The older we get, the more we should rely on our gut feeling, particularly in our areas of speciality – international tax and business structuring in my case. If I look back at my newsletters over the last decade, I note that I was deeply sceptical about the success of the Euro without political union. The differing political, economic and social requirements of the various European Union member states require flexible and variable mechanisms to maintain their economic equilibrium on the global stage. What has happened is that two of the major control mechanisms (exchange rates and interest rates) have been eliminated by a common currency and interest level, leaving only fiscal policy within the sovereignty of each member state. And cutting expenditure on social requirements such as health, education, law and order would have been deeply unpopular during an unprecedented recent period of global growth.

So as usual, political self interest has meant economic collapse in countries like Greece and Ireland with the contagion spreading to Portugal and Spain as I write this. If the Euro is to remain in existence, sovereignty over fiscal policy needs to be surrendered if the requirements originally stipulated in the Maastricht Treaty are to be adhered to. Alternatively, successful EU member states will have to put considerable sums to a fighting fund meaning, yes, a bail out by individuals already suffering from domestic cuts to shore up the economies of more profligate member states. Or of course, throwing out those countries who cannot maintain their fiscal policy within European Union guidelines, reverting to their original domestic currencies and possibly re-entering the Euro at some later date perhaps on new exchange rates equivalents – I cannot see this happening.

So my gut feeling no. 1?
The Euro dream will stumble along but the Euro will weaken and eventually become the common currency of a core number of countries who can maintain a fiscal policy commensurate with having their hands tied behind their back. But what happens when economic growth suffers and hits those comparably prosperous member states, as it inevitably will.  Eventually, the politicians will have to awaken from the Euro dream and realise it’s been a nightmare.

Since VAT in the UK will be increasing to 20% on 4 January 2011, I thought I would revisit the case for indirect taxation as opposed to direct taxation, particularly in the light of tax rises that were instigated by the Labour government in the dying months of their reign. I remembered that I had written a letter to Ken Clarke as Chancellor of the Exchequer in the Conservative government before their historic defeat to Tony Blair in 1997. I did start the letter “Dear Kenneth” (or Gordon in order to hedge my bets), and having re-read the letter I am attaching it to this newsletter. Click here since I believe it has as much relevance today as it did in 1997.  And not only for the UK, but even more importantly in those member states as explained above who only have fiscal policy as a means of regulating their economy. Although there is a common EU Directive for VAT, member states are able to determine both rates of VAT and relevant goods on which VAT should be charged. When will governments realise that increases in direct taxation are a disincentive to growth, whilst increases in indirect taxation on non essential items gives people a choice (as explained in my letter). At this cycle of economic depression, consumer spending needs to be stimulated and increases in VAT may not be the best way to facilitate this process, but I suspect the effect will not be that spectacular, particularly since retailers may well absorb some of the effect of VAT increases.

So my gut feeling no. 2?
During the next decade, forward thinking governments will revisit the complexity of tax laws created by successive governments for the past 50 years with lower top rates of personal direct taxation, significantly lower corporate tax rates and varied VAT rates depending upon the essential nature of product or otherwise (such as existed in France in the 1980s but for some reason were dispensed with as European integration proceeded). By the way, the attached letter to the Chancellor mentions potential changes to the non domicile regime in the UK which have been made, but in a piecemeal, disruptive and technically very confusing way.

The third area that I would particularly like to discuss in this newsletter is within the realm of tax avoidance. Not tax evasion, because this has been fairly well covered by money laundering legislation introduced worldwide since the terrorist attacks of 2001.  There has also been a general crackdown by Revenue authorities through Exchanges of Information (witness the proliferation of Tax Information Exchange Treaties during the Noughties). However, tax avoidance covers such a wide area of business structuring that appropriate structures designed to maximise returns for investors are tainted by media and government attacks on tax mitigation generally. Governments have to realise that there is a direct correlation between levels of taxation and returns available to investors/entrepreneurs, taking into account that their capital is totally at risk and may be lost if the business is unsuccessful.

The issue I will address in this newsletter is that there is still a wholesale misconception as to the use of companies or other entities in particular jurisdictions which are created specifically for a tax advantage, but which have no other purpose, nor any commercial substance. It is true that court cases over many decades have preserved the separate legal personality of particular entities to prevent the corporate veil being lifted. And I have previously discussed the need to establish such entities as being beneficially entitled to whatever income or profits they may receive. In this newsletter, I have prepared an article on company residence, the understanding of which I believe will be fundamental to tax planning in the next decade.

So my gut feeling no. 3?
Tax administrations will introduce legislation if it doesn’t already exist treating foreign entities as resident domestically under the ‘effective management’ concept. Where such legislation does exist, as indeed it does in most countries, court cases will be fought not in order to lift the corporate veil, nor even to establish beneficial ownership.  Instead, the cases will demonstrate that ‘shadow directors’, domestically resident, effectively manage any foreign entities that are engaged in real business activities within any structure. Alternatively, if no real business is undertaken by these entities, then to show that they are clearly conduit vehicles and should be ignored for tax purposes.

I hope you enjoy reading the following article on company residence which I believe is fundamental to tax planning in the coming decade – but even more, I hope you enjoy a quiet, stress free and joyous end of year, a merry Christmas and a happy, healthy and successful 2011.

Company Residence

Imagine a fausty Dickensian office in the heart of the City of London in 1905. A document arrives by ship from South Africa, which the South African local management advises its UK based board of directors to sign and return to them in connection with financing an African subsidiary operation. The board of directors of this South African company discusses the merits of the business as recommended by the local management and decide to approve the new venture. They try and phone local management in South Africa to discuss this but alas, the operator cannot connect them.  So they take out their quill pens and sign on the dotted line, sending the document back on the next boat to South Africa. Such is the background to the De Beers judgement decided in 1905 where the Court decided that the South African company was resident in the UK because that was where its controlling board of directors physically exercised its powers. The Court decided that the “real business” was carried on where “central management and control” abides.

A later case in 1959, Bullock v Unit Construction Co Ltd, endorsed the De Beers ruling and held that African subsidiary companies incorporated and trading in Africa were resident in the UK by reason of the degree of management and control over their businesses exercised in the UK by the parent company. This concept of attributing tremendous importance to the location where the board of directors meet and take their decisions may have been fundamental when communication between locations distinctly separated the functions required to make business decisions. Indeed, one could almost say that the De Beers judgement created the basis of the tax avoidance industry using offshore companies within business structures; all one had to do was to ensure that contracts were signed by the board of directors in their offshore locations, and hey presto, management and control had been accomplished.

Although it has been a slow process, tax authorities and practitioners are awakening to the reality of 21st century business. This time, imagine say Cayman Islands based directors receiving a contract from a US law firm to acquire a new real estate development project in southern Europe. The offices are luxurious with a wonderful sea view, and instead of the contract arriving by ship, it ‘pings’ up on the screen of the director’s latest iMac. This contract has also been sent to the shareholder of the Cayman Islands company, an individual based in Spain. Less than an hour later, the iMac ‘Pings’ again. The Spanish resident individual has sent back both to the US lawyer and to the Cayman Islands director his tracked changed version of the contract including his material, decision making, amendments. The director presses ‘Accept all’, prints out the contract, signs it, scans it and returns it to the US lawyer. He then prepares minutes of the meeting he is supposed to have held with his co-directors in the next office and lo and behold, he has created Cayman Islands management and control in respect of this transaction. And looking at the word “control”, he has indeed voluntarily signed the document without which the company would not be committed to the transaction, so to that extent he has indeed controlled whether the company commits to the transaction or not.

In my opinion, this illustration goes to the core difference between interpretation of management and control in the UK, and similar concepts in continental Europe. The history of UK tax schemes is based largely on semantics, where precise wording of legislation has been manipulated to create a variation to the purposive intention of the legislation. It is then up to the Courts to make sense of what the legislature initially intended.

Certainly, the latest string of cases in the UK such as the Wood v Holden judgement in 2006 demonstrated that the Court was prepared to look at the issue of control taking into account the entire arrangements, distinguishing between the case where real control over a company was conducted by persons other than members of the Board. The even later case of Laerstate BVdecided in 2009 summarised the issues decided in earlier case law. The judgement indicates that the Courts are now abandoning the formalistic approach taken in De Beers, looking far more at factual evidence taking all factors into account.

The first step therefore is to demonstrate that control actually vests with the Board. The directors should therefore be individuals who possess the necessary skills and experience to make informed decisions. Certain responsibilities can be clearly documented and vested with them. For example, the directors may have the power to maintain the company’s debt/equity ratio, ensuring that the company has the relevant working capital; they may receive and examine accounts of subsidiaries; they may also attend Board and shareholder meetings of subsidiary companies instead of simply providing general powers of attorney which deny them the opportunity to have any real input at these meetings. In other words, instead of relying on the word “control”, residence would rely on the place of effective management (commonly referred to as POEM).

Where a company is considered resident for tax purposes in two countries which have signed a double tax treaty between them, it is the POEM that creates the tie-breaker provision to determine which country has taxing rights over the company for the purposes of the treaty. It is therefore interesting to look at the OECD Commentary to Article 4 to consider how the POEM is arrived at, and some practical recommendations to ensure this creates corporate residence in the desired jurisdiction.

The Commentary, while reflecting the general opinion on the subject of a company’s POEM, contains its own recommendations. It advises against using a purely formal criterion like the place of registration, but instead importance should be attached to the place where the company is actually managed (para. 22.) This is defined as the place where key management and commercial decisions that are necessary for the conduct of the company’s business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the POEM. A company may have more than one place of management, but it can have only one POEM at any one time (para. 24.)

The Commentary further lists examples of the factors that tax authorities may consider when deciding on the company’s POEM on a case-by-case basis. Such factors certainly include where the meetings of its board of directors or equivalent body are usually held, but go much further and suggest the POEM may be where the chief executive officer and other senior executives usually carry on their activities, or even where the senior day-to-day management of the company is carried on (contrary to the De Beersjudgement).   It also suggests that the POEM should take into account where the company’s headquarters are located, which country’s laws govern the legal status of the company, and where its accounting records are kept.

