Tax Residency considerations
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When you have an international business with a cross-border corporate structure, and it is not properly managed, it can lead to unexpected taxation and regulatory burdens, and you may find the profits and income of your business being taxed more than once, depending on each jurisdictions’ taxation regime and whether a country’s domestic tax regime taxes on the basis of origin or destination. These consequences are avoided by foresighted structuring so that a company can benefit from double taxation treaties, but in order to be eligible for those benefits, it is necessary to know about the concept of ‘substance’ and how it will affect your business development. So this article talks about understanding ‘substance’ and the future of your business venture, from a tax point of view.
Understanding the tax concept of ‘substance’
'Substance' is a widely known tax concept, often used in cross-border tax situations. Although the word 'substance' does not normally appear in the text of tax treaties, it is a key theme in international structures and tax planning and it is becoming ever more important from tax perspective. Double tax treaties instead use terms like “beneficial ownership” and “residence” to define the qualifying persons entitled to treaty benefits. Most jurisdictions and treaties have not defined (or sometimes even used) the term ‘substance’, however the term generally means that the company has a physical presence (offices, employees, assets) in the treaty country. Tax substance refers to the tests that the tax authorities in each country are making check whether the foreign company is entitled to tax treaty benefits before applying the Double tax treaties. Double tax treaties are valid for transactions between persons that are ‘resident’ for tax purposes (tax resident) in one of the treaty parties and the income is beneficially owned by the treaty parties. Tax resident means that the company is taxed in a treaty party based on the tax rules of that party, and it is preferable to be taxed according to the rules of a jurisdiction with lower tax. In the past, Businesses have for many years relied upon ‘offshore’ or non-resident structures to reduce or defer taxes and improve returns for investors. Companies with an international structure would be so planned so that they would be established in low tax jurisdictions with wide range of double tax treaties, one of which is the Netherlands. They are widely used to earn dividends, interest and royalties, then keep a small profit margin and pay the majority of profits to these tax havens. These have been particularly popular with private equity and real estate structures.
But in most cases, these ‘companies’ that are in jurisdictions with lower tax rates do not, in fact, serve much purpose to the business except for functioning as a vehicle to ascribe the profits and income to, and thereby take advantage of the treaty benefits. In recent times, international tax authorities have been asking whether there is a business reason to set up a company in another jurisdiction, rather than simply following some abusive tax practices that rely on wholly artificial arrangements. If there is a business reason, then the freedom of establishment rights under EU treaties prevents tax authorities of one country from imposing restrictions to entities properly established in another EU country (such as imposing certain withholding taxes or denying certain tax reliefs). But, increasingly, and particularly within the EU, tax authorities are demanding more if the case for tax non-residence and\or relief from local taxes is to be given. The ‘more’ they demand is ‘substance’. In effect, tax authorities are saying they want reality and not the figment of a tax planner’s over-active imagination: you must show you have substance in that other tax jurisdiction before you can get the tax treatment you claim.
Why is ‘substance’ becoming more relevant?
The codification of the Dutch minimum substance requirements is part of the reaction of the Dutch government to initiatives of the OECD on Base Erosion and Profit Shifting (BEPS) and similar initiatives within the European Union. OECD led project widely referred to as the BEPS (base erosion and profit shifting) initiative, due to which the importance of substance has substantially increased. The ultimate goal of the BEPS initiative is to prevent the granting of double tax treaty benefits where international corporate structures are set up for the sole purpose of accessing those benefits. Hence, there has been an international trend towards ensuring that taxation is done in the place where the business accrues its income / profits, there has been a move towards looking into whether, the corporate unit seeking to get taxed in the jurisdiction with lower rates actually conducts business in that jurisdiction. Hence, older models of tax planning that do not sufficiently take these trends into account may turn out to not just be ineffectual, but because countries can deny treaty benefits retrospectively, massive tax bills may be incurred by a company found to be seeking treaty benefits without actual business in that jurisdiction.
