Covid-19: How to manage 'place of effective management' tax risk during lockdown

Under South African domestic law, a company will be tax resident in SA if it is incorporated in SA or has its "place of effective management" in SA. A foreign company may be incorporated outside SA, but it will qualify as South African tax resident if it is effectively managed from SA.

The term "place of effective management" is not defined in the Income Tax Act. Sars' view on what ‘effective management’ means has evolved over time, with the current approach as discussed in Sars Interpretation Note 6 (2015) being that an entity's place of effective management will be the place where top level key managerial and strategic decisions that are necessary for its business as a whole, are made in substance.

It is not unusual for foreign companies to have one or more board members who live in SA, especially if the foreign companies are subsidiaries of a group headquartered in SA. If Sars were to take the view that managerial decisions taken in SA during the lockdown by a CEO or other board members of a foreign company have caused the foreign company to become a South African tax resident, then it will be at risk of being taxed here as well as in the country where it is normally a tax resident.

Dual tax

Where a company is dual tax resident, i.e. tax resident in both SA and another country under those countries' respective domestic legislation, it is necessary to refer to the double taxation agreement entered into between those two countries, if one exists, to determine which country will have the primary taxing rights over the company's income.

In early April, the Organisation for Economic Co-operation and Development (OECD) issued guidance on the analysis of certain tax treaty provisions in the context of the impact of the Covid-19 pandemic.

The OECD suggests that it is unlikely that the Covid-19 situation will create any changes to an entity’s residence status under a tax treaty, because a temporary change in location of senior executives would most likely be seen as

an extraordinary and temporary situation due to the Covid-19 crisis and such change of location should not trigger a change in residency, especially once the tie breaker rule contained in tax treaties is applied.

Currently, and pending the implementation in South African tax treaties of the Base Erosion and Profit Shifting Multilateral Convention provisions relating to the tax residence tie breaker test, most of South Africa's double taxation agreements also look to the place of effective management of a company to decide the issue of which of the two countries which are party to the treaty will have primary taxing rights. In this context, the OECD guidance states that all relevant facts and circumstances must be examined to determine the "ordinary" or "usual" place of effective management and not only "those that pertain to an exceptional and temporary period such as the Covid-19 crisis".

Some treaties take the approach that the relevant tax authorities must decide by mutual agreement which country has primary taxing rights. This should be determined according to the OECD guidance in light of the circumstances that usually apply (where meetings are usually held, where managerial decisions are usually taken, etc) and not just in view of any exceptional circumstances which result from the Covid-19 pandemic.

International examples

This situation is of course not unique to SA. The United Kingdom's tax authority, the HMRC for example has released guidance, which states that "it is very sympathetic to the disruptions being endured" and that

We 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. HMRC guidance makes it clear that we will take a holistic view of the facts and circumstances of each case.

Sars has to date not released any official guidance in relation to this issue. We consider it unlikely, however, that Sars would lightly take the view that a foreign company could become a South African tax resident simply because an unexpected crisis has prevented certain board members from travelling to attend board meetings as they normally would. However, every situation will need to be considered in light of its own facts. The risk will be higher where senior executives of the foreign company reside permanently in SA and normally rely on the argument that they travel to attend board meetings to protect the foreign company from being seen as an SA tax resident.

In the absence of official guidance and given the protracted nature of the lockdown in SA, companies (both South African and foreign) should consider where their current decision makers are currently situated, what managerial decisions are being taken by these individuals during the lockdown, and what planning can be done to minimise any tax risks relating to the place of effective management or the creation of a taxable presence in a country other than the one in which the company is tax resident. There may be steps involving (for example) delegation of authority frameworks, or documentation of certain decisions and relevant factors which can assist in evidencing that effective management of the company remains in the jurisdiction in which it is intended to be tax resident.

To rely only on a defence of exceptional circumstances, particularly as travel remains restricted for a protracted period, may be dangerous.