place of incorporation (e.g. US) or the statutory seat or head office (e.g. Sweden). In alternative, other States have developed more substantive factors or tests such as the central management and control (e.g. UK), place of effective management (e.g. France) and place of main activity (e.g. Israel before 2003).
Whereas only a few countries consider a single criterion to determine a company's tax residence, most States apply several tests, both on a cumulative basis or in an alternative manner (i.e. tax residence exists as soon as one of the requirements is satisfied). The United States for example applies the incorporation criterion very strictly and uses it to determine domestic companies, which are defined by the IRC as "any corporation created or organized in the United States or under the law of the United States or of any State". The place of incorporation, i.e. the place where the articles of incorporation are filed, determines the nationality of the company and thereby its worldwide tax liability. Because it is incorporated in the United States, the company will then be subject to tax on its worldwide income. Any company not incorporated in the United States is, as such, regarded for tax purposes as a foreign company, with its tax residence outside the United States. The UK uses instead the place of central management and control as a single criterion to determine tax residence.
Finally, in the Netherlands, fiscal residence of companies is defined for all taxes as "where an individual is resident and where a company is resident is determined according to the circumstances". However, the tax law includes a legal fiction under which companies incorporated under Netherlands civil law are at all times considered to be subject to corporate tax and dividend tax. The particular formulation of the Dutch "casuistic" approach, where the circumstances of each individual case will determine the tax residence, lead the tax courts to develop a number of non-exclusive criteria, amongst others:
- place of performance of managing functions (i.e. place where meetings are being held);
- place where the (principal) office building is located;
- managing & supervisory board residences;
- location of the (general) accounting department;
- currency and place where the books of account are kept;
- place where the general meetings of shareholders are held; or
- place where the statutory seat of the company is situated.
Dual Residence of Companies
The most frequent cases of dual residence arise when two States apply simultaneously different criteria to determine the tax residence of one and the same company. The best-known cases of dual resident companies were those of companies during the late eighties and beginning of the nineties that were incorporated in the United States and managed and controlled in the UK. Dual residence may also occur when tax residence is determined by one State on the basis of the statutory seat and by other on the basis of the location of the company's management. Deeming provisions that determine domestic residence on the basis of certain tests, such as voting power controlled by shareholders who are residents in a particular country, may also potentially give rise to a situation of dual residence.
The consequence, absent of a tax treaty, is dual taxation of the taxpayer's worldwide income. In cases where a tax treaty, following the OECD Model, is in place between the two countries, the tie-breaker rule for companies (Art. 4(3)) will generally determine that the dual resident "shall be deemed to be a resident only of the State in which its place of effective management is situated." This tie-breaker rule will then determine who is the so-called winner/loser State as regards the claim for residence taxation. Nevertheless, in triangular situations (i.e. cases involving income flowing from or to third countries), the interaction of treaties may well leave some issues unresolved.
Although dual tax residence may and often does result in liability for double taxation, it would be wrong to assume that dual fiscal residence has only disadvantages. Despite recent countermeasures, the use of dual resident company has been effective for example in the field of double dipping of losses (e.g. tax consolidation), financing the purchase of other companies and multiple treaty access (e.g. withholding tax planning).
Assume for example that a group of companies operating in two different countries forms a company, which is dual tax resident. The new dual resident company then borrows to finance other group operation and generating in the process some operational losses. The dual resident company would then potentially be eligible to be a member of two sub-groups in two different countries, with losses equally allowable in both countries of residence under a group taxation regime. The losses could then be set-off against the taxable profits of the other members of the sub-group. In the wake of the use of dual resident companies, United States, UK and Netherlands are examples of countries that enacted domestic rules designed to restrict the access to such companies to loss compensation mechanisms.
As mentioned above, the use of dual resident companies has also been directed to achieve withholding tax benefits, by accessing the more beneficial treaty network of one of the residence countries. Assume for example the case of dual residence companies (A-B) receiving income from a third state (C) In that case, the main issue is that of the consequence of the winner/loser (A-B) tax treaty, especially the residence tie-breaker rule in Article 4(3) of the tax treaty, for the application of the tax treaties with the third State (C). In addition, one can also assume the inverse scenario of a dual residence company paying income to third states. The main issue in this case is that both Winner/Loser (A-B) may want to apply their domestic withholding tax and whether the multiple application of the three tax treaties may restrict such outcome.
Remedies for dual residence in tax treaty situations
According to Art. 4(1), the term "resident of a contracting State means any person who, under the laws of that State, is liable to tax therein by reason of its domicile, residence, place of management or any other criterion of a similar nature. But this term does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein". As mentioned above, in treaty situations in most instances dual residence will be solved, namely by the application of Art. 4(3) of the tax treaty, i.e. the company "(...) shall be deemed to be a resident of the State in which its place of effective management is situated".
