In 2020, the Board of Taxation submitted a series of recommendations to the government for reformulating the Australian corporate tax residence rules. The then Coalition government proposed adopting the main recommendations, but whether the current government will implement these proposals remains uncertain. At the same time, there is an ongoing sentiment that the OECD/G20’s Base Erosion and Profit Shifting (BEPS) project has blurred the traditional residence and source dichotomy.
Australian tax history provides evidence that the corporate residence rules were founded on economic connections and can be seen as an alternative source test. Considering the several inconsistent reform options offered in the past, it is crucial to set a primary goal for the corporate residence rules, such as preventing base erosion and profit shifting.
Historical context and current operation
In Australia, corporate residence is determined by incorporation or, if a company is not incorporated in Australia, whether the company carries on business in Australia and has either its central management and control in Australia or its voting power controlled by shareholders who are residents of Australia.
The concept of corporate residence has significant tax implications in Australia. Resident companies are taxed on income from all sources, whereas non-resident companies are only taxed on income sourced in Australia. The determination of corporate residence is also crucial for applying various tax provisions, including those related to permanent establishments and controlled foreign companies.
Despite its importance, the principles for establishing corporate tax residence remain obscure. This is particularly true in relation the central management and control test.
In response, Australian courts have consistently applied the common law principle that assigns residence by reference to the superior authority or power to control a company’s affairs. Initially applied to assess the presence of economic activities for the purposes of income exemption provisions, this principle has been judicially interpreted in several landmark cases, such as Malayan Shipping and Esquire Nominees, where central management and control were deemed integral to carrying on a business.
However, several reform recommendations at different times in the past have confused the path of the central management and control test. For instance, in 2003, the Board of Taxation recommended replacing the three residence rules with a single Place of Incorporation (POI) test. Following this, the Commissioner of Taxation released Taxation Ruling TR 2004/15, taking a view that companies must also carry on a business to establish residence based on the central management and control test.
The TR 2004/15 approach would undermine the judicial position that high-level decision-making has sufficient economic attributes. The arbitrary distinction between active and passive dealings to operate the additional test likely raised administrative confusion.
The Bywater case and its implications
The latest High Court decision in Bywater in 2016 applied the central management and control test and established that central management and control does not need to be exercised by an appointed director or a shareholder in their legal capacity. The structural façade to disguise the real controller of the companies was struck down to prevent profit shifting abroad.
After Bywater, the Commissioner withdrew TR 2004/15 and replaced it with Taxation Ruling TR 2018/5, aligning administrative practice with established judicial principles.
This led to the 2020 report by the Board of Taxation, recommending that the residence rules be recast based on ‘sufficient economic connections with Australia’. The new standard would apply to the central management and control and voting power tests only, requiring companies to conduct core commercial activities in Australia to be deemed Australian tax residents.
The functional approach to test corporate tax residence based on substance
Given that there is no clear determination for corporate residence to be used as a principled basis for taxation, Omri Marian’s functional approach may be used as a benchmark for analysing corporate residence rules. This means examining residence rules against the prevention of profit shifting and base erosion in source taxation.
The acceptance of residence as an instrument to support source-based taxation of companies has historical merit in Australia. Malayan Shipping established that a company has its residence where it carries on business, and the place where the real business is carried on is where the company’s superior administration and control actually abides.
Esquire Nominees further establishes that control must be actually exercised, and Bywater provides that the person with the superior administration or control of a company need not be a director or a shareholder holding legal capacity or power to control.
Where it is possible for companies to operate in multiple locations through affiliated entities, the important function of corporate residence is to prevent profit shifting and base erosion. In this regard, the Australian Government has taken an over-inclusive approach to widely defining residence for companies. At present, there is no evidence to indicate that the current rules impede the intended operation of the law or give rise to significant integrity concerns. To this end, Bywater shows a judicial departure from the regimented application of the central management and control test.
The Bywater case, however, raises a question as to the necessity for retaining the voting power test. Establishing residence based on voting power ultimately involves seeking the superior or directing power of a company’s affairs, a question which can be answered under the central management and control test.
In other words, voting power does not appear to serve an independent function but may distort the conceptual justification for establishing corporate residence. The test has been little used, according to the Board of Taxation, and suggests no evidence of potential integrity concerns.
It is appropriate to remove the voting power test unless the government makes a change in policy underlying the corporate tax residence rules. This approach aligns with the global movement towards coordinated international taxation under the auspices of the OECD, particularly the BEPS project.
Conclusion
The Australian corporate tax residence rules have evolved through a confusing path with inconsistent reform suggestions. While historical and judicial interpretations have provided a framework, the 2020 recommendations highlight the need for a coherent approach. Functional analysis suggests that the current rules, especially the central management and control test, operate as intended.
Australian courts have assessed the substance of economic connections of companies through the lens of central management and control under the corporate residence rules. That said, it is difficult to define source taxation as source is ‘not a legal concept’ and the source of income is determined ‘in accordance with the practical realities of the situation without giving undue weight to matters of form, and not by the application of absolute rules of law.’
Some commentators have raised concerns that the BEPS project, particularly the recommendations for destination-based taxation and global minimum taxation, departs from the traditionally founded taxation based on residence and source. Whether this argument will succeed or a new framework of source taxation will develop remains uncertain.
In concluding, clear, consistent, and functional reforms are essential for the future of Australian tax rules, ensuring they align with both domestic policy and international taxation principles.
But why do we bother? The US has a place of incorporation test and that prevails under the tax treaty so any company wanting to have exempt overseas income can plan accordingly via Delaware.
It would be more sensible just to have a territorial tax system as we pretty much used to with s 23(q) or, better still, abolish the corporate tax and collect rents directly via a Federal land value tax.
I agree with your sentiment of ‘why not a territorial tax system’. For that discussion, I enjoyed reading Richard Bird’s ‘Why Tax Corporations?’. The lack of theoretical underpinnings of corporate taxation has been dealt with in Allen, C., N. Wilson-Rogers, and D. Pinto. 2022. “Restoring the place of effective management as a tiebreaker rule for corporate residence.” New Zealand Journal of Taxation Law and Policy 28 (4): 369-394. This article is written on the basis that countries nevertheless use the residence concept for corporate taxation, leaving the question to how then to design it. Given the existing tax framework, the international tax issue of how to address the relocation of residence remains.
It is interesting that in the USA the Constitutional justification for the corporation tax was as a franchise tax for the “privilege” of doing business in the corporate form. Rather amusing since one could always use a limited partnership as an alternative or a foreign incorporated company.
The imputation system makes a lot more sense, viewing the company as a withholding agent for profits taxable to its shareholders.