With globalisation permeating every business activity, it is normal and even expected that companies operate in multiple jurisdictions.
The fact remains cross-border activities still carry with it vast amount of operational and statutory friction, as such international financial centres (IFCs) exists, and thrive based on the fact that these jurisdictions are adept at reducing this friction.
IFCs offering tax incentives and business-friendly legislation encourage the intermediation of trade and investments.
Indeed, some business experts have compared IFCs to the oil that lubricates globalisation, and unless we subscribe to the belief that globalisation is dead, the question remains: How do businesses and individuals continue to benefit from IFCs in this landscape of enhanced transparency?
Substance is a common tax concept used in assessing cross-border tax situations, which calls into question the level of operational activity and decision making process which is conducted in a particular jurisdiction.
In general, a company needs to demonstrate that it has substance in its functional structure such as a physical office, staff administering the day-to-day operations of the company and the necessary operating tools or equipment.
Domestic management staff should have basic decision-making authority to run the business while key decisions are made by the board of directors in the jurisdiction.
Without such arrangements, the tax authorities would conclude that key management decisions for a particular company are not made in the jurisdiction where the company is operating, creating a lack of economic substance.
Simply put, tax residency will not be automatically applied even if a company is registered in a particular jurisdiction. There has to be substance to operations of a company in any jurisdiction in operates in, towards creating and evidencing economic substance.
As there is no exhaustive list or a version of the “universal truth” when it comes to defining or curating substance, substance needs to be carefully planned in order to avoid potential challenges by tax authorities. It does not help that the criteria accepted in one jurisdiction as satisfying substance requirements may be deemed insufficient in another.
It is also paramount that companies planning to set up cross-border structures consider incorporating their business units in jurisdictions that have double tax treaty with their home country. This will provide certainty with regard to establishing tax residency of a company.
Becoming a tax resident means that the company is taxed based on the tax rules of that treaty party as prescribed in the double tax treaty. In contrast, a cross-border company structure operating in jurisdictions without double tax treaty agreements may risk higher withholding taxes and possible risk of having to pay double tax.
It is also worth noting that companies without substance may not be considered as a tax resident of the treaty party, denying treaty benefits.
Establishing a company in a particular jurisdiction with the hope that its mere via registering a company with a fiduciary service provider or a trust company in that said jurisdiction will provide access to the tax treaty network is simply wishful thinking.
Yes, building substance incurs additional cost but considering the business interruption risk, wasted resources and the tax burden a company may have to risk when the structure is challenged by the tax authorities, it is always better to be safe than sorry, especially when company’s reputation is at stake.
To this end, companies that established cross-border structures may consider restructuring its existing business structure to ensure the creation of sufficient substance.
Towards this, the re-domiciliation of these structures or corporate entities to jurisdictions which enable substance creation which give access to a wide range of double tax treaties may be a good start.