The Australian corporate residency test is a fundamental concept of international corporate taxation and it is most likely about to change in a significant way. In the 2020/21 Federal Budget (with no further changes announced in the 2021/22 Federal Budget), the Federal Government announced its plan to legislate to clarify – or perhaps more accurately, change – the test for foreign incorporated companies to require a ‘significant economic connection’ with Australia as a pre-condition to Australian residency.
While we wait for this process to be completed and because of an important case law development (namely, the High Court’s decision in Bywater Investments Ltd & Ors v Commissioner of Taxation; Hua Wang Bank Berhad v Federal Commissioner of Taxation  HCA 45 (Bywater)), the Australian Taxation Office (ATO) is currently applying the test in a way that is different to its historical application and is most likely different to how it will be applied in the future, after the planned legislative amendments are implemented.
Accordingly, it is now an opportune time for Australian corporate groups (typically with overseas subsidiaries) that have a tax planning agenda or mandate, to review the issue of tax residency status in a forward-looking way.
The core corporate residency test is legislative (as set out in section 6(1)(b) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) (Test)). However, due to uncertainty in respect of what constitutes ‘carrying on business’ in Australia, case law has played a significant role in the Test’s practical application (see: Bywater and Malayan Shipping Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156 (Malayan Shipping)).
Section 6(1)(b) of the ITAA 1936 provides that a company will be a resident of Australia if the company is either:
(a) incorporated in Australia; or
(b) 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 factual scenario that has proven to be the most controversial is where there is a foreign incorporated company with an active (ie trading) business in an overseas jurisdiction, with central management and control in Australia and/or exclusively Australian resident shareholders.
A brief explanation of the contentious portion of the residency test is as follows:
- If a company is incorporated in a jurisdiction other than Australia, the first pre-condition is that it must ‘carry on business’ in Australia (Carrying on Business Pre-condition)
- The High Court’s decision in Malayan Shipping was arguably authority for the proposition that where there is central management and control in Australia, then regardless of whether the company is conducting an ‘active’ business (eg trading) or ‘passive business’ (eg investment), then the company is also ‘carrying on business’ in Australia for the purpose of the Carrying on Business Pre-condition.
- The ATO formulated a Taxation Ruling (TR 2004/15, now withdrawn) that created an artificial distinction between ‘active’ and ‘passive’ businesses. For passive businesses, the ATO’s view was that central management and control also amounted to carrying on a business. However, for active businesses, it decided that further activities within Australia (beyond those connected with the company’s central management and control) were required for the company to be an Australian tax resident under the Test (2004 ATO Approach). This was the position at the level of practical implementation of the test (by the ATO) for many years.
- In 2016, the High Court in Bywater arguably clarified what Malayan Shipping had left a little unclear. The ATO subsequently withdrew TR 2004/15 and released a new Taxation Ruling (TR 2017/D2, now withdrawn), which provided that where a company’s central management and control is in Australia, this will also amount to ‘carrying on business’ in satisfaction of the Carrying On Business Pre-condition, regardless of the type of business (ie ‘active’ or ‘passive’) carried on by the company.
- In summary, the legal issue of corporate residency is currently principally governed by:
(i) the Test;
(ii) the interpretation given to the Test by the decision in Bywater; and
(iii) the ATO’s practical implementation in accordance with TR 2018/5 and PCG 2018/D3 (2021 ATO Approach).
The final stage will be the amending legislation, which it has been speculated will cause the practical application of the test to effectively revert back to what existed under the 2004 ATO Approach, but by replacing the active/passive distinction with a single test requiring a significant ‘economic connection’ to Australia.
The importance of determining tax residency correctly
Tax residency status is a procedural necessity to ensure tax is paid in the correct jurisdiction and at the correct rates. Australia is also not always the highest corporate tax paying jurisdiction (although these situations are the vast minority).
There may also be instances where an Australian tax consolidated group has overseas subsidiaries that are loss-making, and it could be beneficial for the group as a whole if those subsidiaries were Australian tax residents so that the losses could be used to offset local profits.
- The changes back and forth to the Australian corporate residency test particularly affect Australian-owned overseas subsidiaries engaging in ‘active’ (ie trading) businesses.
- The Test, as applied under the 2021 ATO Approach, is more likely to establish Australian tax residency as compared with the 2004 ATO Approach.
- The 2021 ATO Approach is set to change in response to the Federal Government’s planned amendments to the Test to, in effect, return the practical outcome of the Test to that which was achieved under the 2004 ATO Position.
- ATO Taxation Ruling TR 2018/5 Income tax: central management and control test of residency
- ATO Practical Compliance Guideline PCG 2018/D3 Income tax: central management and control test of residency: identifying where a company’s central management and control is located
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For further information regarding the above, please contact the author Lesley Naik, Senior Associate, at email@example.com, or any member of our Tax team.
This information and contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.