As travel and group gathering restrictions multiply and social distancing takes priority, companies find employees and directors are no longer able to travel for their jobs. Many directors travel to attend board meetings in the ordinary course of their work and companies may have employees resident in one jurisdiction but employed to provide services in a neighboring country. Investment fund executives based in the U.K. and the U.S., in particular, are frequently required to travel internationally to attend meetings of portfolio companies and investment vehicles. Covid-19 travel restrictions and social distancing measures have interrupted this pattern of travel, leading to the following key question:
If directors and employees are performing services in unintended jurisdictions, how will the company’s tax planning be impacted?
The answer to this question will vary greatly based on the facts of each individual company, and its pre-Covid policies and procedures. Companies will need to consider implications for (i) its home jurisdiction—residency and substance analyses—and (ii) the jurisdictions where its employees are now performing services—nexus and permanent establishment issues. We discuss these categories of risk in greater detail below. But regardless of a company’s specific jurisdictional concerns, there are several practical steps to consider up front:
Step 1: Determine baseline risk of company policies.
- Evaluate the tax objectives of the relevant company and evaluate the extent that the company’s policies are aggressive or risky under normal circumstances.
Step 2: Consider if a temporary amendment to company policies is appropriate.
- Companies with strong fact patterns may feel it is sufficient to take a temporary break from the normal pattern and allow directors simply to join meetings by phone or virtually, especially where sympathetic guidance is available from the relevant tax authorities.
- Any adjustment of company policies should be drafted as temporary (unless the policies would strengthen a baseline position), and companies should be careful to revise policies back once restrictions are lifted or relaxed.
Step 3: Consider delay.
- Where more risk is perceived, the ideal solution is often for the company to continue its regular pattern of meetings, but with decisions taken by a meeting held locally and attended only by the company’s local directors.
- In extreme situations, it may be advisable to delay a company’s preferred course of action. For example, it may not be desirable for a company to receive a dividend at a time its ability to establish entitlement to reduced rates of withholding tax is in doubt.
Step 4: Consider alternatives.
- Of course, there are many reasons, both technical and practical, why simple delay may not be possible. In those cases, it is worth looking at alternatives such as the grant of a proxy to a local representative, postponing non-essential meetings, joining by phone but not voting, providing increased external advice or shareholder recommendations for directors to consider, or appointing local employees to boards in place of existing directors.
- Consider engaging local representatives constituting independent agents, such as notaries or attorneys, to execute contracts at the direction of a parent company or headquarters, rather than allowing employees to do so where it could potentially give rise to an allegation of business operations in the jurisdiction where the employee is working remotely.
Step 5: Protective Elections and Filings
- Consider whether local laws have any form of protective election or filing that could limit exposure from changes to operations—for example, a “water’s-edge” election by a non-U.S. corporation in many U.S. states would limit a state’s ability to tax such corporation for the corporation’s federal U.S.-source income. This could protect against the application of more aggressive state-level sourcing rules.
Step 6: Document
- Documentation remains crucial. Except where very detailed minutes are required for signing purposes, pre-drafted minutes should be avoided; minutes should record the debate among the directors as well as the decisions taken, and should explain and support the approach taken in relation to the Covid-19 travel restrictions.
- Location of employee work should be tracked and maintained to support corporate positions regarding employment tax withholding and apportionment of income across multiple jurisdictions.
It will also be worth considering whether measures adopted should be kept in place when travel restrictions are lifted or relaxed, particularly where those measures involve increased local responsibility. This may actually enhance the tax position, as well as avoiding unwanted international travel. Further, companies might need to re-evaluate their tax planning when restrictions are lifted if there is hesitation by employees to travel for a more extended period.
Risk 1: Residency
With directors being forced to remain in their home jurisdiction, there is a risk that a company may find itself unexpectedly tax-resident in the director’s home jurisdiction, giving rise to unanticipated tax charges. The concern arises because many non-U.S. jurisdictions will regard a company as tax-resident if it has its place of central management and control or effective management in that jurisdiction.
For example, the UK will treat a company as tax-resident “where its real business is carried on … and the real business is carried on where the central management and control actually abides”. De Beers Consolidated Mines v Howe  AC 455. In most situations, central management and control will reside with the board of directors and is exercised in decisions taken at board meetings; the location of the meetings therefore determines whether central management and control takes place in the UK. There are situations in which this has been found not to be the case, for example, where the powers of the board have effectively been usurped by a shareholder, or where directors are simply rubber-stamping decisions taken by one of their number (or even a third party) without applying proper consideration; but these tend to be fairly extreme fact patterns.