Hence, the legal doctrine of ‘Substance over legal form’ is brought into play in this assessment. The core point of this concept is that a transaction / structure should not be represented in such a manner as to hide the true intent of the structure. This doctrine, of ‘Substance over legal form’ therefore, allows tax authorities to ignore the legal form of an arrangement and to look into what happened actually. The aim is to prevent artificial structures from being used for tax avoidance purposes. In order for a company to enjoy the beneficial tax regime of a jurisdiction it must comply with the substance requirements of the local tax authorities. Indeed, increasingly, substance is being closely examined not only by tax authorities, but also compliance officers, banks, and administrative service providers for various reasons.
Requirements for substance may vary from country to country, but if analyzed, they all are about the economic substance: there must be substance to the structure of the company and the transactions it does. In modern international tax planning, therefore, the concept of tax substance is becoming more and more important and double tax treaty benefits may be denied in case that the substance of a treaty party cannot be proved.
So what forms ‘substance’ Generally?
The real substance of the structure is the sum total of many factors that make the company ‘real’ and prove its existence or physical presence (its office, its director, its employees) etc. As stated above however, ‘substance’ can be demanded in terminology that does not actually use that word, and is articulated in terms of ‘residence’ or ‘beneficial ownership’.
Residence simply means that the person claiming the treaty benefits should be a tax resident in the contracting state. This means that the “effective management and control” is exercised in the treaty country. Effective management and control in turn requires that at least the majority of the Board of Directors are resident in the treaty country and that the major management decisions are taken in the treaty country. However tax authorities may, and do, as we will see below, add much more “substance” elements to the term such as qualifications of the directors, physical premises, appropriate personnel etc.
While the term ‘beneficial ownership’ itself can be variously interpreted depending on the country, it is important to realize that it is through this terminology that requirements of ‘substance’ are frequently incorporated into the law. A person is a beneficial owner of an income if said income belongs to this person. It means that this person has no obligation to subsequently pass this income or significant portion of it to a person, not resident in the treaty country. Thus, the term “beneficial owner” means that the company receiving the income is the true owner of the income i.e. the income is not received on behalf of a third party or it subsequently actually transferred to a third party. As we saw above however, corporate structures set up purely for the purpose of taking advantage of low taxes are frequently mere vehicles for the income, and so not beneficial owners of the income.
The above structure attempts to use the Double Tax Treaty between the Country A and country B – to argue that any question of taxation should only arise in Country A, with whom country B does have a double tax treaty. But, by channeling a large portion of that income to a branch in Country C, as an inter-corporate loan, with even more advantageous tax frameworks, the corporate structure tries to lower the tax burden on Company X in Country A.
However, once ‘substance’ becomes relevant, tax authorities look beyond the mere form of the transaction to what it actually involves. In this case, Company Z is therefore treated as the ultimate beneficial owner of the income since it receives the actual income generated by company Z. Based on the current tests that tax authorities in various countries are using, it will be very difficult to prove that Company X is the beneficial owner of the interest income. Company Z will be considered as the beneficial owner of the income and therefore the foreign tax authorities (i.e. the tax authorities of country B, in which Company Y, paying the interest to Company X resident) will deny applying the treaty benefits under the Double tax treaty with Country A. In this case the payment will be treated as payment from Country B to Country C with which the foreign country will have no Double tax treaty. The result will be that standard rate withholding taxes of that foreign country will apply with huge cost to the beneficial owner.
It is on the basis of ‘substance’ therefore, that tax authorities will try to determine whether Company X in Country A is the beneficial owner. The test will check whether the company receiving the interest income is not just a shelf company created to avoid taxes, but whether it is a company that undertakes the risks of providing a loan, whether it has the appropriate procedures in place for checking the creditworthiness of the counterparty, if it has employees with appropriate experience, if it has the decision power as to whether to provide the loan or not and finally it has the resources to provide such a loan or to be involved in such an activity. If the above do not exist then the foreign tax authorities will consider that Company X is not the beneficial owner of the income and therefore tax treaty benefits will not apply.
Therefore a company without ‘substance’ is not considered as a tax resident of the treaty party or that it is the beneficial owner of the income. Many countries have their own substance requirements which can also differ from jurisdiction to jurisdiction.
What are the situations in which ‘substance’ becomes relevant?
