It is common practice in Australia for businesses that issue tokens to use a foreign country, which is often less regulated, to reduce the risk of being prosecuted for unlicensed financial services or securities dealings.
Using a foreign jurisdiction can also provide tax advantages for managing the blockchain side of the business, including the issuance of tokens, management of smart contracts, and holding of the treasury.
These entities are called Token Special Purpose Vehicles (Token SPVs), but they may also be referred to by other names. Such companies can be located in many countries, such as the British Virgin Islands, Seychelles, the Bahamas, and many more.
While many people talk about the securities law risks, there are substantial tax risks involved in setting up an international group that many businesses simply do not consider. Three key tax risks for Token SPVs are the Controlled Foreign Company rules, corporate tax residency and corporate tax residency.
1. Controlled Foreign Company rules
The Controlled Foreign Company (CFC) rules, which seek to prevent Australian resident taxpayers from avoiding tax through offshore companies, apply to foreign companies that are controlled by an Australian resident taxpayer. A foreign company is deemed to be a CFC if it meets certain criteria. For example, if five or fewer Australian entities own 50% or more of the foreign company, it could be considered a CFC under the actual control test. Alternatively, a single Australian entity owning 40% or more of the foreign company could result in the company being deemed a CFC under the assumed control test. Additionally, if the foreign company is “controlled” by five or fewer Australian entities, including foreign associates, it may also be considered a CFC.
If a foreign company is deemed a CFC, the income it generates could be attributed to the Australian controllers. This includes income from activities such as selling tokens to the public, staking income, or management/protocol fees earned. However, there is a way for a CFC to avoid this treatment. If 95% of the CFC’s income is “active,” meaning that it is not in the specific category of “tainted” income or assets, then the CFC may not be subject to the CFC rules. This is called the “active income test,” and it is a highly complex exercise, especially for Token SPVs.
Therefore, it is important for all CFCs to ensure that they pass the active income test to avoid falling under the CFC rules. In addition, there are complex record keeping requirements that CFCs need to meet to ensure compliance with these rules.
2. Corporate tax residency
Corporate tax residency is a crucial matter that foreign companies must take into account when doing business in Australia or having Australian based controllers. In fact, a foreign company may unwittingly become an Australian tax resident if it is carrying on a business in Australia and its central management and control is in Australia or the majority of its shareholding is in Australia. This is a complex issue, and recent case law with the Bywater Investments case only highlights its importance further.
It’s worth noting that central management and control is located where the high-level decisions of a company are made. Often, formal board decisions (if they are legitimately made) or formal director decisions guide this. This means that companies that have their central management and control in Australia are carrying on business.
Given the potential tax implications, it’s important for Australian-controlled foreign companies to actively manage this issue. Nominee directors do not effectively deal with this risk. Careful annual planning and processes can help manage Australian tax residency. In addition, foreign companies that are not familiar with Australian tax laws should seek expert advice to ensure that they comply with all relevant regulations and avoid large tax issues with the ATO.
3. Permanent Establishments
Finally, if a company has a permanent establishment (PE) in Australia, any profits attributed to that PE are taxable in Australia. This was designed to prevent large corporations from setting up companies in no-tax jurisdictions and having all operations in high-tax countries. PE is a global issue that international groups must always monitor. For privately controlled Token SPVs, this can easily arise where a core individual has a general authority to negotiate and conclude contracts. This is one of the definitions in the Australian tax law, as most of the low-tax countries used for Token SPVs do not have Double Tax Treaties with Australia.
It is sometimes challenging to prevent a PE from arising in Australia, particularly where there is one core individual who is pushing the business forward and negotiating a contract. Each business is different and requires an analysis of who does what to protect your foreign company or Token SPV from Australian tax risks.
PE risk can arise in almost any country across the world so companies should seek local tax experts who can provide them with advice in each country. Foreign companies and Token SPV’s should regularly monitor their operations to ensure they are managing their PE risk in Australia.
What should you do?
All international groups controlled from Australia should seek specialist tax advice to prevent a disastrous ATO audit. This is even more important for crypto businesses and DAOs that may have a Token SPV or international entity in their group.
Australian tax advice is always required for international groups, and a specialist crypto tax law firm like Cadena is one of the only firms capable of this work in Australia. Crypto can throw up additional challenges, particularly in the CFC rules, and it needs an experienced lawyer’s knowledge.