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Tax Residency for Companies and Individuals: Permanent Establishments, Place of Effective Management, CFC and Certificates

daniels27

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Aug 19, 2023
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There already have been many discussions about how to stop paying taxes. We then often discuss that avoiding CFC rules and getting some mighty certificates won't do the job. But that's not how the magic works.

There is no need to go into details of US citizens as they are subject to taxation no matter where they live. For those concerned, they need to file annually and pay taxes on their world-wide income while accounting for tax credits for taxes paid abroad, the foreign-sourced income exemption (FSIE), foreign bank account reporting (FBAR) and for high-earners also alternative minimum tax (AMT).

Corporate Taxation​

Place of Incorporation​

As a general rule, companies pay taxes where they are incorporated. It is obvious that in most cases, this can be chosen completely freely.

Place of Effective Management / Central Management and Control​

However, this would allow anybody in a high-tax jurisdiction to incorporate in a tax-free place and get around taxation. That's why many countries introduced rules that any company anywhere is liable to taxation exactly like a local company where it is managed. This concept is often referred to as taxation at the place of effective management. In common law countries, such as the UK, Singapore, Hong Kong, Australia, this concept is referred as "central management and control" of a company and was enunciated by Lord Loreburn in De Beers Consolidated Mines, Limited v Howe 5 TC 198.

… a company resides, for purposes of Income Tax, where its real business is carried on. … I regard that as the true rule; and the real business is carried on where the central management and control actually abides.

Many, if not most, countries have some sort of such rules. Typical examples follow.
Estonia is a notable exception with a lack of such rules.

Permanent Establishment​

As it would still be possible to have the place of effective management (sometimes PoEM) in some tax-free place and then run all the rest from a high-tax jurisdiction. That's why there is also a rule that any profit attributable to a permanent establishment (PE) in a jurisdiction will be taxed in that jurisdiction.

Controlled Foreign Corporation​

To avoid taxation in this case, it would be necessary that only other people work in tax-free jurisdictions while the owner lives in a high-tax country to avoid taxation. This is especially tempting for passive income such as investments where only a few transactions generate the profit. As many wealthy individuals already entrust their investments to asset managers, they could simply entrust an asset manager in a tax-free jurisdiction who then incorporates a company for investments. For active income, this often is more difficult as in many cases special knowledge, skills and connections come into play, something unique to the owner. That's why there are Controlled Foreign Corporation (CFC) rules in more and more countries, especially for passive income but also for active income. Even if the owners do not do anything for the company, the company may still be taxed where the owners live.

A good overview of CFC rules around the world has been given by Bloomberg, unfortunately behind a paywall. However, Tax Foundation created a map with data from Bloomberg, which is freely accessible.

Small Businesses​

For small businesses, especially those with just one person who is owner, director and worker at the same time, most attention should be given to PE rules. In most cases, the location where essential work is being performed is the place where the company is taxable. And in many cases we have seen, it is not like you just hire managers and keep the company, the business basically is very few persons working. Already for the place of effective management to play any role, a manager in a different jurisdiction would be needed. And for CFC rules to actually play a role, the owner of the company would have to step almost entirely back from the company and only do mundane tasks for the company. However, anybody living in a place with CFC rules for the type of company he is running, any effort to beat the system with having the company directed outside their home country, effectively becomes in vain.

It is possible to structure the company in a way that there is a director and the owner is just an engineer or lawyer working for the company. And the advantages are not just for tax optimisation. Imaging you are Gerald Cotten and die in India or your house gets raided and you end up in jail. Would you just be a random engineer, the company would keep going while you are away. Now, this is a big benefit. And I highly recommend that. However, it comes at a cost which for many new posters on OCT is way beyond what they currently are paying in taxes.

My Recommendation​

If possible, build a company where there are directors that can keep the company going while the owner is either in the background as normal employee or not involved in the company at all. The setup needs to be credible, i.e. it is difficult to prevent any permanent establishment for any labour intensive business such as consulting/legal where clients are charged hours. In this case, a favourable jurisdiction for the directors can be chosen and a way to CFC rules need to be followed, i.e. in case the owner lives in a jurisdiction with strict CFC rules, he may spare the efforts.

If the absence of possibility of this, most likely the permanent establishment is where the owner, director and worker lives. There won't be any need to start discussing place of effective management or CFC rules.

Individual Taxation​

Good Old Times​

As a general rule, any individual is taxed at the place of living. Before the advent of air travel and high-speed trains, this normally was a pretty clear definition. However, these days, there are people with no or two, three or even ten homes.

It is very obvious that in general nationality does not play any role here. You may have inherited a citizenship from Japan. But if you never set foot there and you have been born and raised in a nice home in UK, there is no way Japan is ever going to tax you. However, you may remain a good UK taxpayer unless you really leave their country. Some double taxation treaties have tie breaker rules which include citizenship, but more on this later on. (As mentioned before, we are not discussing US citizenship for which the whole discussion would be meaning less.)

https://www.ato.gov.au/individuals-and-families/coming-to-australia-or-going-overseas/residency-tests/residency-the-resides-test said:
[Nationality] is almost irrelevant in determining where you reside. However, in a borderline case, your citizenship may be useful where all other relevant facts aren't conclusive.