One of the dominant situations where ‘substance’ comes into play is with regard to the mechanism of tax rulings. A tax ruling is an official confirmation of the tax authorities with regard to the status of the business that allows business owners to know in advance their duties and rights, as well as the tax burden under certain circumstances in certain conditions. When a company has real substance, tax rulings can be made applicable, securing for the company tax benefits of that jurisdiction. In the Netherlands in particular, there are two types of agreements with the tax authorities in the form of tax rulings, the Advance Tax Ruling (ATR) and the Advance Pricing Agreement (APA).
Advance Tax Ruling (ATR): An Advance Tax Ruling is an agreement on the Dutch tax classification of international structures in respect of the applicability of the participation exemption and the presence of a permanent establishment in advance. If the tax authorities agree with the arrangement the ruling is initially passed for a period of 4 years after which it has to be re-examined to assess whether it is feasible and necessary to extend the ruling. The ATR can be obtained with respect to certain international structures with hybrid finance activities or with hybrid entities in the following situations.
Ruling requests for certainty in advance regarding the application of the participation exemption of sub-holding companies in international structure, and top holding companies holding foreign subsidiaries that do not have activities in the Netherlands
Requests for certainty in advance concerning international structures with hybrid finance activities and / or hybrid entities.
Requests for certainty in advance concerning whether or not a foreign company has a Dutch permanent establishment.
The Dutch taxpayer must confirm that the information mentioned in the ruling is not exempted from the exchange of information clauses under the Dutch International Assistance concerning Taxation Act. In case of a request for an ATR with regard to a transaction with a subsidiary of the Dutch holding company, the Dutch holding company that files the request should have financed or will finance the cost price of its subsidiary, with at least 15% equity.
Advance Pricing Agreement: An Advance Pricing Agreement is in effect an agreement that approves in advance the determination of the ‘arm’s length price’ or method of profit calculation with respect to cross border transactions between related (group) companies and cross border transactions between an entity and its foreign permanent establishment. Therefore, to be able to issue a tax ruling under the APA the tax authorities have to make sure that the cross border transactions of the international holding structures where a Dutch company is part to, exist,
and carry out its activities.
Unified Fiscal Structure for Corporate Income Tax: Another situation in which the ‘substance’ of the company may be looked into is to determine the appropriate jurisdiction for corporate income tax purposes. In order to be included in a Dutch fiscal unity, for the purposes of being taxed at the corporate incomes tax rate in the Netherlands, a company needs to be effectively managed and controlled in the Netherlands which in turn is determined by various facts and circumstances. Thus, if all relevant facts and circumstances that affect a company’s decision making process are taken into account, and it lends to the conclusion that its place of effective management and control the company is in the Netherlands, it would apply.
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Do Substance requirements Matter For All Kinds Of Companies?
As part of measures against tax avoidance, the government increased substance requirements for Dutch resident holding companies as well as Dutch group financing and licensing companies – including for Dutch resident intra-group financing and licensing companies. As of January 1st 2014, a new Decree entered into force which codified the existing administrative guidance on substance requirements for companies engaged in intercompany financing or licensing activities and / or licensing activities. Virtually every Dutch company which is involved with providing loans or licenses to related parties for which it claims a reduced withholding tax rate in another state, should take notice of the new substance requirements. Therefore companies based in the Netherlands with intra-group financing, licensing or leasing activities (Service Companies) that could apply the Dutch tax
treaty network or the EU Interest & Royalty Directive (2003/49/EG) (EU Directive), including national rules for implementation of the EU Directive, will be required to meet these conditions.
What does Dutch corporate and taxation law say about substance?