It is important to note that there are differences in real tax treaties, which may impact the resolution of dual resident conflicts. In this regard, a distinction can be between treaties, which conform entirely to the OECD Model, and treaties that have their own concept of residence or establish other ways of resolving dual resident situations.
This first possible solution for the use of dual resident companies can be found in the treaty practices of United States and Canada. These countries retain in their tax treaties the right to use the place of incorporation as the preference criterion or to leave it expressly or implicitly to the competent authorities of the jurisdictions involved to determine the dual resident fiscal residence, either by special proceedings or by mutual agreement.
A second solution is the explicit denial of treaty benefits for dual resident companies. For example, the 2001 US-UK tax treaty clearly states that first the competent authorities shall seek to determine a winner State. Notwithstanding, if the competent authorities do not reach an agreement the dual resident company may generally not claim any benefit provided by the tax treaty.
The third solution to curtail the use of dual resident companies is to deny residence under domestic law. For example UK and Canada have in place provisions in their domestic law that provide that a resident company is deemed not to be a resident if under a tax treaty it is resident in the other country and not in UK or Canada See (UK Section 249 and Subsection 250(5) of the Canadian ITA).
Finally a last possible solution is to argue on the basis of interpreting Article 4(1) of the tax treaty in order to achieve the denial of tax treaty benefits to dual resident companies. In this particular point two sub-arguments must be distinguished:
- In first place, it may be argued on the basis of the second sentence of Art. 4(1), that the term resident of a State (i.e. loser State) does not include any person who is liable to tax in that State (i.e. loser State) in respect only of income from sources in that State (i.e. loser State) or capital situated therein.
- In second place, it may be argued on the basis of the first sentence of Art. 4(1) that the term resident of a contracting state means any person who is "liable to tax" on its worldwide income.
With regards the first line of reasoning it is important to note that in 1989 the Netherlands State Secretary for Finance issued a letter (No. IFZ 320) in which the view was expressed that Art. 4(1), second sentence, does in fact prevent the application of a tax treaty where a Netherlands incorporated company has its tax residence elsewhere based on the Art. 4(3) tie-breaker rule in a tax treaty with a third state. This meant in cases that the Netherlands would be the loser state, the tax authorities would not issue a certificate of residence for a dual resident company receiving income from third countries.
As regards the second type of argumentation based on the term liable to tax, it should be mentioned that the Dutch Supreme Court in a decision of 2001, used that same argument and held that a dual resident company that is, under the "tax treaty" between the Netherlands Antilles and the Netherlands, considered to be a resident in Netherlands Antilles (i.e Netherlands would be the loser State) and therefore not fully liable to tax anymore in the Netherlands is not a tax resident for the purposes of the treaty between Netherlands and Belgium. It should be noted that this Supreme Court case dealt with the scenario of a dual resident company paying an income to a third country and not the inverse scenario of a dual resident company receiving income from a third country.
Recently the US also changed its approach concerning dual resident companies deriving income sourced in the Revenue Ruling 2004-76 underscores the significance of liable to tax element of the definition of a resident. Under the new position, the tax treaty between the United States and the loser state (i.e. the State which is considered not to be the residence state under Art. 4(3) of the treaty with a third country) is not applicable and therefore lower treaty rates will be only available under the treaty between the US and the winner State. The previous position contained in Revenue Ruling 73-354, was that the fact that a company deriving income form the United States had a dual residence would not influence the position of that company as regards the applicability of tax treaties concluded by United States.
A last mention to refer that dual residence may also be approached from a different angle, namely the Loser state may still have a claim for the existence of a permanent establishment, which would result in a significant part of the profits of the enterprise being taxed in the Loser/PE State. This issue was evidenced by a Dutch Court decision of the Netherlands concerning the place of residence under the 1951 treaty with Switzerland. According to Article 2(4), of the treaty with Switzerland, residence of a company "shall be determined in accordance with the tax legislation of each of the two States. If residence in both States results therefrom, the residence is deemed to be in the State where the juridical person has its registered seat." Since in this treaty the statutory seat is decisive, a dispute was raised on whether a legal entity incorporated under Swiss law maintained a permanent establishment, as defined in the treaty. In that regard, Article 4, paragraph 2, of the treaty lists as permanent establishment, inter alia, "the place of management" of the business. A 1982 decision of the Supreme Court determined that "the place of management" of the enterprise of a Swiss Soci?t? Anonyme was found to be in the Netherlands. The Court based its decision specifically on the activities of the managing director resident in the Netherlands (1 out of 3 directors; the other 2 were "nominal" directors resident in Switzerland), and of a managing clerk (officer authorized to sign on behalf of the company) who directed and were able to direct the project that was being carried out by the Soci?t? Anonyme and who often performed their work and activities with respect to the project abroad, but at all times from the Netherlands.