How to manage overseas investments in the era of international exchange of information
- Introduction
International exchanges on the financial information is relatively new topic for international investors but it has a long history, initiated by the OECD Report on the Tax Havens released in 1998. Although it has not been effectively implemented until the recent years, the exchange of information is a part of tax treaties and generally regulated in the Article 25 of respective treaty. Former information exchanges were based on the spontaneous or on-demand exchange of information, but in practice they were limitedly conducted by the respective countries.
However, by the introduction and internationally acceptance of automatic exchange of information on the financial accounts, it has a great impact on the international investors and investments. This was initiated by the US under the FATCA Regime and became a global standard among the G-20 and OECD countries by the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information (the Agreement).
Automatic exchange of information on the financial accounts is mostly applied under the Common Reporting Standard (the CRS). Early adopters of around 60 countries have been exchanging financial information under the CRS since 2017 and the number of countries has dramatically increased and as of today, the number of signature countries of the Agreement is 110. According to OECD’s website, as of December 2020, there are over 4,400 bilateral exchange relationships activated with respect to more than 100 jurisdictions committed to the CRS.
It is clear that adaptation of business to international automatic exchanges will be quite important to manage international investments, not only for individual investors but also corporates. In this article, we discuss the impact of international automatic exchanges on the overseas investments and touch up on the practical issues related to individual and corporate investors.
- Individual Investors
It is typical that individual investors incorporate overseas companies for the business purposes and establish trust, foundation and similar transparent structures to manage their overseas investments. In addition, they may have certain individual investments in other countries and receive income from those investments. Except for the certain financial accounts of individual investors, under the CRS they, as UBOs, are subject to reporting by the financial institutions in the case they hold a foreign account in a country where such investors do not have a tax residency.
In the past, we frequently observed that international investors had a tendency not to declare their overseas income and earnings in the country where they have a tax residency due to lack of automatic exchanges on the financial accounts and client secrecy rules were highly strict in those periods. However, we live in an age of financial transparency and non-compliance with declaration of such income has almost been a moral issue for these type of investors.
Also, tax avoidance is regarded by the public as almost equal as to “tax fraud”. Thus, we can advise individual investors to replace their old investment structures with the CRS friendly ones. For instance, investing in a bond with a 5 year payment-free period could be simple solution but it certainly works and is fully CRS friendly.
Also, individual investors’ private companies and trust, foundation and similar transparent structures should be separately evaluated under the existing exchange of information rules. This topic is further discussed in following sections of this article.
2.1. Individual Investors’ Private Companies
As mentioned, individual financial accounts are mostly subject to reporting under the CRS and year end amounts and realised income e.g., interest, dividends will be reported to the UBO’s country by the respective financial institution of the other jurisdictions. However, financial accounts of an individual investor’s private company are not necessarily reported if that company involves in the active business. There is a threshold of 25% for those companies and in order to be not reported it should be earning income from the active business activities, such as manufacturing, distribution.
On the other hand, in case the income of that company consist of passive income like interest, royalty, dividend and it is more than 25% of its total income, such private company’s financial accounts are report to the country where the UBO is tax resident. This brings a question: whether subsidiaries of individual investors’ private company will be also reported? Let’s discuss this with an example.
Assume that a Turkish individual established an holding company in the Netherlands whereas Dutch Holding Company is the sole owner of Maltese company. If Maltese Company conducts only active business, Maltese financial institution will make a due diligence and not report the financial accounts to both the Netherlands and Turkey.
However, it will be reportable in the case it has mostly passive income and both Netherlands and Turkey will be receiving information on the financial accounts of Maltese subsidiary. It should be noted that Maltese financial institutions will certainly question the UBO and its tax residence when they open an financial account. If they detect that the UBO of the subsidiary is tax resident in Turkey, they will also report to Turkey. This may trigger taxation for the individual tax resident in Turkey and requires tax declaration on the overseas income.
As an additional note, due to nature of its business activities and receiving dividends or passive income, the financial accounts of Dutch Holding Company will be most likely reported under the current international exchange of information rules of the CRS. This case also requires the controlled foreign company (CFC) evaluations which are provided in Section 4 of this article.
2.2. Trust, Foundation and Similar Transparent Structures
According to the CRS, trusts, foundations and similar structures qualify as investment entities and therefore as financial institutions if their gross income mainly derives from the investment in financial assets. This issue could be also clarified with an example.
Assume that an Turkish individual established a foundation under the Liechtenstein Law in order to control its overseas investments and potentially transfer its wealth to next generation. His son and daughter resident in the Germany are the beneficiaries in the Foundation and they can benefit from the income received by the Liechtenstein Foundation.