Generally, Dutch corporate law does not require board members of Dutch legal entities to be Dutch resident and from this perspective Dutch legal entities generally do not have to hold their board meetings in the Netherlands, maintain an office address or their administration in the Netherlands, and neither do they, normally, need to meet any other substance requirements. However, Dutch companies that claim the benefits of a tax treaty or EU directive (treaty benefits) should now declare in their annual Dutch corporate income tax return whether or not the tax payer meets a defined set of substance requirements. considerations of whether companies seeking to take advantage of a double tax treaty, are actually doing business in the Netherlands have become relevant. If the company does not run actual risks and/or does not have substance, it is not possible to obtain certainty in advance and source country tax withheld on the interest and royalties cannot be credited against Dutch tax. Moreover the Dutch tax authorities may spontaneously inform the authorities in the source country (the country where the related company that pays interest or royalties to the Dutch service company is located), about the relevant transactions. Companies registered in other jurisdictions when entering into transactions could also be subject to the procedure of confirming their real substance.
Through the above mentioned decree, in force since January 1, 2014, Dutch tax authorities clarified the then existing Dutch minimum substance requirements in the form of regulations dated 18 December 2013 (Regulations) and specified requirements for companies to be considered as ‘residents’ of the Netherlands. This clarification was aimed at a stronger enforcement of these requirements and the accompanying exchange of information with the relevant foreign tax authorities and are as follows.
At least half of the total number of statutory board members of the company with decision-making authority resides or is actually established in the Netherlands.
The board members residing or established in the Netherlands have sufficient professional capabilities to adequately perform their tasks. The responsibilities of the board include, as a minimum, making decisions – on the basis of the legal entity’s own responsibility and within the scope of usual group business – regarding transactions to be closed by the legal entity and an adequate processing of transactions concluded.
The company has qualified personnel at its disposal for an adequate implementation and registration of the transactions to be closed by the company;
The (important) executive decisions are taken in the Netherlands;
The principal bank account of the company is kept the Netherlands;
The books of the company are kept in the Netherlands;
The business address of the company is in the Netherlands;
The company must comply with all its tax obligations;
The company is a resident of the Netherlands. To the best of the company’s knowledge, the company is not considered a fiscal resident by another state;
The company runs real risks with respect to its financing, licensing or leasing activities.
The company has at minimum an appropriate equity that corresponds to its functions performed.
Let’s explore these requirements in a little more detail below.
Requirements regarding residency of directors:
The first requirement states clearly that half of the Board members, or alternatively called Managing Directors, should be resident in the Netherlands. This does not, however, mean that mere nominee directors will suffice. The managing directors residing in the Netherlands have the professional skills required for the operation of the business – an illustration of which would at least include taking decisions – on the basis of the company’s own responsibility and within the scope of normal group management – on the transactions to be entered into by the company, and executing those transactions.
Requirements regarding board decision making powers:
Real, important decisions regarding the company have to be made in the Netherlands. Hence, the board of managing directors must have real power to enter into agreements, perform activities on behalf of the company and is responsible for the actions of the company, all within the normal framework.
Requirements relating to staff
The company cannot merely have skeletal staff, but must have qualified staff. Subsequent clarificatory rulings explicitly included the possibility that the company can use employees of a third party for proper implementation and registration of the transactions entered into by the company. or has at its disposal hired staff from third parties, in order to execute and register the activities performed by the company;
Requirements relating to Bookkeeping
Bookkeeping of the company must be done in the Netherlands.
Requirements relating to Bank Accounts:
Main bank accounts must be in the Netherlands. The main bank account should not necessarily be held at a Dutch bank, but the company should have full authority over its bank accounts.
Requirements relating to Compliance:
The company must be new, or have a good business history, and must show that it is in compliance with all relevant Dutch legislation. The company in question therefore, must successfully pass the compliance procedure mandated by Dutch authorities. Similarly, the company must have met its fiscal obligations by filing its CIT, value added tax and / or wage tax returns and paying the taxes due. This becomes especially relevant if the purpose of requiring substance is to obtain an ATR or APA as discussed above.
Requirements relating to risk and financing:
A company must run real business risks in relation to its financing/licensing activities and in general take real commercial risks. For financing companies in particular, guidelines have been given in the ruling policy (Advance Pricing Agreement or APA) and the Dutch Tax Act. Relevant risks explicitly mentioned in the APA ruling policy are the credit risk (bad debtor risk and currency exchange risks) and market risk. At least one of these risks must be borne by the company. This requirement typically disqualifies the fully matching back-to-back loan agreements, whereby a company runs (virtually) no business risks. If the company only takes operational risks, this will not lead to “running actual risks”. The most important factor to determine if risks are actually run, is by assessing whether or not capital (equity) held against the assets of the company can be affected.