It also states that when determining that the company is a resident of one of the Contracting States but not of the other for the purpose of the Convention, if this carries the risk of an improper use of the provisions of the Convention (para. 24.1.), then the POEM should not be considered the principal factor.  This last sentence is interesting, since if the title of the double tax treaty includes the term “for the avoidance of double taxation and the prevention of fiscal evasion” as many of them do, the creation of a corporate entity in a particular jurisdiction in order to avoid taxes in the other jurisdiction may not necessarily entitle the company to treaty benefits even if the POEM criteria are adopted. However, fiscal evasion is a term which is far more seriously considered by tax administrations than tax avoidance or tax mitigation, and therefore for most business structures, corporate residence will be accepted in the jurisdiction where the POEM is located, despite this last sentence of the Commentary.

Finally, we need to address the situation where there is no applicable double tax treaty, or where there is a double tax treaty but the POEM is in another location in a third country. Thus for example an individual resident in say Monaco may create a Dutch company to invest in a Spanish subsidiary, taking advantage of the Spanish/Dutch double tax treaty. The Spanish tax administration may have to accept that there is no effective management in Spain, and clearly the Dutch authorities will assess the Dutch company to Dutch corporate income tax since it is incorporated there. Should treaty benefits therefore be applicable?

In my view, if domestic legislation were to utilise the phrase “effective management” (in its full meaning as described above) to determine whether a foreign entity is resident in the relevant jurisdiction by virtue of this criterion, and to incorporate this requirement within its treaty provisions, this would deny the benefits of the Dutch/Spanish double tax treaty in the above example if the Dutch company were effectively managed by the Monegasque resident.

If clients wish to have longevity in their business structures and avoid the necessity of restructuring with all of its tax and legal complexities, it would be wise to anticipate the trend towards imposing the criterion of effective management when considering corporate residence, not only under domestic legislation but also as regards treaty definitions.  There have been many court cases surrounding the concept of beneficial ownership of income by companies interposed for treaty advantage, and limitation of benefits provisions have been introduced in the last 15 years to counteract the use of companies established solely for treaty benefits. Including the requirement under domestic law that a company in any jurisdiction must be effectively managed there to maintain exemptions under domestic or treaty law is not a difficult next step for governments to take.  Current court cases are indeed anticipating this.

The post December 2010 (106) – Company Residence appeared first on IFS Consultants Ltd.

I am proud to say that this was the first conference I have ever attended where every single assessment submitted described the conference as “excellent” and confirmed they would wish to attend next year’s conference. On the strength of that, I have already reserved rooms at the Landmark Hotel for Thursday 3 November 2011, so please make a note of this date so that you can “book early to avoid disappointment”! Of the topics discussed at this year’s conference, I enjoyed most the sessions on permanent establishment issues and how this area of corporate tax is being extended through local legislation and case law. Philip Baker was able to give some interesting insights into current OECD and HMRC thinking in this respect.

Robert Field of Farrer & Co and Karen Payne from Minter Ellison in Sydney explained corporate tax issues relating to acquisitions and mergers, and we discussed the relatively new concepts of corporate migration explained in our October newsletter.

We had a lively session on holding companies and planning for an IPO with speakers from Austria, Cyprus, Russia and Singapore, and then some issues explained in connection with the taxation of e-commerce sales including a presentation from Rafaela Brito from Brazil.

After lunch (yes that was all before lunch!) we discussed the licensing of intellectual property rights using Irish, Luxembourg, Netherlands and Maltese concessions, and looked at how Germany views conduit companies and the beneficial ownership concept. Session six was a discussion of real estate investments in UK, France, Spain and the US led by Lara Saunders with Patrice Lefevre-Pearon, Jaime Azcona and William Byrnes explaining how to structure investments in their country, and finally I discussed with Kishore Sakhrani from Hong Kong, Geraldine Schembri from Malta and Daniel Schafer from Switzerland how to maximise the benefits for both fund investors and fund managers when creating private equity funds for various forms of investment, particularly those relating to renewable energy which we have been structuring over the past two years.

The cocktail party hosted by IFS did not come a minute too soon, and this was a very enjoyable end of conference party in which delegates could meet the speakers who had entertained them. And it is the speakers whom I would like to thank for the success of the conference, and despite coming from so far away, I am hopeful that they will attend next year’s conference. I will be working on a new programme with different topics and hope that we will continue being able to supply 26 nuggets of invaluable information at each succeeding annual ITSAPT conference. Here are the 26 nuggets from this year’s conference in no particular order as they say on X Factor and Strictly Come Dancing!

1. Building site is a permanent establishment
The conference discussed claims by HMRC that a building site itself constituted a permanent establishment. Lara Saunders explained that the site was just the product or place at which the development was situated, not through which the business of the owning company was carried on. Philip Baker agreed with this view and stated that he understood that recent claims by HMRC had been settled on the basis of construction profits only being taxable as opposed to development profits in entirety.  Matteo Rapinesi pointed out that even construction profits should not be assessable to local tax unless the construction exceeded a certain time, normally six months or 12 months as may be identified under local legislation or double tax treaty arrangements. He pointed out however that in Italy the time limit was only three months so that construction work that lasted for a longer period could be assessed to Italian tax.

2. Allocation of branch profits
It has always been the practice of tax administrations to disallow payments of for example interest from a branch to its parent company on the basis that the branch is the same legal entity and cannot therefore separate itself from its parent company when identifying tax deductible payments. However, the latest OECD thinking on the attribution of profits to a permanent establishment now requires a “separate entity approach” even for branches, so that indeed a branch needs to calculate an arm’s length interest payment in respect of financing from its parent company. This is also true in respect of any intellectual property that the branch uses which is the property of the parent company, so that it is now a requirement to pay notional royalties to the parent company, or at least suffer the tax consequences of doing so.

3. A permanent establishment for VAT
Patrice Lefevre-Pearon explained that the main difference between a permanent establishment for corporate tax purposes and one for VAT is the degree of permanence required for VAT purposes, which generally requires an element of human personnel in comparison with a PE for corporate tax purposes. He explained that in most cases, a VAT fixed establishment will also constitute a permanent establishment for corporate tax purposes, but that the opposite is not true.

4. Creation of a service PE
This is a relatively new development whereby employees of a company who are present in another country, but who do not create a dependant agency for that company where they are currently residing, can nevertheless create a service permanent establishment for that company if more than 50% of the company’s gross income emanates from their services. This will typically affect an employment group which seconds personnel to another country and where its gross income from that particular country exceeds 50% of its total gross income. It can also affect companies who subcontract a particular assignment to a local subcontractor, and that assignment constitutes more than 50% of the company’s gross income for the relevant year.

5. Company migration
Robert Field suggested that this is likely to be an area of international tax planning which becomes more important, particularly within the European Union. Cross border mergers, spanning the divide between civil law and common law, is now possible within the European Union, even with UK companies merging with those incorporated under civil law within continental Europe.  He gave a practical example which he is currently working on with IFS and warned against using newly incorporated companies for one of the merging companies in view of a perception that this may constitute tax avoidance; clients should consider existing companies for both parts of the merger operation.

6. Step up in basis for acquisitions
Karen Payne explained that when acquiring an Australian operating company by an offshore company, a direct acquisition does not reset the tax basis of the underlying assets. However, acquiring the operating company through an Australian holding company creates a consolidated group for tax purposes, allowing the acquisition costs within the Australian holding company to be pushed down to the operating company’s assets themselves. In this way, a sale of the underlying assets would not create a capital gains tax charge except to the extent that the sale proceeds exceeded the value upon acquisition.  This step-up in basis is an essential consideration when making cross-border acquisitions.

7. Acceptability of shareholder loans
Karen discussed further the financing of the Australian holding company’s acquisition which could be through shareholder loans, and of course discussed thin capitalisation rules which generally were accepted at a 3:1 safe harbour rule i.e. allowing 75% debt to 25% of equity. However, she pointed out that the loan has to be properly structured so that is not re-characterised as equity itself, and therefore needs to be for a limited period (maximum ten years) during which interest is payable. This may be tax beneficial taking into account the fact that the Australian corporate tax is 30% whilst withholding tax on interest payable is limited to 10%.

8. Austrian holding company with passive interests
Erich Baier confirmed that normally, an Austrian holding company will be subject to tax on dividends received from subsidiaries if the relevant income is considered passive income e.g. royalties which are then distributed as a dividend. However, if the subsidiary actively manages the licence arrangements, then the income may be regarded as active income, even if earned in a tax haven BVI company, and the subsequent distribution of such dividends could be received by the Austrian holding company without Austrian taxation.

9. Cyprus companies owning Russian real estate
Savvas Savvides pointed out that the current Cyprus/Russian double tax treaty allows Cyprus companies to sell the shares of Russian real estate owning companies without Russian capital gains taxation and, in the absence of capital gains tax in Cyprus generally, without Cyprus taxation. The recent protocol to the Russian/Cyprus double tax treaty has changed this and introduced an amendment to Article 13 of the Treaty permitting Russia to tax gains on the sale of Russian real estate owning companies. However, this change will not become effective until four years after the protocol enters into force, and therefore it is not until 2015 that restructuring needs to be considered. Dmitry Zapol pointed out that since 90% of Russian real estate is considered to be owned by Cyprus companies, this restructuring could be a significant activity for tax professionals!
 