Tax Residence​

The general definition of who is tax resident in a particular country varies a lot among all countries. In continental Europe, the general rule is that anybody registered as resident is a taxpayer at their residence. Typical triggers for tax residence are
  • Household registration
  • Habitual residence
  • Number of days in the country
  • Being employed for the government while stationed abroad
While often a 183-day rule is cited, the threshold is typically much lower. For example in Switzerland as 30 days while working and 90 days without work is sufficient to become tax resident.

Tax Emigration​

It could be very tempting to just leave the country you have always been for the last two decades and then pay taxes elsewhere. Maybe even by keeping the house, family and kids in the old jurisdiction while claiming to life just across the border in a neighbouring Schengen country. That's why certain countries started to keep former residents as tax residents, even if they are no longer there but keep all too many ties or simply only leave for nine months.

The rules vary greatly from country to country. Sometimes, it is only about days present in the current and past years, the number of years present in the past, while in other cases existing ties to the country matter. Then, there are countries, where you simply remain a tax payer for a certain number of years into the future. On top of that, double taxation treaties may help to get out quicker.

Below are some countries with such rules. Please check the links and the law as only a short summary will be given here, neglecting many particular cases. Also, please note that laws are changing constantly and that information gets outdated fairly quickly, particularly in this field.

Norway

Anybody who has lived in Norway for ten years or more, will only cease to be tax resident three years after emigration. A common workaround is to make use of double taxation treaties as they supersede any national rules. Particularly interesting is Switzerland in this case as it is one of the few countries which includes wealth taxes in their treaty, something which only few countries currently know.

United States

The United States are known for their substantial presence test. If somebody was in the US for two years or more, he keeps being a tax resident for the year he left if he is there for at least 31 days.

United Kingdom

The UK has a pretty sophisticated Statutory Residence Test. Apart from the number of days spent in the country, also the number of sufficient ties play a crucial role in determination of tax residency. To make matters worse, there is a different set of tests for inheritance tax for UK long-term residents.

Australia

Australia has a total of three tests: the resides test, the domicile test and the 183-day test. The tests are pretty detailed and pay attention not only to days present and personal ties, but also to the individual intentions behind moves.

In 2024, Australia proposed new residency rules, which have not yet been implemented.

Canada

Canada requires not only the tax payer to leave, but also their spouse or common-law partner and dependants. Furthermore, they also require that a residency in a new country has been established.

Italy

Italy requires its citizens to register in A.I.R.E. The embassy of the new residence normally requires at least some proof of residence.

Other Countries​

There have been various reports over the year of agitated citizens from more and less corrupt places that urgently needed a tax residence certificate. So far, we are not aware of any legal requirements in any country for such certificate to emigrate. However, any country may ask for any sort of proof in case the emigrant's story becomes incredible. While it certainly could help, it is by far not the only source any such country will rely on. And presenting such certificate unrequested may curb suspicion and lead to further checks.

Exit Tax Capital Gains Tax

This is just mentioned to clarify matters. Many countries with capital gains tax have deemed disposition rules. It basically means that investments increase in value over time. While capital gains could be charged yearly, this would cause a lot of problems as people could be forced to sell their assets just to pay taxes. Hence, the taxes are actually just postponed and are due when the assets are sold. To close the loophole, they are also charged when the tax person emigrates as if investments were sold that day. It is not actually a punishment for leaving, it is more like an opportunity to settle capital gains taxes due whithout actually selling.

My Recommendation​

If you want to stop paying taxes in a certain country, you need to leave as soon as possible. It is better to spend your time on packing rather than dreaming of almighty tax residency certificates.

Double Taxation Treaties​

Double taxation treaties are bilateral treaties between two countries. While there are treaties dating back to as far as 1815 for UK and US, most double taxation related articles are much newer and most smaller countries only started signing a vast number of such treaties in the last two decades, mainly due to pressure from the US and OECD on Switzerland and others to implement double taxation treaties with mutual assistance clauses.

Most double taxation treaties base on a OECD template. The main differences normally lie in the resident definition (typically article 4), permanent establishment (typically article 5) and limitation on benefits (typically article 22). For recipients of passive income in form of dividends, interest and royalties, there typically is one article for each of them, often reducing withholding taxes. Also the taxes covered may be of importance as some treaties include wealth taxes while others don't.

For the determination of any corporate tax residence, proper planning to have or avoid a permanent establishment whiling paying attention to the limitation on benefits is crucial. For example most treaties specifically stipulate that any company can maintain a self-operated warehouse in the other country without forming a permanent establishment.

For the determination of a individual tax residence, there is a series of rules in which country a person is tax resident and what happens if it is still not clear (mutual agreement procedure). It is important to note that this tax residence mainly is of relevance for passive income, wealth tax or inheritance tax. For active income, there are more rules regarding employment income, self-employment income, business profit and even permanent establishments.

It often is in the course of such treaty benefits that a contracting party will ask for a confirmation of the other contracting party that the subject is actually tax resident in that jurisdiction. While some countries prefer such confirmation on special forms they issue, most counties offer generic tax residence certificates. However, possessing such certificate does not guarantee anything and most likely, the other country will investigate whether a potential taxpayer is not actually tax resident of their jurisdiction.

Still, these treaties may come in very handy not only for lowering withholding taxes but also in cases where somebody would normally be taxed in two countries, effectively limiting the number of taxing countries to one. If somebody permanently stays 122 days in the US and the rest of the year in UK, they would be subject to full US and UK taxation. But thanks to the treaty, the US substantial presence test is superseded by the double tax treaty and they only pay taxes in the UK.