Corporate tax residence: Avoiding the dual residence pitfall

In summary:

• It’s a common misconception that incorporating a company outside the UK is sufficient to ensure that the company will not be UK tax resident
• In reality, the central management and control test means that if key decisions are taken in the UK, the company will be considered tax resident there 
• Since many other countries determine residence by reference to incorporation, a company may be resident overseas while simultaneously being treated as UK resident 
• The risks have been heightened by new tests under the new BEPS Multilateral Instrument (MLI) introduced by the OECD, reducing certainty and increasing complexity 

When establishing a company overseas, it is common for business owners and investors to focus on where the company is incorporated. However, incorporation is only the first part of the analysis. If residence is not managed appropriately, companies can inadvertently become tax resident in more than one jurisdiction. This introduces complexity and uncertainty into the structure, as well as creating compliance burdens and potentially increasing tax costs. 

Each country has its own domestic rules to determine which companies fall within its jurisdiction for tax purposes. The UK applies two principal tests. A company will generally be UK tax resident if either: 

• It is incorporated in the UK
• Its central management and control (CMC) is exercised in the UK 

The incorporation test is straightforward. A company incorporated under UK company law will ordinarily be treated as UK tax resident. The CMC test is fact-sensitive and is often more challenging, however. It focuses on where the highest level of decision-making takes place within the company, not the day-to-day operations or administrative activities. 

In most cases, CMC will be exercised in board meetings by the board of directors. But the board's formal authority is not conclusive; if the directors do not genuinely exercise control, or decisions are taken outside the board meeting, CMC will be located elsewhere. Tax residence issues can arise where the board meeting does not feature a substantive decision-making process but merely gives formal approval to decisions taken elsewhere. 

A common misconception is that incorporating a company outside the UK is sufficient to ensure that the company will not be UK tax resident. In reality, merely incorporating a company overseas but exercising strategic oversight from the UK is problematic: it almost certainly means that the company will be UK tax resident under domestic law. 

Sometimes, business owners will go one step further. Having incorporated a company overseas, they will appoint local directors too. However, the substance-over-form approach adopted in the UK tax residence rules means that this still may not be sufficient. If those directors are not the real decision-makers, UK tax residence could still arise. 

Ultimately, if key strategic decisions are being made by individuals based in the UK, or if board meetings are routinely held in the UK and substantive decisions are taken there, the company can still be regarded as UK tax resident despite being incorporated overseas. 

The consequences of this can be significant. A UK-resident company is generally within the scope of UK corporation tax on its worldwide profits. Businesses that believed they were operating exclusively outside the UK may therefore find themselves exposed to unexpected UK tax obligations. And even where UK residence is successfully avoided, that is not the end of the analysis: a non-resident company can still be taxed here on the profits of a UK permanent establishment, an area which is itself subject to proposed change.

The position becomes even more complicated where the overseas jurisdiction also regards the company as resident under its own rules. As with the UK, many countries determine corporate residence by reference to incorporation, meaning that an overseas-incorporated company may remain resident in that jurisdiction while simultaneously being treated as UK resident under the UK's CMC rules. 

This dual residence situation is rarely a desirable outcome. At a minimum, it can create parallel filing obligations, significant compliance burdens and uncertainty over taxing rights. It can also disturb reliefs that a group would otherwise expect to be available: A dual resident company that is an investment company, for example, is generally prevented from surrendering its losses as group relief to other UK group companies. Dual residence can also give rise to so-called “hybrid mismatches”, triggering the UK anti-avoidance rules. 

Importantly, businesses often drift into dual residence unintentionally. The issue frequently arises not because of deliberate tax planning, but because governance arrangements do not align with the intended tax position. 

Fortunately, dual residence does not always mean double taxation. The UK has an extensive network of bilateral double tax treaties, which seek to resolve situations where both countries regard the same company as resident in their own jurisdiction. 

Historically, many treaties contained a “tie-breaker” rule based on the company’s place of effective management (POEM). Broadly speaking, this focuses on where the key management and commercial decisions needed to run the business are made, which can put more weight on senior day-to-day management compared to CMC.  

In most cases, CMC and POEM will point to the same territory, but they can diverge where the formal strategic decision-making sits in one place and the practical running of the business in another. Where a treaty with a POEM tie-breaker applies, the company would usually be treated as resident only in the jurisdiction where its POEM was located. While the analysis could still be complex, the test at least provided a framework for reaching a definitive answer. 

The position has changed relatively recently following the introduction of the Multilateral Instrument (MLI) as part of the OECD BEPS project.

Where both jurisdictions have adopted the relevant provision, the treaty is modified to replace the traditional POEM tie-breaker with a competent authority agreement procedure. Under this approach, the tax authorities of the two jurisdictions must seek to agree the company’s tax residence, having regard to a wider range of factors, such as where it is managed, where it is incorporated and any other relevant circumstances. Critically, if the two authorities do not reach agreement, the company is denied the benefits of the treaty entirely, save to the extent that they agree otherwise. 

This change has introduced a greater degree of uncertainty and has also removed a company’s ability to self-assess its tax residence. Businesses may now be required to engage with tax authorities in multiple jurisdictions and await an agreement between them. The process can be time-consuming, costly and administratively burdensome, and treaty benefits may remain uncertain until that agreement has been reached. 

That is not to say the outcome is unknowable. HMRC has published the factors the UK competent authority will typically weigh. These include CMC and POEM — so the earlier analysis is not wasted — but also where the company is incorporated and where its real economic substance lies.  

That last point can be decisive and is easily overlooked: a company with genuine premises and staff in one country may be treated as resident there even though its strategic control is exercised elsewhere. These are the factors the UK will bring to the discussion, however, and HMRC is clear that the other jurisdiction may not approach matters the same way. 

The Covid-19 pandemic changed how companies are managed. Directors found themselves stranded in jurisdictions where they would not ordinarily have been present, virtual meetings replaced physical board meetings, and management teams became increasingly geographically dispersed. HMRC and the OECD each published guidance at the time, indicating that temporary changes of this nature would not, of themselves, be expected to disturb a company's residence position. 

That guidance was a concession to exceptional circumstances, however, rather than a change in the law, and the law has not changed since. The core UK domestic tests remain unchanged, and no permanent relaxation of the residence rules has been introduced. What has changed is the factual backdrop. Hybrid working and virtual governance are now permanent features of how businesses operate, so the same long-standing questions must be answered on messier facts and with less obvious evidence. 

Corporate tax residence remains one of the more nuanced areas of international tax. In today's world of virtual meetings, hybrid working arrangements and instantaneous communication, running an overseas company from the UK is easier than ever before. However, that convenience can create significant tax risks. 

Given these, companies with international structures should: 

• Make a conscious decision about their intended tax residence 
• Ensure that their governance arrangements, board procedures and record-keeping practices consistently support that position 

A dedicated set of guidelines for managing the company's tax residence should be developed, followed, and reviewed regularly. 

Approval code: BTSAM072642