There is a school of thought that central management and control is highly mobile and that, for example, a temporary shift to UK board meetings could result in a company immediately becoming UK-resident. Thankfully, HMRC has confirmed in its latest guidance (available here) that they “do not consider that a company will necessarily become resident in the UK because a few board meetings are held here, or because some decisions are taken in the UK over a short period of time.”
Where the company’s intended jurisdiction of residence has a double tax treaty with the UK, even if the company’s central management and control abides in the UK, the company will not be treated as UK- resident if it is treated as resident in the other jurisdiction under the treaty. In this context, the OECD has recently issued guidance (available here) to the effect that temporary changes enforced by Covid-19 should not usually change the outcome of treaty tie-breakers, either under the place of effective management model or the competent authority determination model.
However, it should be noted that companies in jurisdictions with the latter model can be in a difficult limbo position before their residence situation is resolved between the competent authorities.
While the HMRC and OECD guidance is reasonably helpful, care needs to be taken, particularly in situations where the residence position was already questionable prior to the Covid-19 pandemic. In addition, many jurisdictions which may claim residence on a similar basis have yet to issue guidance.
Risk 2: Substance Requirements
Even assuming the situation can be managed so as to avoid the company becoming unexpectedly resident in another jurisdiction, it is necessary to consider whether affected companies are also subject to minimum substance requirements. These fall into two broad categories: (i) specific requirements imposed by the intended jurisdiction of residence; and (ii) minimum requirements, which are generally less specific, imposed by third jurisdictions in order to qualify for the benefits of double tax treaties, European directives or domestic exemptions (for example, reduced rates of withholding, exemption from source state capital gains tax).
An example of the first category is the Taxation (Companies-Economic Substance) (Jersey) Law 2019, which requires Jersey resident companies carrying on certain types of business to meet specified levels of substance, including the board meeting in Jersey at an adequate frequency, with a quorum of directors physically present in Jersey. Jersey has issued guidance relaxing these rules in the face of Covid-19-enforced travel restrictions, for example, where “a company would normally hold directors’ meetings in Jersey but, to avoid travel or because individuals are self isolating, these meetings are temporarily held virtually”. Several other offshore jurisdictions, including the Cayman Islands, have recently introduced similarly relaxed substance rules. It is worth noting that the Cayman Islands guidance on this topic is not as helpful as the Jersey guidance, possibly reflecting the Cayman Islands’ delicate and ongoing negotiations to be removed from the EU blacklist of non-cooperative jurisdictions.
The second category comes about because many jurisdictions now take the view that companies need to do more than meet the bare requirements for tax residence in a particular jurisdiction in order to obtain tax benefits offered to residents of that jurisdiction generally. Following the OECD’s Base Erosion and Profit Shifting (BEPS) Project, many double tax treaties now include a provision denying treaty benefits where the principal purpose of an arrangement is to obtain those benefits (not including U.S. treaties—the U.S. imposes the alternative limitation on benefits test). OECD guidance on the interpretation of this test includes the example of a holding company, RCo, established by a Fund, which is entitled to treaty benefits in a situation where, inter alia, “RCo employs an experienced local management team to review investment recommendations from Fund and performs various other functions…”
In the context of European Directives, such as the Interest and Royalties Directive, the Court of Justice of the European Union has recently found, in the context of private equity and other holding companies, that entitlement to the benefits of the Directive is denied, even where the formal conditions for the directive are met, if the relevant arrangement amounts to an abuse of rights. The Danish cases: T Danmark (C-116/16) and Y Denmark ApS (C-117/16) and cases N Luxembourg 1 (C-115/16), X Denmark A/S (C-118/16), C Danmark I (C-119/16) and Z Denmark ApS (C-29916). While the distinguishing hallmarks of an abusive arrangement are unfortunately not clear from the decision, many take the view that a company’s local substance will play a role in determining eligibility for benefits under the Directives as well.
These hints, and more concrete anti-avoidance provisions of individual jurisdictions, have led many asset managers and others to take steps to bolster substance in their chosen holding company regimes. This often involves senior local employees as directors (rather than, for example, external directors provided by a service provider). The current situation may stress-test some of these arrangements. If changes to the arrangements are made in light of Covid-19, how is that likely to be perceived—might it look as though the organization doesn’t trust the local directors after all? If local employees typically commute across borders, but are unable to do so now in the current environment, does that alter a company’s substance for these purposes? For organizations that have not yet taken these steps, could the promotion of a local employee to the board help (with the possible beneficial side effect of bolstering substance on an ongoing basis)?