As depicted in the below figure, Liechtenstein Foundation holds all the financial assets, and all subsidiaries are attached to it.
In the case German and Russian subsidiaries are involving in active business, there will be no reporting issue for Settlor in Turkey. However, as Investment Co potentially obtains passive income e.g., rental income from the overseas real properties and interest from certain investments, its financial accounts will be reported by Swiss financial institution to Lichtenstein, as well as Turkey due to settlor’s tax residency.
On the other hand, Lichtenstein Foundation’s financial accounts will be reported to Turkey as it does not carry out active business and has only passive income of dividends. Besides, beneficiaries known by name are reported only in the years when they receive distributions from the Lichtenstein Foundation. Accordingly, financial institution of Lichtenstein will report the beneficiaries to Germany if they receive distribution from the foundation.
- Corporate Investors
Corporate investors are also within the scope of international exchange of information but reporting threshold is much higher than the individuals. Accordingly, under the CRS a threshold of 250,000 USD is applicable for pre-existing entity accounts and if it is lower than that threshold, it does not require financial institutions to report on foreign assets held by non-resident corporate account holders whereas no “de minimis” threshold applies for the new entity accounts.
Reporting obligations are all applicable to subsidiaries and branches of corporate investors. This also includes holding and sub-holding companies within a corporate structure. In terms of reporting of corporate investors, controlling person(s) who exercises control over the entity (generally controlling ownership interest in the entity, which is often interpreted ≥ 25% ownership) plays a key role. We can explain this with another example of international corporate structure.
In this case, as the controlling person is tax resident in the UK all holding, branch and operational and investment companies are potentially within the scope of international exchange of information reporting. As explained in the previous section, active companies are not reported as a general rule.
On the other hand, assume that BVI Co receives dividends from its subsidiaries, it will be important from a corporate taxation in the Netherlands and individual taxation in the UK. Assuming the dividends received from BVI Co is not within the participation exemption, that income will be included in the corporate income tax basis of Dutch Holding Company. In the case CRS does not exist, such an income would not be reported in the Netherlands.
As can be easily understood from this example, the CRS and automatic exchange of information play an important role especially if there is no CFC rules are available in the domestic law. It is also important for the country of UBO because it cannot be informed about the overseas income of its own taxpayer. In this case, it is important to underline that the UBO, tax resident of the UK, is not necessarily regarded having a taxable income from BVI Co unless there is a specific CFC rule applicable. This also reveals that international exchange of information on the financial accounts and reporting in this sense do not have to eventually result in taxation in the resident country.
- Impact of International Exchange of Information on the Controlled Foreign Companies
As discussed above, international exchange of information has a considerable impact on the controlled foreign companies practices. This applies to both individual and corporate investors. The impact of international exchange of information on the CFC practices could be also elaborated with following case study from both Turkish and Dutch perspective.
Turkish CFC rules applies if a Turkish resident company (i) controls directly or indirectly at least 50% of the share capital, dividends or voting power of a foreign company; (ii) and 25% or more of the gross income of the CFC is comprised of passive income; (iii) and the CFC is subject to an effective tax rate lower than 10% in its country of residence; (iv) and the annual total gross profit of the CFC exceeds the foreign currency equivalent of TRY 100,000.
On the other hand, as of 1 January 2019, the Netherlands has introduced new CFC rules in the Dutch Corporate Income Tax Act in line with the European Union Anti-Tax Avoidance Directive (ATAD 1). An entity will be considered a CFC if: (i) a Dutch taxpayer (in)directly holds an interest exceeding 50% (in vote or value) in a foreign entity or branch; (ii) the income of this entity or branch consists of more than 30% passive income; and (iii) this entity or branch is tax resident in a jurisdiction listed on the EU list of non-cooperative jurisdictions (EU Blacklist) or in a low-tax jurisdiction (i.e., a jurisdiction with a statutory corporate income tax rate below 9%).
The Dutch CFC rules allocate certain types of undistributed passive income (e.g., income from dividends, interest, and royalties) from controlled entities that are tax resident in low taxed jurisdictions to the Dutch company holding the interest. Low taxed jurisdictions are listed on the Dutch list of low-tax and non-cooperative jurisdictions or on the EU list of non-cooperative jurisdictions for tax purposes. American Samoa, Anguilla, Bahamas, Bahrain, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Dominica, Fiji, Guam, Guernsey, Isle of Man, Jersey, Oman, Palau, Panama are some of those listed jurisdictions by the Netherlands.
As we look at the company structure in this case, Turkey Co is an active company established by an Turkish individual and manages its overseas investments through Netherlands Holding Co which also incorporated Jersey Co which has only passive income from the overseas investments.