10. Listing a Russian company for IPO
Dmitry continued discussing Russia and the traditional method of financing Russian companies through GDRs (Global Depository Receipts), issued by Russian or western banks. It is now however becoming more popular for Russian companies to seek IPO arrangements through a foreign holding company, and in this respect, the UK holding company is probably the most interesting jurisdiction for Russians (in preference to the Cyprus route). This is because even though the Cyprus/Russian double tax treaty provides for a 5% withholding tax on dividend distributions as opposed to the 10% to UK holding companies, the reputation of UK companies coupled with the substantial shareholders exemption for trading entities, and the Finance Act 2009 exemptions for foreign dividends means that the UK holding company is top of the list for Russians seeking western finance.

11. Asian holding companies: Hong Kong and Singapore
Hong Kong is now extending its double tax treaty network so that it now has treaties with Luxembourg and Belgium and is negotiating treaties with many other countries. Singapore already has an extensive network of double tax treaty arrangements, and in view of the territorial approach adopted by both jurisdictions, foreign dividends may be exempt from local tax, and can be distributed to investors without further withholding taxes. Thus Singapore and Hong Kong could be interesting vehicles for IPO listings on Asian stock exchanges particularly. Moreover, Shanker Iyer explained the Singaporean incentives for financial services and shipping in generally, whilst Kishore Sakhrani demonstrated why Hong Kong companies are the most practical entities for investment into China. The Chinese withholding tax on distributions to Hong Kong companies is restricted to 5%, and with no Hong Kong tax on inbound dividends nor on capital gains, no VAT or estate duty, an investor would improve after tax returns by investing into China through Hong Kong than any other country.

12. Requirement for substance in holding companies
Roy Saunders wrapped up the session on holding companies by explaining the views of tax administrations generally to the interposition of holding companies without the relevant degree of substance. Thus the Swiss tax administration are very reluctant to commit the avoidance of their 35% withholding tax on dividend distributions to a holding company without the relevant degree of substance, namely an office and at least one personnel fully employed by it. However, in a June circular by the Swiss tax administration, they accepted that this condition did not apply to EU holding companies, and generally this is the view of other EU tax administrations. Nevertheless, if it may be considered that a company has no substance in one country but is effectively managed in another, then double tax treaty relief may be denied. It was recommended therefore that any holding company in any corporate structure must have a certain degree of substance, certainly as regards effective management even if no office or personnel is employed.

13. General reliance on double tax treaties
Roy continued his talk to explain that the title of a double tax treaty is “for the avoidance of double taxation and the prevention of fiscal evasion”. There have already been cases where tax administrations attempted to deny the benefits of a treaty to residents of a treaty jurisdiction who are exempt from tax (even if liable to tax as a resident) on the basis that the treaty does not exist to deny a single level of taxation but merely to avoid double taxation. Taking advantage of a treaty to avoid single taxation is tantamount to fiscal evasion which the treaty is designed to prevent, and therefore the treaty should not be applied in certain situations. Although this is a far reaching development, and generally frowned upon on the basis that double tax treaties should be interpreted literally according to their terms, and therefore specific provisions should be incorporated within treaties to prevent erosion of a single level of taxation, this is nevertheless a cause for concern. Thus now that Jersey, Guernsey and the Isle of Man have eliminated the 20% corporate tax rate for most entities, one has to wonder whether HMRC will respect the current double tax treaty arrangements with these countries since there is a possibility of no single level of taxation arising.

14. Avoiding VAT through e-commerce sales conducted offshore
Robert Field explained that certain items of minimal value may be imported into EU countries without the imposition of VAT e.g. in the UK items of less than £18 for VAT and £9 for customs duties can be imported without tax. Thus Jersey or Guernsey based servers can be employed to design and print greetings cards, for example, and have them sent into the UK without any VAT, and this of course is similar for all low priced products. Daniel Schafer suggested that Switzerland could be an alternative since the Swiss VAT system is not applied to goods flowing outside of Switzerland, yet companies may register for VAT to reclaim any input VAT which may be relevant e.g. on professional services. In addition, depending on the value of the goods sold, input EU VAT may not be due in the EU jurisdictions where those goods are imported due to de minimis rules. Moreover, a beneficial tax rate can be achieved with total federal and cantonal taxes of approximately 10 to 11.5% (or even lower if the company qualifies as a principal company and/or if a federal and/or cantonal tax holiday is made available following the creation of a substantial number of new jobs).

15. Intellectual property rights within an Irish company
Mark Barrett presented Ireland as an excellent jurisdiction to own intellectual property rights, citing the 12.5% standard tax rate for trading companies which could also be applied to passive income if the company is actively managing its licence negotiations and participating in the R & D process. Research and development work itself can qualify for a 25% tax credit and this may be offset against a corporate tax liability with excess even being refunded to the tax payer for example against PAYE liabilities. Moreover, income from qualifying patents is entirely exempt up to a limit of €5mn per annum, and there is no need to register the patent in Ireland for this exemption to be available.  And finally, income earned by writers, composers etc will be exempt from Irish income tax under certain circumstances.

16. Conduit licensing companies
Heinz Zimmermann asked the question whether an intermediary licensing company is a conduit company or a valid entity, and cited the German rules concerning conduit structures. Basically, interposed entities are to be disregarded if the ultimate beneficiary would not benefit from income received direct from Germany e.g. a BVI company that has no treaty with Germany. Moreover, there is a general anti avoidance law which treats the interposition of conduit companies as an abuse of law. However, he accepted that companies may be incorporated within the European Union without being qualified as conduit companies, and therefore the use of Dutch and Luxembourg licensing companies may still be available.

17. The Luxembourg securitisation entity
Although primarily discussing the beneficial Luxembourg tax regime whereby 80% of gross income is considered a deemed income deduction for self developed patents exploited by the taxpayer itself (leading to a 5.72% effective Luxembourg tax rate), Herman Troskie discussed an entity which could be very useful for international tax planning, the Societe de Titrisation. This entity is a securitisation company which is a normal Luxembourg company and which can benefit from double tax treaty exemptions in respect of royalty income. Its shareholders may even be Luxembourg individuals, but investors can invest in the securities company either through special shares issued or through participating bonds, each of which can be “stapled” to specific underlying assets of the Luxembourg company. Thus real estate may be owned by a securitisation company in order to avoid net wealth tax or inheritance tax in the country where the real estate is located, or the special taxes such as the 3% tax in France, Spain and Portugal designed to attack corporate structures beneficially owned by relevant individuals.

18. The Dutch regime for intellectual property rights
Christian Strik explained that Dutch licensing companies were always hitherto conduit companies where royalties were received from licensees and paid out to a head licensor subject to a 7% maximum spread of royalty income permitted by the Dutch tax administration, on which Dutch tax would be payable. Although conduit companies may still be relevant, Dutch legislation has introduced the box system of taxation whereby the patent box may be ticked in respect of income received from licensees without the need to pay a head licensor, but still with a beneficial tax consequence. Thus in total the Dutch tax rate will be 5% in respect of royalty income with the ability to benefit from lower rates of withholding taxes according to Netherlands treaties, subject to limitation of benefits clauses. Moreover, Christian introduced the concept of being able to split economic ownership from legal ownership, so that the patents could perhaps be owned by an offshore company that permits royalty income to be earned by a Dutch subsidiary subject to tax within the patents box.

19. Re-domiciliation of R & D companies with valuable rights
The Conference discussed generally the situation where research and development had taken place within a high tax jurisdiction, with relevant grants and credits attached thereto, but suddenly the entity found itself with valuable IP rights, the income from which would be taxed at high corporate tax rates. A disposal of these rights to a related group company in a more favourable jurisdiction would create a capital gains tax issue, whilst an export of the company could trigger an exit tax as if the assets had been sold on the date of migration. Rachel Saliba discussed the Maltese laws relating to re-domiciling foreign entities in Malta, and although the standard Maltese tax rate is 35%, refunds are allowed in respect of dividend distributions to shareholders depending upon the source of income so that the effective tax rate can be reduced to 5%. Roy Saunders suggested that corporate mergers may be the way to transfer assets across borders without exporting a company, as may be permitted under the EU merger directive. When re-domiciling a company it is also possible to uplift the tax base.

20. Hidden tax charge for owner occupiers of UK residential homes
The typical way of avoiding inheritance tax on assets situated in the UK is to buy those assets through an offshore company, often itself owned by a trust. In this way, when an individual dies, it is the shares in the offshore company (its non UK situs asset) that passes to the heirs rather than UK situs asset, the real estate direct. Lara Saunders pointed out however that in respect of private homes, an individual could be considered a shadow director of the offshore company and as such an employee to which the benefits in kind legislation in the UK applies. Thus a home of £10mn could create a taxable benefit giving rise to an annual tax charge of almost £250,000. However, this is only relevant if the individual can be considered a shadow director, not if the individual does not have any control whatsoever over the owning company or the way that it enters into agreements in connection with the property and pays relevant expenses.

21. UK income tax on speculative property transactions
Lara then went on to explain that an individual entity buying a property for the purposes of making a capital gain will be treated differently from someone who clearly buys a property for investment purposes. An anti avoidance section will treat the gain as being in the nature of a trade and will subject that gain to income tax. This may even apply to the sale of shares in an offshore company owning such real estate. This section however would not apply to trading entities which, if non-UK based, would only be subject to UK tax in the event of a permanent establishment existing if such entity were able to benefit from a double tax treaty with the UK.

22. Sale of shares in French real estate owning companies
Oliver Couraud suggested that the 3% special tax applicable to French real estate held by non resident entities may be avoided if more than 50% of the company’s assets are not French real estate but for example portfolio assets. Since the 50% is based on gross assets, one could consider borrowing funds for the purposes of purchasing a portfolio of non French real estate interests in order to avoid the 3% tax. Moreover, this could be an idea for other jurisdictions where sale of shares in real estate owning companies are subject to capital gains tax, but not where the company’s assets comprise more than 50% in non real estate assets.