Companies will also need to evaluate the viability of their policies going forward, even once travel restrictions are lifted. Many employees might not be willing to travel and/or restrictions might be replaced with cautionary statements from governments discouraging unnecessary travel. In such cases, companies will need to find permanent solutions taking into account the new normal without relying on temporary forbearance from governments.
Risk 3: Places of Business and Permanent Establishments
With directors working or meeting in a jurisdiction other than the company’s jurisdiction of tax residence, a company could be at risk for increased income tax and filing obligations due to either the creation of a new place of business of the company and/or the application of local nexus rules. At the international level, a non-resident company will typically not be subject to income tax in a jurisdiction unless it is deemed to be engaging in business in that jurisdiction. Where a double tax treaty applies, the minimum level of business operations that can give rise to the right to tax business profits is a “permanent establishment.”
According to Article 5 of the OECD Model Tax Convention, a permanent establishment can arise under two scenarios, both of which are possible with remote working directors and employees: when a company has a “fixed place of business” in the jurisdiction or when a “dependent agent” habitually concludes contracts on behalf of the company in a jurisdiction. Generally, a non-resident company is considered to have a “fixed place of business” in a jurisdiction when it has a facility or premises in that jurisdiction that has a degree of permanence, is available to the company, and carries on the business of the company (usually through personnel or employees). OECD, Model Convention on Income and on Capital: Commentaries, art. 5(1) (2017). In particular, Article 5(2) of the OECD Model Tax Convention lists a “place of management” and “office” as specific examples of fixed places of business.
In the current circumstances, a director using space outside of the company’s jurisdiction of tax residence to make business decisions or perform managerial roles could give rise to a fixed place of business permanent establishment. These spaces include a home office, rented space, or hotel. Important factors would include the degree of participation in and/or control over the day-to-day management that occurs in this jurisdiction and the extent to which the premises used is “permanent.”
Separately, a non-resident company could have a permanent establishment in a jurisdiction if a dependent agent (such as a director or employee) negotiates and concludes contracts for the company or otherwise conducts business on behalf of the company in that jurisdiction, regardless of whether any fixed premises is used. Under this dependent agent test, the key question is whether these business decisions are being made “habitually” and whether these decisions are actually being made in the new jurisdiction. Like the fixed place of business test, this is a fact-intensive and fact-dependent analysis. Key considerations would include the frequency of the director’s presence in the jurisdiction and the type of decisions made.
In light of travel restrictions and increased remote working, the OECD Secretariat has provided guidance on the impact of Covid-19 government measures on permanent establishments (available here). The OECD recommends that an office or premises used in response to the “extraordinary nature of the Covid-19 crisis” should not constitute a permanent establishment because it lacks permanence, is not at the disposal of the company, and is temporary. OECD Secretariat, Analysis of Tax Treaties and the Impact of the COVID-19 Crisis, Paragraph 9 (April 7, 2019). Similarly, the OECD has recommended that a permanent establishment is unlikely to arise through the work of a dependent agent (such as an employee or director) in these circumstances, assuming the arrangement is temporary: “An employee’s or agent’s activity in a State is unlikely to be regarded as habitual if he or she is only working at home in that State for a short period because of force majeure and/or government directives extraordinarily impacting his or her normal routine”. Id. at Paragraph 11.
The OECD recommendations are not binding, however, and while countries have begun to implement the recommendations, each company must look to its relevant jurisdictions. For example, Ireland’s Department of Revenue recently enacted guidance (available here) that a company will not be subject to corporate income tax due to the presence of a director, service provider, employee, or agent if such presence has resulted from Covid-19-related travel restrictions. In the UK, HMRC has released updated guidance (available here) that suggests that a degree of permanence is required to create a fixed place of business. The updated guidance goes on to state that “whilst the habitual conclusion of contracts in the UK would also create a taxable presence in the UK, it is a matter of fact and degree as to whether that habitual condition is met.” This should provide some comfort if personnel who would ordinarily limit their UK activities so as to avoid creating a permanent establishment are unable to do so, but it would be a misreading to regard the guidance as an amnesty, particularly where the position was already open to question.
Overall, applying this guidance, we would expect a director who is performing his/her duties in a different jurisdiction purely due to Covid-19 travel restrictions would not trigger a new permanent establishment for the company, absent any other countervailing facts. It may nonetheless make sense for that director to refrain from executing contracts where possible. However, a director who previously worked remotely on an ad hoc basis and is now continuing to work remotely presents a more complicated case, as would a director who continues to work remotely after Covid-19 measures have been lifted. Companies should evaluate their baseline risk exposure, including evolving jurisprudence in a particular jurisdiction—many countries will come out of the Covid-19 crisis seeking revenues, and companies who have historically adopted aggressive tax planning may find themselves targets for revenue-generating enforcement efforts.
