The Court of Appeal has overturned the taxpayer’s successful appeal to the Upper Tribunal in the case of Development Securities v HMRC, a case on the tax residence of companies.
The appeal succeeded on technical grounds and arguably complicates, rather than clarifies, the test for corporate residence in circumstances where a subsidiary receives instructions from a UK resident parent.
What was the issue?
Development Securities plc set up a number of Jersey subsidiaries in June 2004 in order to participate in a tax scheme recommended by a major accountancy firm.
The purpose of the scheme was to increase available capital losses relating to interests in UK real estate held by Development Securities that had decreased in value. It involved the Jersey companies acquiring assets for more than their market value and then becoming UK resident by appointing UK based directors in place of Jersey based directors.
Crucial to the scheme’s success was the fact that the Jersey companies were resident in Jersey for UK tax purposes from incorporation until after they had acquired the assets at an overvalue.
To defeat the scheme, HMRC argued that the Jersey companies had always been UK resident on the basis that the central management and control of those companies took place in the UK and not in Jersey, where the majority of the directors were based.
The test for corporate residence
The Court of Appeal once again confirmed that the correct starting point for considering where a company is tax resident is De Beers Consolidated Mines v Howe (Surveyor of Taxes). In that case, the House of Lords set out the test for corporate residence as being where the central management and control (or the “real business”) of a company takes place as a matter of fact and not as determined by a company’s constitutional documents.
Like the Upper Tribunal, Newey LJ examined Park J’s judgment in Wood v Holden. He concluded that a company is resident where its “constitutional organ” exercises management and control. If management and control is exercised independently of, or without regard to, a company’s constitutional organ, or if an outsider dictates the company’s decisions, then the company is resident wherever management and control is actually exercised. Newey LJ contrasted an outsider dictating decisions of the company (which would affect the company’s central management and control) with somebody merely proposing, advising or influencing a company’s decisions (which would not affect the company’s central management and control).
In the context of a subsidiary, Newey LJ noted that central management and control would not be affected “just because it is following a tax planning scheme propounded by its parent...[or] a company’s board takes decisions without full information or even in breach of the directors’ duties”.
Criticism of the Upper Tribunal’s decision
The First-Tier Tax Tribunal found that the Jersey directors had acted in accordance with what they considered to be “instructions” or “orders” from their parent and that the transaction was “wholly uncommercial” from the perspective of the Jersey subsidiaries. On this basis, the First-Tier Tax Tribunal found that the Jersey subsidiaries were controlled by the UK resident parent and so also UK resident.
The Upper Tribunal disagreed that the Jersey directors had abdicated their responsibilities in this way. Based on an interpretation of the facts found by the First-Tier Tribunal, the Upper Tribunal concluded that the Jersey directors gave proper consideration to the instructions of their parent company in the context of their duties as directors and so exercised central management and control of the Jersey companies at the board meetings held in Jersey.
The Court of Appeal overturned the Upper Tribunal’s decision on the basis that it mischaracterised the First-Tier Tax Tribunal’s decision. Where the Court of Appeal considered that the Upper Tribunal had erred was in stating that the basis of the First-Tier Tax Tribunal’s decision was that the Jersey directors had failed to decline to do something that was improper or inadvisable. Instead, the First-Tier Tax Tribunal simply found that the Jersey directors had followed the instructions of the parent to enter into the transaction and that this was sufficient for central management and control of the Jersey subsidiaries to rest with the parent.
Subsidiaries following the instructions of a parent
The decision raises the issue of whether a subsidiary following the instructions of a parent inevitably leads to the subsidiary being centrally managed and controlled by the parent.
Despite the fact that the Court of Appeal overturned the Upper Tribunal’s judgment, Nugee LJ noted his “very considerable reservations” about the decision of the First-Tier Tax Tribunal. In doing so, he agreed with Sam Grodzinski QC (acting for Development Securities) that “the [First-Tier Tax Tribunal’s] decision was the first time in any case where the local board of directors of a company had actually met, had understood what they were being asked to do, had understood why they were being asked to do it, had decided it was lawful, had reviewed for itself the transactional documents, had been found not to have acted mindlessly, but had nevertheless been found not to have exercised [central management and control]”.
In Nugee LJ’s view, the First-Tier Tax Tribunal had added a gloss to the authorities by stating that central management and control could only be exercised by the directors “actively engaging” with the decision to enter into the transaction. He considered that:
The question is not why the directors made the decision they did, or how much thought they gave to it, or what they did or did not take, or should or should not have taken, into account. The question is a much simpler one, namely: did they make the decision? The authorities establish that in some cases it can indeed be said that the duly appointed board of directors is not exercising CMC...The present case does not seem to me to be like that. On the FTT’s findings, the directors regarded themselves as in effect instructed to enter into, and then exercise, the options by DS plc on the basis that DS plc certified that it was for the Group’s benefit, and without discussing or considering the benefit for themselves. That seems to me to be an explanation of why they decided to enter into, and then exercise, the options; it does not to my mind justify a conclusion that they did not decide to do those things at all.
Nugee LJ’s comments did not affect the result of the appeal for technical reasons. Because Development Securities did not appeal the basis of the First-Tier Tax Tribunal’s decision, the Court of Appeal could not overturn it (and indeed the point was not fully argued before the Court of Appeal). In any event, Richards LJ seemed to agree with the First-Tier Tax Tribunal’s decision and Newey LJ declined to comment.
It remains to be seen whether the Supreme Court will hear an appeal, and whether any such appeal would clarify the test for corporate residence for a subsidiary in similar circumstances.
What lessons can be learned now?
Corporate residence should remain a concern for non-UK incorporated companies that have UK shareholders, directors or possibly shadow directors. HMRC are known to be looking more closely at corporate residence in other situations and so it is vital to ensure the right processes are in place.
The detailed findings of fact set out in the First-Tier Tax Tribunal’s decision raise some useful points for overseas directors to consider.
- Get terminology right – the loose use of words such as instruction or direction rather than advice, recommendation or request can have a significant impact.
- Make sure that the rationale for entering into a transaction is discussed and recorded in the board minutes, as well as a consideration of the relevant duties of the directors and the decisions taken under local law.
- Ensure that the directors have sufficient information properly to make any decision.
- If the benefits of a transaction include tax benefits, obtain advice on the benefits and risks.
- If action is to be taken in the UK between board meetings, the offshore board should authorise this in advance and should still make a final decision on any significant aspects.
- Be prepared for a forensic analysis of company records. In this case, the review was conducted by the First-Tier Tribunal in minute and painstaking detail. The level of disclosure required can come as a surprise.