23. Use of participating loans
Jamie Azcona described the benefits that can be derived by non residents investing in Spanish real estate through the use of participating loans, i.e. loans carrying a relatively low level of interest but with a participation in relevant profits. These participating loans are permitted under Spanish law, with the participation in profits treated as tax deductible interest rather than as dividends, and indeed may be used for other assets and businesses generally. Participating loans are also allowed in other jurisdiction such as France and Italy, and indeed may be considered generally in international tax structures e.g. participating equity certificates (PECs) in Luxembourg structures. Notably, the US re-characterised equity kicker loans so as to avoid interest deductions being permitted on such loans.

24. Private equity funds in Malta
Geraldine Schembri explained the private equity fund rules in Malta and particularly the professional investor fund with investments in excess of €750,000. She described the funds as having access to Malta’s double tax treaties, and the absence of Maltese taxation if more than 50% of the assets are non prescribed (assets based outside of Malta). Fund management companies would then be taxed at an effective 5% tax rate with the tax refund due on distributions to shareholders.

25. Carried interests for fund managers treated as capital gains
Switzerland is trying to attract fund managers to base themselves in Switzerland, and Geneva particularly has benefited from the UK attack on relevant non-domiciled individuals. Daniel Schafer described the way of avoiding carried interests being treated as income (management fees) on the proviso that any investments in equity share capital in the relevant funds made by the fund managers have the same rights as other investors. Thus the other investors would subscribe for preference loans or preference shares at the same time as subscribing for ordinary equity, as long as all ordinary equity shares have the same rights as those shares issued to the fund managers. In this way, any capital gains derived from those shares in the form of the carried interest would be tax free (Switzerland does not impose capital gains taxation on individuals) as opposed to being subject to income taxation at federal and cantonal level.

26. Splitting fund management fees between related entities
Roy Saunders explained that where there is one entity which performs all fund management activities, it is difficult to assert that the carried interest should be earned by a related entity in another jurisdiction. However, such is the variety of functions undertaken by a fund manager that in reality, one can set up related entities in different jurisdictions with the relevant level of substance in each jurisdiction. As for any other split of activity, transfer pricing considerations will be relevant, but Roy listed the type of services that may be reviewed as to their place of supply as follows:

* promotion and marketing development
* brand management
* fundraising from investors
* subsequent liaison with investors
* investment preparatory work and research
* investment recommendations
* investment decision making
* cash management
* regulatory and compliance work
* fund accounting and documentation
* administration services

Such is the variety of these services that if conducted in different jurisdictions, it would be difficult to ascribe entire carried interest to any one jurisdiction, particularly if a significant investment is made by the fund managers into the fund at the outset as initial risk capital.

The above are my 26 nuggets of information although I have to say that there were many other issues discussed at the conference – this comment is to encourage readers to express their interest in coming to next year’s conference by clicking here. No need for any commitment or payment as yet!

With my best regards to all readers.

The post November 2010 (105) – ITSAPT 2011 Summary appeared first on IFS Consultants Ltd.

The entire industry was hauled up by its bootstraps in the early ‘80s following the Ramsay decision which created the requirement of commerciality for transactional activities that were designed to mitigate the tax burden. There then followed a decade of wholesale treaty shopping until the US imposed its first limitation of benefits article in the 1992 Dutch treaty effective from 1994, preventing conduit companies used for treaty shopping purposes to minimise the impact of US withholding taxes. Tax authorities then became more aware of the conduit company rules and started to challenge whether an entity was really the beneficial owner of relevant income, and imposed anti-abuse provisions under unilateral legislation, within double tax treaty arrangements and also under multi-lateral Directives.

I suppose the Noughties could be seen as the decade when tax technicians from both the profession and the tax administrations locked horns through a plethora of court cases as to the merits of assessments based on source of income as well as personal residence e.g. Vodafone case and the Gaines-Cooper case. Certainly the money laundering push of the Noughties seems to have drastically reduced the use of offshore entities in international tax structures. So what does this leave us for the ‘10s.

My prediction is that the international tax technicians will examine ever more closely the hugely complex web of domestic and international tax legislation in order to utilise wholly legitimate paths for securing tax advantages wherever possible. One of these areas is company migration, using the tax laws of another more favourable jurisdiction to reap advantages for an entity which can no longer benefit from tax advantages in its state of residence. Indeed, this type of entity was envisaged when creating the Societe Europeene which is described in the article below. But even if an SE has not been created at the outset, the EU Merger Directive explained below provides the opportunity to change residence of an entity from one EU state to another without crystallising adverse tax charges.

Or it may be that offshore entities, finding themselves incurring additional tax burdens as a result of changes in legislation in a particular country, decide to re-domicile from their jurisdiction into another. Or finally, without any re-domiciliation or merger, a company may simply move its tax residence by virtue of the resignation of its directors and the appointment of others in another country, thereby moving management and control to another state.

Examples of benefits derived from such cross-border migration of one type or another are explained in this month’s special article, and I would be delighted to receive the views of our readers with any comments they may have on what I believe will be one of the new concepts of international tax planning which categorises this coming decade. Click here for your comments.

This is the last newsletter before our Conference on 28 October 2010 at The Landmark Hotel, London, hosted by IFS. Cross-border migration will be amongst the topics discussed at the Conference and should any reader wish to attend the Conference who has not already booked their place, please do not hesitate to click here click here for the Conference programme and booking form.  This will be an invaluable opportunity to listen to international tax experts from over 20 different jurisdictions discuss the commercial and tax issues relevant to the development of a company as it becomes an internationally renowned brand name and successfully quoted multinational group.

I look forward to seeing you soon.

Company Migration: A Tax Planning Concept

 “One step forward, two steps back” was how Vladimir Lenin described the state of Russian political affairs in 1904. Had the famous revolutionary met Stephen Holmes, he would have invariably described him as “full speed ahead.” Mr Holmes scared his competitors and awed his allies with the swiftness of his decisions and velocity of Polycon’s expansion beyond its home state. The flipside of Mr Holmes’s business acumen was the excessive self-confidence and gusto with which he attempted to plan his tax affairs, and which created a bottomless source of income for the advisors hastily summoned to remedy the situation. We are reminding you that Mr Holmes and his Polycon group are the subjects of the International Tax Systems and Planning Techniques (ITSAPT) case study that lies at the heart of IFS’ Conference which will be held at The Landmark Hotel, 222 Marylebone Road, London, NW1 6JQ on Thursday, 28 October 2010.

Many years ago Mr Holmes left his Northern European Republic (NER) homeland in search of a better life in the UK. There he created Polycon Group Holdings Ltd, which held together the pieces of the Polycon lens-manufacturing empire. As a UK tax resident Stephen was taxed heavily on the generous income and dividends that he received from the holding company and envied his more fortunate Monegasque friends who paid no taxes at all. When the top income tax rate hit 50%, Stephen decided that something had to be done.

Although living in the UK for many years, Mr Holmes never abandoned the hope of returning to the NER one day (at least that is what he maintained), and thus he was not considered domiciled in the UK. A search on the HMRC website showed that while he paid taxes on income arising in the UK, he had the option to have his foreign source income taxed only upon remitting it to the UK. Although the bulk of his income was generated in the CER (Central European Republic), that company was owned by the UK-based Polycon holding company, and by receiving dividends from that company, he was effectively converting foreign source income into UK source income taxed on an arising basis. He wondered whether he could move the UK company abroad, and Maurice Brightman was the first point of call.

Maurice explained that Stephen was about to engage in cross-border tax arbitrage through either migration, re-domiciliation or perhaps a more convoluted merger arrangement of his holding company. This had to be approached from two different angles. First, the corporate law and tax regimes of both the destination and emigrating jurisdictions had to enable the strategy to be pursued. Second, the method of effective re-domiciliation had to be time and cost-effective, especially taking into account charges that the host jurisdiction could impose on the departing enterprise.

Addressing the first issue, the ideal tax regime would have a low rate of corporate income tax, it would not tax dividends or capital gains received from the subsidiaries and would not withhold tax on profits distributed as dividends. There also would be a wide network of double tax agreements. These considerations are well-known, and Maurice suggested migrating the holding company to say Cyprus, Malta or Luxembourg.

Regarding the second issue, often jurisdictions discourage companies from abandoning their residence through introducing the “exit charge.” The charge operates on an assumption that the company has realised and immediately reacquired its assets at their current market value on the day of becoming non-resident and it taxes the resulting gain. Maurice therefore said that the method of re-domiciliation depends on legislation of the states to and from which the company was migrating, as well as on any applicable supra-national agreements that could offer tax benefits. As Mr Holmes contemplated moving the Polycon holding company within the EU, its laws should be considered first.

Until relatively recently in the EU, it was considered unacceptable for companies to profit from ‘legal tax arbitrage’. The “real seat” approach in states such as France, Germany or Luxembourg prohibits companies from having their head office (the real seat) and registered office in different countries. The transfer of the head office abroad either results in the winding up of the original company or is subject to conditions and penalties (such as an “exit charge.”) There is currently a shift towards the “incorporation” approach, practiced in the UK and Ireland. The enterprise retains its status of a national company in the state where it was incorporated and under whose corporate laws it operates and it can establish its head office in another state.

A company’s residence is also determined by the tie-breaker residence clause in any applicable double tax treaty (DTT), which also stipulates the taxing rights of each jurisdiction. Maurice stressed however that although DTTs make tax arbitrage more accessible, they do not provide for every eventuality, and an enterprise may be subject to some obscure charges and levies in both states.

This move towards the “incorporation” method is the result of the developing ECJ jurisprudence, which found the “real seat” approach to be in violation of the freedom of establishment principle. Although, most EU “incorporation” states still impose exit charges on companies whose head office moves to another Member State (MS), these are contrary to the EU law and should be non-enforceable. As a result, enterprises are not prohibited from having their registered office and the head office in separate MSs, making the best use of corporate and tax laws in different jurisdictions. Where a company, which is lawfully incorporated in one state, moves its office to a “real seat” jurisdiction, the latter may not discriminate against the immigrating enterprise but must regard it as a national company.