Risk 4: U.S. State Nexus Rules—Physical Presence
Similarly, within the U.S., nexus rules operate at the state-law level and, like permanent establishment rules, permit a state to tax the income of a non-resident company or impose filing obligations on a non-resident company when there is a sufficient connection (a “nexus”) between the non-resident company and the state. The U.S. Supreme Court in Complete Auto Transit v. Brady, held that the commerce clause of the U.S. constitution prevents states from imposing any form of taxation without “substantial nexus” with the state. What constitutes nexus varies across states, although the federal Public Law 86-272 prevents states from imposing corporate income tax without a minimum level of physical presence, and excludes certain marketing activities. Thus, at a minimum, where a company has carefully structured its operations to avoid physical presence in a state beyond marketing and solicitation of sales, the sudden presence of an employee performing other activities could trigger the imposition of tax.
For example, Massachusetts imposes a corporate excise tax on companies that are “engaged in doing business in the state,” which includes companies with “full or part-time employee acting on its behalf in the state, irrespective of the nature of the employment.” Massachusetts General Laws Chapter 63, Section 39(a) and (b). The Massachusetts corporate excise tax has been interpreted to apply to an offshore company where the company’s representatives (including officers and directors) take certain actions, including, inter alia, the execution of contracts, the maintenance of a place of business, and conducting shareholder and board meetings. Massachusetts Department of Revenue Technical Information Release 98-6. Many offshore companies that are affiliated with Massachusetts businesses, particularly in the asset management industry, are careful to ensure that key contracts are executed and board meetings are held outside of Massachusetts. Massachusetts has not yet issued any relief guidance loosening these rules in light of Covid-19.
As of now, no state has indicated that it intends to apply nexus rules to businesses with increased state presence due to Covid-19 measures. Additionally, some states, including Indiana, Minnesota, Mississippi, New Jersey, Pennsylvania, North Dakota and the District of Columbia, have recently issued verbal statements or some form of guidance noting that nexus rules would not apply in this situation. However, this type of guidance may not be binding or broadly inclusive, and with many states looking for income to fund their own Covid-19 measures, nexus laws could be an attractive source of revenue in the future. As a result, companies could become subject to additional state-level corporate tax due to directors’ remote working and remote participation in board meetings.
For non-U.S. corporations, there may be ways to mitigate this by filing certain protective elections. For example, in Massachusetts, eligible offshore corporations can apply to be treated as a security corporation, limiting their corporate excise tax obligations to a minimum annual filing. Also, many states allow a “water’s edge” election, limiting the amount of net income that can be apportioned to a state to the company’s U.S. source income for federal income tax purposes. A company that has not previously taken these steps due to a determination of limited risk may want to re-evaluate that determination now.
Risk 5: Sourcing and Apportionment
Finally, where a company already engages in business in multiple jurisdictions, rules for sourcing income and profit to the respective jurisdictions often depends on the physical presence of employees. Particularly in the U.S., the shift to employees working from home in jurisdictions other than their typical locations could materially change the apportionment of business profits across offices.
This also has material employment tax considerations arising from employee services shifting to a new jurisdiction—state withholding tax obligations are generally keyed off an employee crossing a minimum threshold of work in a particular state. Companies might historically have avoided withholding tax in some states where now, because of employees working remotely, they are exposed to increased withholding and reporting obligations. For example, an employee opting to work remotely for an extended period from a vacation home in a state where her employer does not otherwise have a presence could trigger employment tax obligations in that state.
With governments and health professionals continuing to update their Covid-19 measures and guidance, companies are operating in a fluid regulatory environment. While public health considerations and government regulations must always take priority, there are some practices that a company can implement to reduce the risk of becoming subject to unexpected taxation and filing obligations, as described above. As new advice and regulations are announced, best practices may change and will depend on the specific circumstances of the company, its employees and directors, and the relevant jurisdictions. And in the long term, companies may need to adapt to changed norms regarding business travel and remote work—that may mean adjusting tax planning or just embracing shifts in tax reporting and filing obligations.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Andrew Howard is a partner with Ropes & Gray LLP in London, Kat Gregor is a partner in Boston, Ellen Gilley is an associate in Boston, and David Johns is an associate in London.