Place of effective management- tax residency of companies

This article will focus on tax residency of companies, with a particular focus on the meaning of "place of effective management".

1.     Introduction

Prior to any country imposing a tax, there has to be a nexus between that country and the income (that country intends to tax). Two major principles in ascertaining whether there is in fact a link between the country and the income are the source and residence principles of taxation.

In South Africa, a resident for tax purposes pays tax on its worldwide income. A non-resident for tax purposes will only pay tax in South Africa on income that is, or is deemed to be, from a South African source. It is important to understand the concept of tax residency, as failure to understand can lead to situations where a taxpayer is unaware that they may in fact be a tax resident of South Africa (for example, a foreign company trading in South Africa, with its place of effective management located in South Africa) and may lead to potential double taxation of income earned by that company.

2.  Residency for tax purposes    

In terms of Section 1 of the Act, a resident (other than a natural person) is:

“(b) person (other than a natural person) which is incorporated, established or formed in the Republic or which has its place of effective management in the Republic [note- i.e. it need not be incorporated in South Africa- it could be a foreign company, but if managed from South Africa it could be regarded as a tax resident of South Africa if it meets the criteria]

but does not include any person who is deemed to be exclusively a resident of another country for purposes of the application of any agreement entered into between the governments of the Republic of that other country for the avoidance of double taxation...”.[3]                                              

Accordingly, to ascertain whether a juristic person is a resident in the Republic for tax purposes, it would need to be incorporated, formed or established in the Republic or have its place of effective management (“POEM”) within the Republic. In the event of dual tax residency, a double taxation agreement would need to be looked to in respect of a "tie-breaker" rule, which will assist to determine, in terms of the tie-breaker rule, which country the entity is a tax resident of for the purposes of the double taxation agreement.

2.1  INCORPORATED, FORMED OR ESTABLISHED IN THE REPUBLIC

S13(1)(b) of the Companies Act 71 of 2008 (the “Companies Act”) provides that a company may be incorporated in South Africa by filing a notice of incorporation with the Companies and Intellectual Property Commission.[4]

Accordingly, a company is naturally a tax resident in South Africa if it is incorporated in South Africa. 

2.2 POEM

At present, there is no definition within the Act for “POEM”. In terms of the Constitution of the Republic of South Africa, “when interpreting any legislation, every court must prefer any reasonable interpretation of the legislation that is consistent with international law over any alternative interpretation that is inconsistent with international law.”[5]

Hence, to establish what POEM means, common law, judicial precedent and international law would need to be consulted, from a South African perspective.

2.3 OECD MODEL TAX CONVENTION

The Convention states that the POEM is:

“the place where the key management and commercial decisions that are necessary for the conduct of the entity’s business are in substance made. All relevant facts and circumstances must be examined to determine the place of effective management. An entity can have only one place of effective management at any one time.”[6]

2.4 CASE LAW

In De Beers Consolidated Mines v Howe[7],it was stated that “a company resides is where its real business is carried on… and the real business is carried on where the central management and control actually abides.”

In Untelrab Ltd v McGregor[8]the principle was established that even though the board may do what it is instructed to do, it does not mean that the central management and control is with someone else, provided the board exercises discretion when deciding what to do, and also refuses to partake in a decision that is unwise or improper.

In Laerstate BV v HMRC[9], it was stressed that not only the actions of the board of directors must be considered in determining the POEM, but the decisions of any persons who were involved in making the strategic decisions of the company.  It also stated that where the directors meet is only a matter of fact, but if decisions were made outside of board meetings, then it needed to be ascertained as to who made those management decisions and where. The court also looked at the actions of the director to establish whether he had control over the company or he acted in a secondary capacity.

In Commissioner for Her Majesty’s Revenue and Customs v Smallwood and Another[10](a United Kingdom case), it was held that POEM is where the key management and commercial decisions are made, where the highest senior management makes their decisions. It was also held that no definitive rules could be given and all circumstances, both objective and subjective, need to be considered. Most importantly, the court held that whilst an entity may have more than one POEM, it could only ever have one POEM at any given time.

In Oceanic Trust[11], the court dismissed the taxpayers’s appeal against its tax assessment, on the grounds that the Trust had not proved that its POEM was not in the Republic (as the onus is on the taxpayer to prove that it is not a resident, and not the Commissioner). 