Such right to the non-discrimination abroad still does not fully equate to the ability to re-domicile a company while keeping its legal personality. In fact, a company that wishes to migrate must often first be liquidated under the laws of the home jurisdiction, incurring financial penalties, such as exit charges, discussed earlier. In the absence of the specific legislation such as 14^th Company Law Directive on cross-border transfer of the registered office, the only effective alternative lies in the cross-border merger method, derived from the EU Merger Directive.

Were Mr Holmes to migrate the existing holding company from the UK to, say, Luxembourg, the first step would involve establishing the company’s presence there by incorporating a Luxembourg company. In fact, this should be an existing company which has a record of activity to be acceptable to the UK court. The two would then perform a down stream merger, whereby the UK company would cease to exist and the Luxembourg company would take on all of its assets. This legal procedure requires the pre-consent of the UK court, followed by a notarial deed in Luxembourg which eventually gets registered in the UK court again, after which the company is dissolved.

Alternatively, Mr Holmes could simply replace the company’s CEO – an Englishman Mr Smith with his Luxembourg based director Monsieur Lefevre, and ensure that the company is effectively managed in Luxembourg, thus changing its residence under the UK-Luxembourg double tax treaty residence article. However, this would create a change of residence of Polycon Holdings from the UK to Luxembourg, as opposed to a dissolution of the company, and this may have other UK tax consequences which could be argued by HMRC. In both cases, Mr Holmes would of course become the shareholder of a Luxembourg holding company and therefore enable him to receive foreign source income taxed only on a remittance basis, permitting him to remain in his favourite location overlooking the Thames not far from central London, without the adverse tax costs he currently faces.

The principal benefit of the merger method lies in the absence of any sanctions that the home state (the UK) can impose on the migrating company or on its shareholders under the protection of the EU framework. Its main disadvantage stems from the relative rarity of cross-border mergers and lack of regulatory experience on the part of the national tax authorities, which still could attempt to impose financial penalties. Also, until passing of the legislation permitting the direct company re-domiciliation, the shareholders must contend with the cost and the need to establish a prior presence in the target MS through incorporating a company there.

As an additional option, Mr Holmes could convert the Polycon holding company into a Societas Europaea (SE) – a relatively new European corporate structure, and then transfer its registered office to Luxembourg. Although corporate migration within the EU is expressly pertinent to the SEs, this method is only likely to be acceptable in very particular circumstances. First, only a public limited company with a subscribed share capital of at least €120,000 can become an SE. This may attract corporate giants, such as Basf SE, Porsche Automibil Holding SE and BP Europa SE, but excludes smaller privately-owned enterprises. Also, a company can only be converted into an SE provided that for at least two years previously it has had a subsidiary company governed by the law of another MS.

Concluding on his discussion of company migration within the EU, Maurice Brightman pointed out that thanks to the EU Merger Directive and the principle of the freedom of establishment, the Polycon holding company could effectively be moved across the EU without incurring any tax losses and charges normally associated with winding up a company, and in most cases subject only to direct legal and registration expenses.

Mr Brightman warned that the same cannot not be said in case Mr Holmes wanted to move the enterprise beyond the EU. In most states the only way to strike a resident company off the register is through winding up, while only a few permit corporations to re-domicile abroad without incurring financial penalties. A Cypriot company for example can continue its existence abroad, provided the laws of the host country allow it and subject to receiving the consent of the Registrar of Cyprus Companies. A Maltese company can also emigrate to an approved jurisdiction which includes the MSs of the EU, EEA and of the OECD, together with the Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Gibraltar, Guernsey, Isle of Man, Jersey and Mauritius. Redomiciliation is conditional to the laws of the host country envisaging such move and subject to the company retaining or succeeding to all assets and liabilities of the Maltese company. Similar requirements apply in Switzerland. Less stringent conditions apply in low tax jurisdictions, such as Bahamas, Barbados, Cayman Islands, Cook Islands, Guernsey, Isle of Man, Jersey and Mauritius.

Shareholders thinking of migrating their holding company from a State whose laws do not envisage re-domiciliation and which are not limited by the EU legislation should be wary of the exit charges that may apply. For example, if a UK-incorporated and resident company or a non-UK company, which has been previously fiscally resident in the United Kingdom ceases to be UK resident, it will be treated as if it has disposed of its assets at the date of changing its residence, and to have reacquired them at their market value, crystallising any unrealised gains for corporation tax purposes (TCGA s185). Such a charge may be postponed where the exiting company is itself a 75 per cent subsidiary of a UK parent, and will only crystallise if either the assets are actually disposed of within the following six years or if the exiting company ceases to be a 75 per cent subsidiary.

Similarly, if an Italian-resident company transfers its tax residence abroad, it is similar to the transformation of its legal status and change of its nationality. For income tax purposes this entails a realisation of the company’s assets or of its business at a fair market value, unless these are conveyed to a permanent establishment located in Italy.

Just as explained earlier, a company’s residence is determined by the residence clause in any applicable DTT. Sometimes failure to observe these rules can lead to unexpected results, particularly for companies registered in “incorporation” states. If, for example, Mr Holmes as the sole director of the UK-incorporated Polycon moves to the NER, he will be deemed to have acquired residence there. As a result, the company itself would be treated as having changed its residence and subject to the “exit” corporation tax charge on deemed disposal of its assets.

Having virtually held his breath during Maurice Brightman’s discourse, Stephen Holmes breathed a sigh of relief that at last he had learned the value of asking questions first and acting later. 

The post October 2010 (104) – Company Migration appeared first on IFS Consultants Ltd.

The legislation of each country relating to stock options, as indeed other topics, is carefully scrutinised in the 2010 edition of “International Tax Systems and Planning Techniques” or ITSAPT.  This is being published by Sweet & Maxwell and will be available at the end of this month and also (at a 20% discounted price) for those who attend our ITSAPT Conference at the Landmark Hotel in London on 28th October. 

As I have explained previously, the ITSAPT Conference analyses the development of the Polycon Group into a worldwide conglomerate, exploring the tax issues arising at each stage of the group’s development.  It also carries with it 6 hours of CPD accreditation from the Solicitors Regulation Authority.  I hope that you enjoy reading the article on stock options, and would welcome any comments that you have – click here.  Also, in the event that you would like further information about the Conference, please click here.

Incentivising Employees through Securities Options

About to leave the office for a well-deserved Christmas break, Stephen Holmes sat down to think about the past year. He thought that although markets fluctuated wildly, his clients never let him down: neither fashion victims, hooked on changing their designer spectacles every month, nor the army, using sophisticated optics to promote their means across the world. Unlike his insatiable customers, satisfied with what they were getting, the same could not be said about Mr Holmes’s employees, and the issue of keeping his staff happy and motivated deeply troubled the benevolent patriarch.

We are reminding you that Mr Holmes is the protagonist of the case study that lies in the beginning of International Tax Systems and Planning Techniques (ITSAPT) – the leading international tax reference book which Roy started over 27 years ago and which completed its 59th loose leaf version in April this year. It has now been re-written, brought up to date as at the end of June 2010 and will be available in a bound version and on-line as from September 2010. Roy would like to thank our colleagues in over 30 jurisdictions for their invaluable contributions to this new book. The case study will also form the basis of the first ITSAPT Conference which will be held at The Landmark Hotel, 222 Marylebone Road, London, NW1 6JQ on Thursday, 28 October 2010 and which will be a unique opportunity to listen to international tax experts from over 20 different jurisdictions discuss the commercial and tax issues relevant to the development of a company as it becomes an internationally renowned brand name and successfully quoted multinational group. For further details and information on how to reserve a place on the conference, click here.

Let us return to Mr Holmes who on his way home met Maurice Brightman to seek advice about the best and the most tax-efficient way to motivate Polycon’s staff across the globe. Mr Brightman agreed with Mr Holmes that giving a pay rise constitutes a very short-term and expensive solution for the company. Instead he suggested instilling the sense of ownership vis-à-vis the corporation through stock options and pushing the employees to perform better in order to reap the benefits when the company’s value appreciates.

He explained that a stock option (or a share option) is a right granted to an employee by a corporation that allows the employee to purchase a certain number of shares at a specified price (the “option price”) at a specified period of time. The corporation is usually either the employer corporation or in the same corporate group. The option price is usually greater than or equal to the market price at the time the option is granted. Typically, there is a “curing period” during which the employee cannot exercise the option. When this period has expired, the option is considered to “vest” with the employee who thereafter can “exercise” the option at any time during the specified period. Frequently, an employee may be granted a number of options with some of the options vesting before the others so that the longer the employee works for the corporate group, the more options that vest with the employee.

The “option benefit” is the difference between the option price and market price at the exercise date. The general rule is that this option benefit is treated as employment income. Maurice explained that while the idea behind stock options is uniform across the developed world, what differs are the specifics that determine the portion of the option benefit that is taxable, whether it is taxable, the timing of the taxable event and the kind of tax, chargeable on granting and exercising the option, as well as on subsequent share disposals. Mr Holmes, conscious that Mrs Holmes would have dinner on the table before long, asked Mr Brightman to highlight in a written memorandum the most important points for him to understand before deciding on how he may incentivise his various employees around the world.

The next day, Maurice reviewed the memorandum again (replicated below) confident that some of the pertinent issues relevant to an international group such as Polycon were sufficiently explained to Mr Holmes, but that he would undoubtedly highlight on the Alternative Stock Option Plan at the end of the memorandum for further discussion.

Memorandum for Polycon Lens Company re Stock Options

A. Timing of taxable event and characterisation of option income

Typically, a country may tax the benefits resulting from an employee stock option plan at one or more of the following events:

* When the option is granted;
* When the option vests;
* When the option is exercised;
* When there are no longer any restrictions on the sale of the shares acquired under the option; or
* When the shares acquired under the option are sold.

The timing mismatch caused by the varying rules of different countries may lead to issues of double taxation or double non-taxation, as described below.