Here, CFC issues should be separately and collectively evaluated from points of both Turkish and Dutch CFC rules. Then, we can examine international exchange of information on the CFC practices in both Turkey and the Netherlands.
From a Turkish CFC Perspective, Netherlands Holding and Jersey Co are regarded as CFC in the case those entities meet all conditions. If Netherlands Holding and Jersey Co have only passive income, their income will have to be reported by Turkey Co. Even if they are not reported, Turkish tax authorities will be able to access their financial accounts by means of the international exchange of information, mainly the CRS.
In this case, as Jersey is one of the listed jurisdictions and Jersey Co has only passive income, its income will be included in the corporate income tax base of Netherlands Holding Co and be subject to Dutch corporate income tax under the Dutch CFC rules. This means there would be double taxation on the same income if such an income is not allocated by Jersey Co and then Netherlands Holding Co.
When we examine this case on a collective basis by considering CFC rules in Turkey and the Netherlands, as mentioned there would be double taxation if no income is allocated to Netherlands Holding Company and then Turkey Co. However, if the same income is allocated, this income will be only taxed in the Netherlands but be exempted in Turkey under the Article 23 of Turkey-Netherlands Tax Treaty. This also means the CRS reporting will not have an impact on the CFC income of Turkey Co because it will be reported as exempted income.
In this case, financial accounts of Jersey Co will be exchanged both with the Netherlands and Turkey and that financial information could be potentially used for the CFC application. This case clearly shows that international exchange of information will most likely result in active use of CFC rules by tax authorities as a result of receiving financial account information of the CFCs from other jurisdictions.
Consequently, it is not recommendable that former practice with CFCs is carried out. That also comes with the certain questions which we will reply in the following sections.
- Do we really have ways not to be reported or are the CRS friendly structures better?
Carrying out international business with the old school approaches will not be helpful, even not sustainable. Then, we need reforms. Basic solution could be liquidation of off-shore structures or convert them into active entities. Certainly, these solutions cannot be good enough for all cases.
If this is our reality, so we should try to answer question of “Do we really have ways not to be reported?”. The CRS already replies this question. For example, it could be certain employer-sponsored group insurance contract or annuity contract. Such contract is a financial account but also not a reportable account until the date on which an amount is payable to an employee/certificate holder.
Another good example of a CRS friendly structure is “international collective investment vehicle”. In practice in order to benefit from exemption of non-reportable account under the CRS, following conditions should be met;
- the fund is regulated and,
- all interests are not held by reportable persons.
Again, this could not meet the needs of all business and individuals. Thus, we may need complex solutions which may require complex studies. One should also keep in mind that these complex solutions are not targeting tax avoidance but the CRS compliant.
In conclusion, we believe the CRS friendly structures could be better solutions, especially if no CRS reporting is accrued.
- How to manage overseas investments: Do we need restructuring of international investments?
International exchange of information has already brought significant changes in the international practices of corporates and individuals. Nevertheless, we have not completely experienced the impact of such information changes in many countries. However, especially during the Post COVID-19 period, tax authorities will likely conduct many tax audits based on the international financial information exchanges (not only CRS based but also other information exchanges e.g., exchange of tax rulings) by other jurisdictions.
If we also consider other international tax changes, especially to be brought by the BEPS Multilateral Agreement (the MLI), it is inevitable for an international investor to restructure his international investments to comply with the new tax regulations and practices. Based on this, the first step for restructuring of international investments could be diagnostic analysis on the new international tax changes, especially automatic exchanges of information.
In this sense, in order to mitigate the risks associated with international exchange of information, the operating model and the structures within the model may be reviewed and risk-bearing areas could be identified, consequently. Thus, it may be possible to determine whether existing structures and transactions have a negative impact on the international business as a result of international information exchanges.
If it is decided that the operating structure is not in alignment with new international rules and practices, then the operating structure may be renewed or a brand new model may be adopted, taking into account recent international regulations including information exchanges at the international level. It is particularly important to increase the substance within the operating model and to restructure the business transactions. Also, converting off-shore structures into on-shore structures should be considered within the context of operational changes.
Since restructuring may also provide new tax-related advantages, it is worthwhile to handle the matter from this respect. Therefore, while restructuring, a structure should be created that will lead to the minimum level of risk, but at the same time, not result in high tax burden. This will require supporting the restructuring with tax planning tools. In addition, it is advisable a structure that offers better advantages in the age of international exchange of information should be established.
Please contact Ramazan for your queries and to discuss further on the impact of international exchange of information with your business and overseas investments.
Ramazan Biçer
Level-International, Founding Partner
E: ramazan@level-international.com