Requirements relating to equity and operations:
Relatedly, an aspect that tax authorities will investigate is whether or not the company runs the risks as described above and the company should have sufficient capital in order to bear the risks and therefore, the capital (equity) of the company must accurately reflect the activities of the company. The equity requirement is supposed to be met, if the company has a (realistic) equity at risk of at least 1% of the amount of outstanding receivables or, if this is lower, € 2,000,000. For licensing activities also a minimum equity requirement applies which can be used as a safe haven, in case the risks turn out badly.
Requirements relating to tax residency:
Relating to the residency, it is not enough, for ‘substance’ that the company merely has a virtual office. It must have a physical office, which is appropriate for its activities, for at least 24 months. and not be dually resident in another state.
What Pre-Emptive Actions Must A Company Take?
A Dutch company that falls within the scope of the legislation and does not meet the substance requirements, however, cannot simply leave it to the tax authorities to make their own determinations. In order to not endanger the tax status of the business, the company mustindicate which requirements are not met, provide all necessary information for the tax authorities to determine which of the substance requirements are met, and provide an overview of all interest, royalty and similar payments for which a reduction of (withholding) tax has or could be claimed under any tax treaty or the EU Interest & Royalty Directive. This information can then be exchanged by the Dutch tax office with the tax authorities of relevant other states. This enables them to assess whether the benefits of the Tax Treaty or EU Directive have been applied correctly, and possibly to refuse to grant these benefits (the reduction of the WHT rate on interest/royalties) in the future or even to recoup such benefits already granted in the past. It is also, of course, possible, that the exchange of information will result in other actions from the tax authorities in the other state, like a refusal to deduct the interest/royalty expenses for the levy of corporate tax from the payee, or an attack of the structure as a whole, which is why meeting these requirements becomes of paramount importance.
What Are The Consequences Of Not Meeting ‘Substance’
The substance issue is likely to materialize when the Dutch tax office processes an annual corporate income tax return, or sooner, when the Dutch company makes an application with the Dutch tax office for a residence certificate (generally required to effectuate a reduction of foreign withholding tax on the basis of applicable tax treaties). However, the tax office currently also spontaneously investigates individual companies. Under the latest laws, it is no longer possible for the Dutch company in question to object against the exchange of information and the Dutch tax office has (no longer) the obligation to notify the company about an (intended) exchange of information. In theory therefore, exchange of information could thus occur without the Dutch company having any knowledge about it.
The non-compliance with substance requirements, and failure to inform the tax authorities as elucidated above, is likely to result in an automatic exchange of information, even if the improper use of tax treaties or EU Directive was not intended. It is recommended therefore, that every Dutch company which falls under the scope of the new rules, reviews its own situation to determine whether or not it currently meets the substance requirements. In many cases, the substance requirements will be met, or can easily be met by upgrading internal procedures for board meetings, etc.
Additionally, Dutch tax authorities may refuse to issue tax rulings for the company; the Dutch tax authorities may refuse to recognize the residency of the company, and refuse to issue tax residency certificates necessary for application of any other double tax treaty.
Should I be considering this at the stage of incorporation itself?
Appropriate tax substance solutions should be focused on ensuring that the company that derives income from a company, resident in a treaty country, is a tax resident of the other treaty country and is the beneficial owner of the income. Solutions, therefore should be found so as to maximize the benefit and minimize unpleasant surprises if the company is found to not have ‘substance’. Such substance solutions should take into account all business aspects of the company including its functions, its sector, the industries it affects, risks, employees, decision makers, financing, premises, assets etc. Ensuring that the company is set up with these requirements in mind therefore, requires professionals familiar with the requirements at the stage of incorporation itself.
Adequate corporate structuring that takes into account tax substance therefore, should be based mainly on the following factors:
The company should have appropriate functions and undertaking business risks
The company should have employees
The company should have directors with appropriate decision making powers
The company should have appropriate premises and assets
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