Not only may there be a timing mismatch, but option income is characterised differently in different countries – as employment income in some countries and as capital gains by others.

For example, Belgium taxes stock options on grant like a benefit in kind, irrespective of whether the grant of the option is conditional or otherwise. The interesting consequence of this is that the granting of the option can create a tax charge even if the option is never exercised.

A parallel can be drawn with Luxembourg that does not have any specific legislation in relation to the granting of shares or share options to employees, except that the tax treatment of options depends on their transferability. Transferable share options are regarded as a benefit in kind and hence taxable at the time of the granting of the option. Non-transferable share options, that is, options that cannot be sold by the employee to third parties, are taxable on the date on which they are exercised. Thus, where the option is transferable, this gives rise to an effective asset and it is therefore appropriate for this to be taxed on grant.

Singapore bases its tax jurisdiction on the territoriality principle. Share options exercised or vested on account of the local employment are taxable in Singapore either on the date of grant or on the date of vesting if vesting is imposed. The option gain from stock options granted for non-Singapore employment is exempt from tax even if exercised in Singapore. Equally, in Hong Kong gains on exercise or sale of share options will be deemed employment income of an employee and subjected to salaries tax. However, to be assessable, the gain to be taxed must be from Hong Kong employment leaving open some planning possibilities for employees able to prove that options were granted at a time when they did not have Hong Kong employment.

In Germany, it is not the granting of a stock option to an employee, but its exercise, which is a taxable event, to the extent the market value of the shares at the time of exercise exceeds the exercise price (strike price). According to some commentators, however, the option exercise can produce non-taxable income: any advantage derived therefrom is outside the context of the employee relationship and, as a purely private event, not subject to tax under German law. The exercise of a stock option creates taxable income for the employee, which at high marginal tax rate of some of the employees may have a disincentivising effect. Consequently, to counter the undesired tax consequences companies may have to offer quite expensive stock option packages to its key German personnel.

Compared to the above, the United Kingdom is a state with a clear two-tiered system that separates non-approved and approved employee options schemes. Taxation of the former is reminiscent of the principles applicable in the jurisdictions described above. In limited circumstances employees may incur an income tax liability when the options are granted, inter alia, to non-resident employees or at a discount under the CSOP approved scheme. Other than that, the liability to tax is determined by the individual’s place of residence at the time the option is granted (even if the employee becomes non-resident before the option is exercised). The view taken by HMRC, although this is far from set in concrete, is that if the individual is no longer resident in the UK at the time the option is exercised, assigned or released, there may still be a liability to tax, notwithstanding the fact that the person is non-UK resident since, as stated above, the grant of an option is the taxable event and arises from a UK employment, even if the tax is only chargeable on exercise.

The options granted under extensive HMRC-approved schemes enjoy preferential treatment, and the income tax or National Insurance Contributions charges do not normally apply when the options are granted, or in respect of the acquisition of the shares acquired under their terms. Subsequent disposal of the shares acquired by the option will be chargeable to capital gains tax under normal conditions. However, the limits available under approved schemes are so small for top executives (in US as well as UK) that they are unlikely to be of interest, as explained below.

B. Timing mismatch and problems for mobile employees
Because countries tax option income at different times and characterise it differently, where holders of stock options perform services or reside in different countries, the different rules can lead to potential double taxation or double non-taxation. For example, if a Belgian resident employee of Polycon’s Belgian subsidiary is granted stock options and then moves to Germany, he potentially could be taxed both in Belgium on grant and Germany on exercise. By the same token, if a German resident employee is granted options and then moves to Belgium where he then exercises the option, there would be no tax charge on grant in Germany and no tax charge on exercise under the Belgian rules. Furthermore, the subsequent sale of the shares would not lead to a capital gains tax charge in Belgium. 
And so how is this problem addressed by double taxation treaties? There being no specific article in the OECD Model Treaty dealing with stock options, the OECD issued a series of recommendations to clarify how tax treaties should address the differing interpretations of countries on this subject. The 2005 publication, The Taxation of Employee Stock Options is a comprehensive run through of the issues, as summarised below.

In the first example above of potential double taxation, Article 15 of the OECD Model Treaty allows the state of source to tax not only income from employment which is paid, credited or otherwise definitively acquired when the employee is present therein, but also any income obtained or realised before or after such presence that is derived from the services performed in the state of source (Belgium).  But this does not necessarily address the problem illustrated above, as it does not prevent the state of residence (say now Germany) from also taxing the same benefit at a different time and in a different way under the domestic rules of that state. The problem of relieving double taxation when the two states do not tax the option at the same time is partly addressed by the fact that the double taxation provisions of the OECD Model Treaty are not restrictive in terms of time i.e. relief must be given even if the state of residence taxes at a different time from the state of source. The OECD added a new paragraph 2.2 to the Commentary on Article 15 which addresses this issue.

Another issue arises where the two states not only tax at different times but also characterise the benefit differently. Although there may be no doubt that the granting by a company of an option provided as part of an employee’s employment package constitutes “salaries, wages and other similar remuneration” for the purposes of Article 15, it could certainly be argued that the holding and subsequent exercise of the option is an investment leading to a capital gain under Article 13, which unlike Article 15 does not allow source taxation of the gain. Some commentators have argued that this analysis should only apply to the part of the gain that accrues after the option has vested since the employee cannot make an investment decision to keep or exercise the option before that time. It has also been suggested, however, that any benefit derived from the option, including any gain realised upon the sale of shares acquired with that option, should be considered as employment income as the employee exercised the option and acquired the share solely because he was remunerated with that option.

Although some countries treat the entire benefit from a stock option as a capital gain, a larger number of countries tax as employment income the whole gain realised at the time of exercising the option, therefore indicating, for the purposes of Article 13 and 15, a dividing line between when the option is exercised and when the employee becomes a shareholder. The OECD shares this view so that any benefit accruing in relation to the option up to the time when the option is exercised, sold or otherwise alienated should be treated as income from employment to which Article 15 applies. Indeed, the new paragraph 32 to the Commentary on Article 13 states these conclusions.

The 2005 Report also addresses other potential areas for difficulty, such as determining to which services the option relates where the services are performed in more than one state and multiple residence taxation. These proposals are in important step in harmonising the disparate tax rules for stock options.

C. Approved schemes vs Non-Approved schemes

The United Kingdom allows for two types of employee option schemes that are selective in nature i.e. offered on a selective basis to key personnel: the company share option plan (CSOP) and the enterprise management incentive share option scheme (EMI). It is these schemes that may interest Polycon, rather than the all employee schemes.

Under a CSOP selected employees, including directors, may be given an option to buy a certain number of shares at a future date at a price fixed at the time the share options are granted at the maximum share value of £30,000 per person. Participation in the scheme is not open to employees who own more than 25% of the company. Subject to the scheme receiving a preliminary HMRC approval, no income tax and National Insurance Contributions (NICs) is charged on the exercise of the option provided the option is exercised between three and ten years after it was granted. Full tax relief is available when the option is exercised early due to exceptional circumstances. Subsequent disposal of the shares acquired by the option will be chargeable to capital gains tax under normal conditions. The base cost would be the exercise price paid for the shares plus the amount chargeable to income tax.

The EMI Scheme is for smaller, higher risk companies. In order to qualify, the company’s gross assets must not exceed £30 million, and conditions are attached to the amount of work that employees must do for the company. Options over shares worth at the date of grant up to £120,000 (including any amount granted under an approved CSOP) can be granted. This is subject to a limit of £3 million of options for the company as a whole. Subject to certain restrictions, income tax and NIC exemption is subject to the condition that an EMI option is exercised within ten years.

In circumstances where share options are granted under the UK approved schemes, the eventual gain on sale of the shares is subject to capital gains tax calculated on the ordinary basis after deducting all costs incurred in acquiring the shares. Where share option schemes are unapproved, and subject to income tax at the date of exercising the options, the subsequent sale of the shares will nevertheless also be subject to capital gains tax calculated by reference to the difference between the basis on which the income tax charge is calculated as above (market value at the time of exercising the options), and the eventual net sale proceeds.

Thus the UK encourages employers to motivate their staff through participation in the company’s share capital through offering substantial tax benefits. These primarily relate to the absence of income tax liability on exercise of the options as any subsequent disposal of shares is uniformly subject to the capital gains charge. The major draw-back of HMRC approved schemes is a frequent inability of foreign corporations to comply with the requirements attached to such option plans or their unsuitability for a particular enterprise. By way of example, failure to have a UK permanent establishment or to exercise a qualifying activity automatically precludes a company from implementing an EMI. Alternatively, the £30,000 share value per person barrier may deter it from introducing a CSOP, particularly for top executives. Therefore, non-approved schemes are often used, leading to the tax consequences explained above.

In the United States, stock option plans are either ‘qualified’ or ‘nonqualified’ in nature. Preferential tax treatment is given to the holders of options issued under qualified plans in that there is no realisation of income for federal income tax purposes when the option is issued by the company or exercised by the holder. In the case of nonqualified stock options an employee will realise income, at ordinary income tax rates, when they exercise their options if the fair market value of the shares purchased exceeds the price they paid for the shares under their option.

Thus, if the fair market value of the shares under a nonqualified plan, when the options are exercised, is greater than the option exercise price, the employee’s tax obligation can be substantial. Since the employee’s profits in the stock may not be liquid (i.e. the stock may be restricted or the market for the stock may be limited) he may have to pay those taxes from his other resources.

By contrast, holders of qualified stock options incur no federal tax obligations until they sell their stock at a profit, with no income being realised when the option is issued or exercised. When the stock is later sold, the gain realised is taxed at the lower personal capital gains rates.

