Many providers of offshore corporate services still promote offshore companies incorporated in tax haven jurisdictions as a panacea from taxation. They claim that the company is exempt from taxes in the country of incorporation. True. But it’s not carrying on any business in that country. Where does your offshore company carry on its business and pay taxes then?
Generally, there are two main principles that may define a tax residence of your offshore company: place of incorporation and source of income.
Place of Incorporation
Most countries charge their residents, be it an individual or a legal entity, to tax on their worldwide income. A number of countries, such as Panama, Hong Kong, BVI, have a territorial principle of taxation, meaning that only a domestic sourced income is charged to tax. And there are a vast number of so-called pure tax haven countries that provide for incorporation of companies exempt of taxation: international business companies, non-resident companies, offshore companies etc. The main principle a tax haven country follows is granting a company tax-free status in exchange for restriction to trade on its territory.
So, indeed your offshore company may not be taxable at the place of incorporation. But it might be taxed at the source of income.
Source of Income
Many highly developed countries have adopted similar legislation in this regard.
Normally, for an offshore company, i.e. a foreign company, to be recognized as a tax resident in a high-tax country two main requirements are to be met:
- the company carries on business on the territory of the country, and
- the central management and control of the company is located in the country (CM&C), or the voting power is controlled by shareholders who are residents of the country.
Generally, the company is to meet both requirements. The mere fact of carrying on a business in the country is not sufficient to make the company liable to tax in that country. If no business is carried on in the country, there is no need to go further and check whether its CM&C is located in the same country.
On the other hand, depending on circumstances, merely meeting the second requirement, the CM&C location, may lead to qualification of the company as a tax resident. There is also a concept of specific business activities inferring that place of business of the company is where its management is located. For example, in such business as investments in property or shares to generate rental or dividend income, acts of control and management are acts for carrying on business.
Central Management & Control
One or a scope of the following can evidence the location of CM&C of an offshore company:
- residence of the majority of its board of directors
- place of the majority of meetings of the board of directors
- residence of controlling shareholders, in cases where the company’s board is not in fact a strategic decision maker
- residence of “shadow directors”, or real directors, managing the company’s business, if the company’s board is recognized as nominee people with no power to control
- residence of another persons holding general power of attorney and acting on behalf of the company
- existence and residence of a parent company with substantial controlling powers over its offshore subsidiary
Generally speaking, it is about who is the high-level decision maker and where he resides when he makes decisions. Having authority to make high-level decisions does not automatically make a person the CM&C of the company. Most countries’ regulations require the exercise of such power or authority to a substantial degree.
If your company is recognized as a tax resident in the country where it carries on business, it is subject to tax on all income from sources in this country.
Double Taxation Treaties
It might happen that a company is recognized as a tax resident in more than one country. This can lead to double taxation of its profit, say, in the country of the profits’ origin and at home upon repatriation of the profits. Many countries with close taxation systems have concluded agreements on prevention of double taxation of their residents. They are often known as Double Tax Treaties (DTT). Most treaties contain a tie-breaking provision for dual residents, allowing them to pay taxes once, at home, unless they received the profit through a permanent establishment in another country.
Another benefit of using a DTT is lower withholding tax rates on dividends, interests and royalties received from the other country, which otherwise would in most cases be substantially higher.
In practice, this is not the case of offshore companies incorporated in most low-tax jurisdictions. “Pure” tax havens cannot provide their exempt companies with protection by a DTT with high-tax countries; there are no such agreements in place. Very few low-tax countries and territories, like Cyprus or Labuan (Malaysia), have a substantial DTT network with high-tax countries that can be beneficial under certain circumstances. In any way, a DTT can reduce a tax burden, but not exempt your offshore company from taxation.
CFC Attributed Income
Even if your offshore company is not paying taxes anywhere, it might happen that you are to pay tax on its profit yourself. Many developed countries have in place controlled foreign companies (CFC) regulations to prevent deferral of income repatriation and payment of taxes. If you have interest in such legal entity, a part of its profit as per your interest share may be attributed to you as your personal income, even if no formal dividends were ever distributed to you.
It is also appropriate to mention that very few tax havens offer exempt or low-tax regime to resident companies, as opposed to those non-resident ones mentioned above (international business companies, non-resident companies, offshore companies).
In some business, you may successfully use a properly structured non-resident tax-exempt company, dealing worldwide and paying taxes nowhere. But in some circumstances it might be very important for a company to have a certain and transparent tax residence.