2.5 SARS Interpretation Note 6 (version 2)

SARS issued a first version of the Note, which was inconsistent with the Organisation for Economic Co-operation and Development’s (OECD) article 4 of the OECD Model Tax Convention on Income. Following the Oceanic Trust case judgment (which was in line with article 4), SARS issued a second issue of Interpretation Note 6 to deal with the Oceanic Trust judgment and to bring the Interpretation Note 6 (version 2) (the “Note”) in line with article 4.  In terms of the Note, POEM is where the “key management and commercial decisions that are necessary for the conduct of its business as a whole are in substance made”[12] (simply put "where most of the shots are called").  

This definition is in accordance with article 4 of the OECD Model Tax Convention[13](the “Convention”). Whilst the Republic is not a member party to the Convention, in practice the Convention is utilised in most Double Taxation Agreements (“DTAs”) to which the Republic may be a party to. POEM plays an important role in Article (4)(3) of the Convention, which is a tiebreaker rule where a resident (other than a natural person) is considered to be a resident of both the Contracting States which are party to a DTA.

Interpretation Notes are not binding on our courts, as was stated in ITC 1675 62 SATC 219[14].  South Africa is however obliged to acknowledge the OECD’s Convention guidelines, as was stated by the court in SIR v Downing[15].

2.6 SUBSTANCE OVER FORM

The principles as stated above and which are relevant in establishing whether a POEM is in question, it is evident that such principles are subjective rather than objective (the “substance over form”) test. Accordingly, in terms of the Note SARS would likely consider the following to be substantial circumstances in determining where a company’s POEM is:

1.     The location of the head office of the company. This is where the company’s senior management and the support staff of the company are most likely to be located and run the operations of the company, and make the most key strategic decisions.

2.     Delegation of authority, where the board has delegated part or all its authority to an executive committee, which exercises and makes the key management and commercial decisions of the company.

3.    The place with the board meets, provided that the board of the company exercises autonomy and discretion in making key management and commercial decisions.

4.     Modernisation and global travel and circumstances applicable to where decisions take place.

5.     Shareholders and whether they exercise controlling influence over the company and whether they usurp power and limit the authority of the board.

6.     Operational management versus broader top level management-  where a distinction is made between operational management, which are the day-to-day business decisions of the company, in contrast to the key management and commercial decisions.  Consideration would need to be given as to what are deemed to be operational decisions and what are key management and commercial decisions.

7.     Legal factors, for example the country of incorporation.

8.    Any economic nexus between the company and the relevant country.[16]

By way of a practical example, a non-resident for tax purposes natural person may decide to immigrate to South Africa for leisure reasons. If such non-resident directly/ indirectly owns a foreign company, and "calls the shots" in respect of the effective management of the company from South Africa, such foreign company could be at risk of being regarded by SARS as being "effectively managed" from South Africa, with the result that the foreign company could be deemed to be a tax resident of South Africa.

3. Conclusion

It is essential that taxpayers seek legal advice in respect of the tax residency status of their foreign companies, and take cognisance of the implications of effective management of foreign companies from South Africa. Failure to plan correctly, or seek advice, may have significant consequences for the taxpayer, such as being regarded as a tax resident in more than one jurisdiction, and of course, penalties/fines and/or interest on late payment due to incorrect filing and/or non-filing of returns.

This article has been prepared by the writer, Natalie Macdonald Govender, which may contain errors and/or omissions, and should not be regarded as legal advice.

Copyright.

[2]The Income Tax Act 58 of 1962, Section 1

[3]Income Tax Act 58 of 1962, Section 1

[4]Companies Act 71 of 2008, Section 13(1)(b) 

[5]S233 of the Constitution of the Republic of South Africa, 1996

[6]Model Tax Convention on Income and on Capital (Condensed Version) (2014) OECD, article 4(3)

[7][1906] AC 445 

[8][1996] STC(SCD) 1 

[9](HMRC) [2009]

[10][2010] EWCA Civ 778

[11]Oceanic Trust Co Ltd N.O , and the Commission for the South African Revenue Service 2011

[12]SARS Interpretation Note 6 version 2: “Place of Effective Management” 

[13]Model Tax Convention on Income and Capital (Condensed Version) (2014) OECD

[14]ITC 1675 62 SATC 219  

[15]SIR v Downing, 37 SATC 249 

[16]SARS Interpretation Note 6 version 2: Place of Effective Management