The significant benefits of qualified stock option schemes are conferred only after authorisation has been granted by the IRS, and are subject to shareholder approval within 12 months of adoption by the company’s board of directors.  Specific classes of employees must be identified, with each option valid for no more than 10 years.  Most important, as with the UK, there is an upper limit so that the total fair market value of stock subject to qualified options that can vest in any one employee in any one year cannot exceed $100,000. If less than the total $100,000 in value is not used in a given year, a portion of the unused part may be exercised in later years.

Any incentive stock option plan that does not meet all of the requirements of a qualified stock plan, is treated by the IRS as nonqualified. This means that although the employee will not receive the tax advantages of holding qualified options, they will not be subject to the $100,000 value limitation or to the requirement that they are employees. Nor does the term of their options need to be tied to their employment.

Nonqualified options issued to employees also entitle the issuing company to deduct against its income tax obligations an amount equal to the compensation income attributed to the employee upon the exercise of the option. The amount of this deduction is the same as the amount of income attributed and taxed to the employee because of his exercise of the option, being the difference between the option exercise price and the fair market value of the shares purchased. To be certain of obtaining the deduction, the company should be sure to withhold the proper amount from the employee’s income.

It is also important not to forget the alternative minimum tax (AMT) consequences of obtaining rights under a qualified plan. The difference between the holder’s exercise price for the shares in a qualified plan and the fair market value of those shares when he exercises the option is a tax preference item that may become subject to the alternative minimum tax. The application of the AMT rules can make qualified options less attractive to these individuals.

D. Alternative Stock Option Plans

A company that wishes to incentivise its employees in a tax efficient manner without necessarily granting them control over their option shares may benefit from alternative arrangements which are designed to create capital gain from investment rather than employment income. The main features of such plans involve the company granting the staff the right to buy say non-voting shares, which can be retained or sold for gain, provided that the employer does well and the shares appreciate in value. The acquisition of such shares will not trigger an income tax or NIC liability, whilst the disposal of such shares will create a capital gains tax liability.

The plan may further be split into separate stages and is best illustrated by an example. The employer may wish to incentivise its employees and grant them the right to buy in aggregate say 20 percent of its non-voting dividend bearing shares. In furtherance of its goal, it sets up a discretionary unit trust that will hold the shares during a relevant period of say 5 years, so that the employees do not have absolute access to these shares during that period.  Assume that the shares have an expected dividend yield of 5% p.a.

The company extends non-recourse loans to the employees at say a 5% annual interest rate. The individuals use the proceeds of these loans to acquire units in the unit trust (used as security for the loans).  In turn, the trustees of the unit trust use the amounts received from the subscription of the units to subscribe for 20 per cent of non-voting shares in the company. The underlying trust deed provides that through holding the trust unit, the employee is beneficially entitled to the income from the relevant assets of the trust, which in this case comprise the non-voting shares.

The company declares dividends on its non-voting shares, which it distributes to the unit trust. The dividend amount is calculated to be equal to the interest on the loans owed by the employees. The unit trust distributes the dividends to the unit holders, who use them to repay the interest on the loans to the employer.

At the end of say a five year period, the trustees of the Unit Trust exercise their discretion over the trust assets, and redeem the units by distributing the non-voting shares in specie to the employees. The employees are then at liberty to keep the shares and receive dividends or sell them for gain, chargeable to capital gains tax.  The original loans plus interest are still accruing, or the employees may repay the loans (which may indeed be a condition of the in specie distribution.

If the employer company is unable to declare dividends on its non-voting shares, thus ceasing the only source of the unit trust’s (and by proxy the employees’) income, the company allows the interest due from the employees to be accumulated until better times.  Should the company neither be able to declare dividends nor increase the value of its non-voting shares to grow in excess of the loans plus cumulative interest, the employer waives the loan and covers out of its own funds the income tax and NIC chargeable on the waived loan and interest, thus keeping the employee’s tax position unaffected.

Employer companies often calculate that the limited costs of alternative stock option plans (even with potential income tax charges if the company fails to increase in value) is a much better ‘option’ than incurring the substantial costs of entering into stock option arrangements, accepting the restrictions imposed under approved schemes, and potentially exposing employees to unintended tax costs as outlined above.

The post September 2010 (103) – Incentivising Employees through Securities Options appeared first on IFS Consultants Ltd.

I hope all our readers are enjoying an exceptional summer with family interests taking over from work. And perhaps the last thing you want to receive is a newsletter analysing technical issues which do not necessarily need to be thought about when the sun is shining. But maybe it is useful to take a half hour respite in the shade and allow this month’s topic to permeate your relaxed brain so that you can avoid nasty tax surprises leaping out at you when the weather turns.

Indeed, the question that I am being asked consistently by clients is whether they have a taxable presence in another country as a result of their business activities. It makes no sense to find out years later that the local tax authority has decided to raise an assessment based on such a taxable presence which could totally negate the benefits of any corporate structure created. Even worse is the potential double taxation which could arise, and which could be avoided with a better understanding of what constitutes a taxable presence in another country.

I did write about the concept of permanent establishments in our December 2009 newsletter but make no apology for repeating much of that material within this comprehensive article which our new colleague, Dmitry Zapol, has written. Dmitry, who has joined IFS as from the beginning of this month, is a Russian lawyer who spent several years working at Barshevsky & Partners in Moscow before coming to the UK to embark on an international tax planning course. It was while he was a student of mine at the Institute of Advanced Legal Studies MA course on International Taxation that I became aware of his competency in understanding the commercial, legal and tax issues of client requirements, and I look forward to introducing him to you at future meetings.

In the meantime, in addition to the issues raised in the December newsletter, Dmitry has included relevant legislative and juridical information provided by contributing authors to our new book (with the same title), the 2010 edition of “International Tax Systems and Planning Techniques” or ITSAPT. This is being published by Sweet & Maxwell in September 2010 and will be available (at a discounted price) at our Conference at the Landmark Hotel in London on 28th October.

Dmitry has used the case study of ITSAPT as the basis for this month’s article. As I have explained in other emails, the ITSAPT Conference analyses the development of the Polycon Group into a worldwide conglomerate, exploring the tax issues arising at each stage of the group’s development. Clearly, the permanent establishment concept is just one of the issues which will be relevant during the planning of the growth of Polycon into a multinational group, and the contributing authors to ITSAPT will be discussing at the ITSAPT Conference how these various issues are interpreted by the tax administrations of their particular country. 
I hope that you enjoy reading this, and would welcome any comments that you have (click here). Also, in the event that you would like further information about the Conference, please click here.

POLYCON CASE STUDY

In life two things are certain: death and taxes. The optometrist-turned-entrepreneur Mr Stephen Holmes was having none of the former: he exercised regularly, ate well and practiced yoga in the back yard of his family home in the Northern European Republic, or NER as it was commonly called. As to the latter, Mr Holmes had a nagging feeling that the taxman would ring more than once and in more than one country where Mr Holmes’s Polycon Lens Company Ltd (or simply Polycon) was putting down its roots.

We are reminding you that Mr Holmes is the protagonist of the case study that lies in the beginning of International Tax Systems and Planning Techniques (ITSAPT) – the leading international tax reference book which Roy started over 27 years ago and which completed its 59th loose leaf version in April this year. It has now been re-written, brought up to date as at the end of June 2010 and will be available in a bound version and on-line as from September 2010. Roy would like to thank our colleagues in over 30 jurisdictions for their invaluable contributions to this new book.

The story of the case study follows Mr Holmes, who uses his training as an optometrist to make a break-through in acrylic lenses manufacturing. Mr Holmes establishes the first Polycon company abroad in the Central European Republic (CER) to manufacture haute couture spectacles, soon broadening his product range with military telescopic lenses and then supplying both kinds of product to customers worldwide. Polycon goes through the increasingly complex stages of business development. A small start-up soon has an established board of directors, subsidiaries, representative offices, agents, storage facilities and distributors, all in different jurisdictions worldwide.

Mr Holmes is advised by Maurice Brightman – an international tax advisor, who some may know from Roy’s earlier book The Principles of International Tax Planning. While Mr Holmes instigates the company’s development, Mr Brightman plans for the tax-efficient international development strategy. Mr Brightman knows when there is a permanent establishment and what it entails, advises what kind of business entity to choose for a particular purpose or cautions against high gearing to avoid the effect of thin capitalisation provisions. With Mr Brightman’s help Polycon soon turns into a listed diverse international conglomerate that boasts its own in-house finance company, e-commerce subsidiary, real estate investment group and an off-shore private equity fund.

Each stage of Polycon’s development in various fictional jurisdictions is interspersed with references to different countries’ chapters of ITSAPT to demonstrate the variety of the relevant international tax planning issues. The book thus serves a double purpose of being an encyclopædia of practical taxation in 31 different jurisdictions and providing model answers to common tax planning issues that an international minded entrepreneur may encounter.

Let us return to Mr Holmes who wants to venture beyond Polycon’s birthplace in the CER and expand the company globally, but who is wary that entering foreign markets will cause Polycon to incur heavy foreign tax liabilities. Mr Holmes asked Maurice Brightman to explain to him in uncomplicated terms whether and on which basis will a foreign state claim the right to tax a non-resident company running a business in its territory.

Mr Brightman began his foray in international tax law by explaining that states levy taxes on the basis either of residence or source of income. Thus domestic companies, which are incorporated and registered there, may be taxed on the basis of residence, whilst foreign companies may also be taxed if the source of their income is in that state. Such foreign companies may conduct their business in the relevant territory through a registered branch, and the profits allocated to that branch will therefore be subject to domestic tax.

Such a simple explanation was clear to Mr Holmes. “But surely, I do not HAVE to register Polycon’s branch abroad,” he ventured, “can’t I just sign a contract with a buyer abroad and ship him the goods or rent a foreign warehouse quietly and sell the lenses from there?” “My dear Holmes,” – Mr Brightman replied, “unfortunately things are not as elementary here as we would like them to be.” This time Maurice explained to Mr Holmes the concept of the permanent establishment of a foreign company abroad (usually shortened to “PE”). The PE is that margin that separates a foreign corporation merely appearing as a blip on the domestic market’s trading activity radar from the same corporation establishing itself permanently on the foreign soil and whose profits, attributable to that place of business, are taxed under local laws.

