Tax substance requirements for Natural Resource groups – 8 key issues tax authorities will test

What your group does, and where it operates, matter for tax purposes. For Natural Resource groups, the separation between the territory where the head office is located, and the territories where operations are located are commonly different. But this creates a tax audit risk if there are very few staff in the head office jurisdiction. Tax authorities want profits to be taxed where the people and value creating activities are, and the consequences of a successful challenge by tax authorities on substance can be expensive!

What tax substance questions should international NR groups be considering?

1. Are your holding companies tax resident in the expected jurisdiction? Have you implemented good procedures and gathered documentation to prove it?

   Entities can become tax resident where they are managed and controlled (rather than simply incorporated). In testing this, tax authorities increasingly scrutinise the substance of decision making, rather than the rubber stamping of decisions in board meetings. Dual resident entities can often be denied tax treaty benefits - creating the potential for double taxation. This also creates uncertainty over the appropriate taxation regime for the entity - with implications when restructuring, on audit or when under due diligence.

2. Do your non-UK resident tax directors travel to board meetings in the UK?

   In the NR industry, directors are generally internationally mobile and will often fly into the UK for decision making and board meetings. Under UK rules, non-resident directors are taxable on emoluments for this time in the UK, with associated payroll withholding requirements for their employing entity. If this is missed, it will require special disclosure to HMRC. There are also potential social security related implications to consider – read more on International mobility cost projections

3. What is the substance within your holding and finance companies? Are you up to date on all local and international substance-related changes that might impact the expected tax treatment of these companies?

   New anti-avoidance rules around the world can neutralise the tax benefit of using shell companies with no substance. For example, a European draft Directive (known as ATAD 3) is expected to come into effect by January 2024 that introduces a prescriptive rule-based approach to assessing an entity’s substance. It focuses on the level of active (rather than passive) income, the level of international income and evidence that the company is managed in-house with its own employees. It is not yet clear how each EU member will implement these rules, but the downsides of failing the tests could include being denied the benefits of double tax treaties.

4. Does your transfer pricing align with your business? Where are potential risk areas that a tax authority could challenge?

   Following the OECD’s anti-base erosion and profit-shifting initiative, tax authorities around the world are very focused on checking that transfer pricing models align with the economic substance of the entity. For NR groups, this often includes testing whether fees for marketing activities and other services truly reflects the location of value creating activities. Also, tax authorities will look at group funding to ascertain whether the characterisation and pricing of related party debt funding (and interest on it) is supportable from a tax and transfer pricing perspective.

5. What does your country-by-country (CBC) reporting risk assessment say?

   Country-by-country reporting allows the comparison of profits (and tax paid) with personnel on per territory basis. This enables both the group and the relevant tax authorities to take a risk-based approach to the review of transfer pricing – so it is well worth doing your internal review before the CBC report needs to be filed.

6. Do you have entities tax resident in ‘haven’ jurisdictions that have introduced economic substance rules? Are you comfortable you are complying with these rules?

   Many low-tax jurisdictions have introduced rules that require clear evidence of economic substance in their jurisdiction. Failure to comply can lead to penalties and being struck off the local register. This is driving many international groups to make operational and personnel changes to be sure they meet these requirements. Groups may also decide that their presence in the haven jurisdiction is no longer justified and restructure accordingly.

7. Do your holding companies have enough substance to register for VAT or is there potential for irrecoverable VAT costs?

   For NR holding companies, it is common that the time between raising finance and earning substantial operational returns can be significant, and there may be limited ability to charge out any services and earn a business return in this period. This means they can struggle to prove sufficient activity to allow them to register. As a consequence, recovering VAT on acquisition costs is a constant source of challenge from tax authorities.

   Particular problems can arise when a holding company does not provide services for consideration to all its subsidiaries, payment for services provided to subsidiaries is contingent, or there is insufficient substance to the services (e.g. the holding company has no employees).

8. What reputational damage could scrutiny of your entity structure cause?

   Public scrutiny of international groups’ tax affairs is higher than ever, and the media is keen to highlight NR groups that are seen as not paying their fair share of tax. This is heightened in the current environment where approaches to environmental, social and governance issues is so important.

   Adverse media coverage can affect groups bidding for local licenses and contracts, as well as impact how a group is seen by stakeholders including tax authorities, customers, suppliers, employees, shareholders, governmental and non-governmental organisations. Unsurprisingly, Boards are looking to their finance functions to ensure that the group’s tax compliance is beyond reproach.

How we can help

We work with our clients to assess substance-related risks and mitigate where possible. Mitigations can include improving process and controls, ensuring documentation is maintained to demonstrate the robustness of your position, or restructuring or taking other steps to ensure that the legal entity, tax and transfer pricing structure is aligned to the substance of commercial activities.

Whatever your current holding, financing and operating structure is, we can help you reduce the tax risk.