Professor Bob Baxt outlines a recent case and explains the importance of corporate law principles in determining tax liability.
Two recent decisions in the High Court of Australia, Bywater Investments Limited v The Commissioner of Taxation and Hua Wang Bank Berhad v Commissioner of Taxation  HCA 45 (heard together, judgment delivered on 16 November 2016) (HCA 2016), apart from sending a “shudder” through the tax professional advising community, have emphasised the significance of corporate law principles in determining how Australian income tax legislation will be interpreted when the taxation of foreign companies is considered.
When foreign companies set up a subsidiary in Australia and direct this business from overseas, the question of how the Australian subsidiary company’s operations will be taxed under Australian tax law will often be determined by the consideration of the location of the “central management and control” of the Australian company. The question of whether the company is a “resident” of Australia for the purposes of Australia’s income tax legislation is critical.
Justice Perram, at first instance in these cases, ((2014) ATC 20-480) determined that the “central management and control” of each of the relevant companies was in Australia. He ruled that each of the relevant directors resided abroad; meetings of directors were held abroad; the “central management and control” of the companies was in Australia; and that the Commissioner of Taxation had established that tax was payable by the relevant companies in Australia pursuant to the operation of Section 6(1) of the Income Tax Assessment Act 1936 (the Tax Act). In this view, the relevant companies were operating in Australia. His decision was confirmed by the Full Federal Court  FCAFC 176, with Justice Robertson, Justice Pagone and Justice Davies upholding his decision.
The High Court decision
The companies appealed the decision of the Full Federal Court to the High Court of Australia. In their unanimous decision, the High Court ruled that the findings of both Justice Perram and the Full Federal Court should stand.
In dismissing the appeal, the High Court relied on a number of earlier cases and noted that the arguments contended for by the appellant in this case suggested that “the Full Court departed from the correct approach by failing to accept [the decision in previous cases on the question] the ‘real business’ of a company and the ‘superior or directing authority’ of the company were references to the ‘constitutional organs’ of the company and the ‘lawful organs with authority to bind the company’ meant the board of directors of the company. It was submitted that a person cannot be regarded as part of the ‘constitutional organs’ or, therefore, part of the ‘real business’ or ‘superior or directing authority’ of a company, unless the person is at law a director of the company. Consequently, a person making decisions regarding the affairs of the company cannot be recognised as exercising its central management and control of that company unless the person is a director of the company.” (see 2016 HCA at para 30). In this case, the High Court agreed with the rulings and findings of Justice Perram and the Full Federal Court that the appellants had not been able to show that the companies should not be taxed in Australia. In essence, the principal question in this case, which is really a question of corporate law underpinning the operation of the interpretation of the Tax Act unless directed by specific language in the legislation to adopt a different approach, remained one of interpretation of the question of how a corporation operated.
It was argued by counsel for the appellants that if their understanding of the law was to be disregarded, then the court would be in effect ruling that “persons who had planned their affairs on the basis of the [assumption of their understanding of the law] would be severely disadvantaged. The better approach [argued by counsel] was to retain a presumption, in effect, that boards of directors do the work which they are appointed to do and, consequently, central management and control inevitably resides where a board of a company habitually meets.
By contrast, if the test of residence were held to depend on the state of mind of directors, and in particular on whether the directors of a foreign subsidiary actually turn their minds to directions from an outsider then actually decide whether the directions are proper and appropriate, there would be a lamentable degree of uncertainty as to tax liability and a greater increased volume of litigation” (see 2016 HCA at para 34).
Appropriate legal definition
The High Court emphasised the significance of the meaning of the expression “central management and control”. It noted at paragraph 41 that “ordinarily, the board of directors of a company makes the higher-level decisions which set the policy and determine the direction of operations and transactions of the company. Ordinarily, therefore, it will be found that a company is resident where the meetings of its boards are conducted. But, contrary to the [submissions of the appellants in this case] it does not follow that the result should be the same where a board of directors abrogates its decision-making power in favour of an outsider and operates as a puppet or cypher, effectively doing no more than noting and implementing decisions made by the outsider as if they were in truth decisions of the board.”
It is not surprising that the High Court did not accept the arguments put forward by the companies but relied on the rulings based on the facts that the Commissioner of Taxation had put to the court. The High Court added, in assessing the way in which companies operate (which is critical in questions of tax law) that: “There is little which is uncertain about the difference between a board of directors that actually meets and makes independent judgments, than a board whose meetings are mere window dressing comprised of rubber-stamping decision actually made elsewhere by others. In Australia, directors of a corporation are required by law [referring to Section 180 of the Corporations Act] to inform themselves about the subject matter and decisions relating to the corporation to the extent that they reasonably believe is appropriate and to make decisions on the basis of what they rationally believe is in the best interests of the corporation. Similar obligations apply in the UK. Experience suggests that there is no particular difficulty in determining whether or not directors have complied with these obligations, still less in determining whether a board has so abrogated its decision-making powers as to become in effect the mere puppet or cypher for the implementation of instructions from another. Civil actions and prosecutions for breach of directorial duties are routinely prosecuted on that basis” (see HCA 2016 at para 80).
In conclusion, I note that the taxation firm that is associated with Herbert Smith Freehills (where I work as a consultant), regard this decision as “catastrophic”. They have said in a publication put out under their name that the obvious question flowing from this case, and which remains unanswered is just how much influence can be exerted from Australia by an Australian parent company before the offshore subsidiary becomes a resident? The influence of a parent company will usually be extensive and undeniable. Indeed, it was part of the taxpayer’s case [in these cases], that treating these companies as an [Australian] resident would turn on its head 40 years of commercial practice that the “directors of foreign subsidiaries of Australian companies [can and do] act as they were instructed to by their Australian parent companies without fear that the central management and control of the subsidiaries would thereby by situated in Australia”.
There is now of course no appeal to the Privy Council, which was the practice until a number of years ago. So the decision of the High Court remains the law. Perhaps in a later case, on different factual scenarios, the High Court may be given another opportunity to qualify the decision.
The Commissioner of Taxation now has a clear avenue for pursuing the foreign companies that operate through Australian subsidiaries under the Australian income tax regime rather than allowing them to rely on perhaps more advantageous legislative arrangements operating through double tax agreements and overseas legislation.
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