Mr Holmes was surprised to learn that such seemingly subjective concept could be defined by rules, which existed in the laws of practically all jurisdictions; these though could be superseded by the definition given in any relevant double tax treaty entered between the state of the parent company and that where the PE was deemed to exist. Where, however, the definition of the PE under domestic law is more favourable to the taxpayer, it can normally be used in lieu of the double tax treaty definition.

The basic definition of the term ‘PE’ is a fixed place of business through which the business of an enterprise is wholly or partly carried on. This contains the three basic conditions: the existence of a “place of business,” such as premises or sometimes machinery or equipment; the place of business must be “fixed,” that is, it must be established at a distinct place with a certain degree of permanence; and the business of the enterprise must be carried on through this place of business by its personnel.

Pre-empting Mr Holmes’s questions, Maurice moved on to consider some examples.

Were Polycon to deliver a few shipments of lenses to the foreign buyer, it would only have a temporary place of business in his jurisdiction (such as its delivery lorries in the cargo unloading area.) Generally it is considered that anywhere which has a duration of less than six months could not be considered a fixed place of business.

Let us now suppose that Polycon decides to penetrate a foreign market. It sends an employee abroad who finds office space, brings products samples, organises viewings and establishes client relationships, although yet conducts no sales. In legal terms such activities would most likely be considered to be “preparatory and auxiliary,” and Polycon would still have no PE abroad; it would have no reporting or tax liabilities.

Polycon would have a PE abroad were it to rent an office abroad for, say, 12 months and to start selling goods to local customers. The most important point though is whether Polycon has a right to use premises, even if they are indeed fixed and exist for more than six months. Thus the company must either own, rent or otherwise have premises available for its use as a result of a legal right. So if Polycon had signed up with a foreign landlord to occupy an office for 12 months, even if it is only actually selling there for one or two months, Polycon would have the legal right to use fixed premises at a specific location for a certain duration, and this is where its business is carried on. Ergo, a PE (taxable presence) would exist. Alternatively, Polycon could use the garage of Mr Holmes’s foreign uncle under an oral agreement; or a Polycon salesman could arrange sales over the phone from the foreign club of which Mr Holmes is a member – the result would still be the same.

Carrying on of the business of the enterprise through the fixed place of business usually means that persons dependent on the enterprise (personnel) conduct its business in the state where the PE is situated. Polycon’s personnel may include both paid employees and dependent agents, i.e. companies or individuals who are not employed by Polycon but are under a contractual arrangement with and receive instructions from Polycon. This should be contrasted with the situation where Polycon retains an independent firm or a broker (i.e. an independent agent) that specialises in sales of lenses and caters to the needs or several manufacturers. On the condition that such entity is independent from Polycon both legally and economically and Polycon cannot control its activities, as well as if it acts in the course of its ordinary business capacity, there will be no PE.

Neither will there be a PE where Polycon incorporates a foreign subsidiary – the latter will be taxed independently and will distribute dividends subject to withholding tax. Should, however, Mr Holmes, as the shareholder of Polycon, decide to excessively interfere with how the subsidiary’s CEO or the board conduct their business in the country of the subsidiary’s incorporation, the local tax authorities may come to the conclusion that a PE of Polycon itself exists.

Although it is usual for the business to be carried on mainly by natural persons, a human being need not necessarily perform the activities. Were Polycon to install an automatic spectacles dispenser abroad, it would thus constitute a PE from the moment of commencement of sales. Mr Holmes was also very keen on the idea of selling his products over the Internet. He envisaged sales through an online retailer, such as Amazon and eBay, as well as creating Polycon’s own website in the local language. Maurice explained that e-commerce is a complex topic in the international tax planning world and is subject to constant change. Currently, however, selling spectacles lenses through the above e-tailers or through a dedicated corporate website does not normally constitute a PE in the absence of the location that can constitute a “fixed place of business available to Polycon.” This should be contrasted with acquiring a foreign server, locking it up in a room to which Polycon has regular access, and using it to host the foreign website. On the condition that the server is fixed (i.e. literally bolted to the floor, as opposed to being a laptop) and Polycon has access to the room it is located in, the server may constitute the place where the business is carried out, resulting in the existence of a PE. The usual way to circumvent this would be to lease server-space from a specialised foreign company (ISP).

“These provisions,” – concluded Maurice, “constitute the basis for the concept of the PE in the field of international tax planning and are typically used by states across the world as the starting point in drafting of their domestic laws or negotiating double tax treaties.” Maurice then proposed to look at how the idea of the PE may differ across jurisdictions, taking a dog-eared and heavily underlined copy of ITSAPT from the mahogany bookshelf.

Mr Brightman began by pointing out that PEs, in addition to direct primary taxation, often suffer the same secondary withholding tax (as for example the branch level tax levied by France or Spain), which can create double taxation issues if assessments are raised much later when a foreign tax jurisdiction becomes aware of the existence of a PE. It may be, for example, that Polycon is time barred from claiming any relevant credits that would otherwise be available. He then proceeded flicking through the book’s pages, reading from the bookmarked passages.

Mr Holmes learnt that, for instance, France, in addition to using the concept of the “fixed place of business,” explained above, deems a PE to exist where the foreign company has derived income from a complete cycle of commercial operations that has been performed in France, and which is disconnected from the other operations of the foreign company (a so-called cycle commercial complet).

Quite unusually, Canadian legislation starts with a fairly expansive definition of “permanent establishment”. Absent the normal starting point of a fixed place of business, the definition expands the term to include “where the person carries on business through an employee or agent, established in a particular place, who has general authority to contract for the person or who has a stock of merchandise owned by the person from which the employee or agent regularly fills orders, the person shall be deemed to have a permanent establishment at that place” but does provide “the fact that the person has business dealings through a commission agent, broker or other independent agent or maintains an office solely for the purchase of merchandise shall not of itself be held to mean that the person has a permanent establishment.”

Another interesting feature of the Canadian legal framework results from case law. An American taxpayer convinced a Canadian court that he did not have a fixed base in the premises of his client because the taxpayer’s access to those premises was restricted and he did not identify or use the premises as his own – even though he attended there most of the year. Canada responded by renegotiating that section of the Canada-U.S. Tax Treaty to capture such activity as a Permanent Establishment starting in 2010 if carried on for more than 183 days in any twelve month period, and if either more than 50 percent of the gross active business revenues of the enterprise consists of income derived from the services performed in that other State by that individual, or the services were to the same customers.

Australia follows the general provisions of residence and source, the latter being determined both by general law principles worked out over the years by the courts and by specific statutory provisions. Thus income derived from carrying on a business (which includes a gain made on the disposal of an asset made in the ordinary course of the business or as part of a profit-making scheme) will be subject to tax in Australia where that income is Australian sourced. The concept of ‘source’ is not defined in the Tax Act, but given under case law. The judgement of Issacs J in Nathan v F.C. of T (1918) 25 CLR 183 is commonly cited for this purpose: “The legislature using the word ‘source’ meant not a legal concept, but something which a practical man would regard as a real source of income. Legal concepts must, of course, enter into the question when we have to consider to whom a given source belongs. But the ascertainment of the actual source of the given income is a practical hard matter of fact, the Act on examination so treats it.”

States may have different attitudes to interpretation and application of the basic conditions outlined earlier. Thus, as for most countries, Luxembourg stipulates that a non-independent agent of an enterprise which has authority to conclude contracts on behalf of and to commit the enterprise contractually, may create a permanent establishment of such enterprise in Luxembourg, based on that agent’s specific factual situation. However, it is not necessary for the agent to be a Luxembourg resident for his activities in Luxembourg to create a permanent establishment of an enterprise in Luxembourg.

A sales agent or commission agent that has other customers and does not act exclusively for one enterprise may be regarded as an independent agent. The authority to conclude contracts is understood as being the ability of the agent to represent the enterprise in such a manner that the enterprise is legally bound by such authority. Being able to bind the enterprise and complete a transaction is relevant, but mere signatory powers are normally not sufficient to create a permanent establishment. Compare this with the approach adopted in the UK. In determining whether one person is an agent for another, HMRC will examine the three “Rs”—risks, responsibilities and rewards. In deciding whether a branch/agency exists or not, the presentation of the facts, explanation and interpretation of those factors will have an influence on the opinion of the tax inspector.

There are also different approaches to the establishment of the existence of a PE in e-commerce situations. In Italy domestic law takes a stance opposed to the one discussed above in that it excludes the possibility that a “server” used for the purpose of selling goods and services may constitute per se a PE. However, the suitability of such equipment and its use for the commercialisation of goods and services belonging to the foreign enterprise might constitute evidence of the existence of a PE in Italy. The UK concurs with the Italian position. It takes the view that a server, either alone or together with web sites, could not as such constitute a PE of a business that is conducting e-commerce through a web site on the server. Surprisingly, this is regardless of whether the server is owned, rented or otherwise at the disposal of the business.

Maurice kept talking. He explained to his friend such (what Mr Holmes thought to be) arcane ideas, as establishment of the PE through a mine or an oil well, both in and outside the country’s territorial waters; the difference between states in the length of the construction period following which a contractor acquires a PE; the significance of the PE for VAT purposes and varied attitudes of jurisdictions to tax avoidance schemes using the PE concept. It was a long day but Mr Holmes learnt a lot. He thought that the most valuable lesson was the realisation that prior to entering a foreign market, the business owner should consider its expected level of involvement and the scope of its future activities. This should be weighed against the tax consequences arising from a PE that may be established as a result of such market penetration. Last, but not least, the treaty network and domestic laws of the target jurisdiction must be analysed. And finally, one should let professionals be good at what they are doing and leave tax planning to Maurice Brightman with his trusted ITSAPT!

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