Taxation is a fairly complex universe, especially when it concerns entities that operate outside their country of tax residence. It is sometimes difficult to determine in which country a given company must pay certain of its taxes. This tax ambiguity is often the cause of disputes between companies and states.

As such, tax substance is a concept that sheds light on companies’ tax obligations and can make the difference when a dispute between the state and the company goes to court.

It is important to understand the concept of tax substance well, particularly if you yourself own a company operating abroad.

Non-cross-border taxation

We live in a liberal world where there are numerous free trade agreements and where commercial exchanges are the primary form of communication between countries. Everything is designed to facilitate these exchanges so that each country benefits from them.

However, this open world does not concern all domains. Thus, taxation is not really in the same league.

We can even consider that there is sometimes real tax competition between countries, since certain states, often small ones, use taxation to attract foreign companies and investors.

As a result, companies have well understood the interests they could derive from this international tax situation.

The search for tax optimization

The goal of a company is to generate profits to continue developing and gaining market share. To achieve this objective, companies seek to generate as much revenue as possible while reducing their expenses to the maximum.

To reduce the expenses incumbent upon them, companies act on different domains, including taxation which represents an important part of a company’s expenses.

Indeed, as we mentioned previously, taxation is a relatively complex universe, often difficult to regulate and even more so when it crosses borders. Tax optimization consists of finding the best solutions to reduce the company’s tax burden.

Tax substance is generally reflected by the presence of an office, an address, employees and an activity.

There are different tax optimization techniques that involve tax arrangements of varying complexity that allow for considerable reduction of the tax rate. One of these techniques consists notably of exporting its revenues to a jurisdiction where taxation is significantly lighter, or sometimes even non-existent. The company will then create an entity in the country in question, in order to move its revenues there.

What is a company’s tax substance?

There is no exact definition, but to summarize, a company’s tax substance is somewhat its identity card that proves it is indeed active in the country in question. In other words, a company has tax substance in a state when it truly exercises an activity there. Conversely, a company is said to be without tax substance when it is simply an entity without real action.

Several elements allow determining whether or not the company has tax substance in the country:

• Address that is not just a simple mailbox, but a real premises
• Telephone line
• Employees
• Activity exercised
• Powers and roles of the entity
• Boards of directors
• Etc.

In other words, to have substance, the company must at least have an office and its address, a telephone line and employees.

What is the interest of tax substance?

Tax substance represents an interest for both states and companies.

Indeed, by proving that the company has no tax substance in country B where it exports its revenues, country A where the company is really present, can claim taxation of revenues generated on its territory.

Let’s take the example of France. If a large foreign company is present on the French market, but has its headquarters located in another European country that is more fiscally attractive, thanks to the notion of tax substance, France can tax the company’s revenues.

Conversely, for the company, the interest of properly defining its tax substance is to be able to prove that it is really established in the country in question and that it exercises a real activity there. In this sense, the company benefits from the tax regime of the country in question.

Tax substance is essential to avoid double taxation

No state appreciates losing tax revenues, especially when these cumulated revenues represent a very high amount. This common point between countries is surely the primary force in the fight against tax evasion.

The result is that many countries have signed conventions between them. They allow establishing rules between two countries when a company that is a tax resident in country A is also present in country B.

Conventions between states allow companies not to suffer double taxation on the same revenues.

However, to benefit from the convention and avoid double taxation, it is necessary that the company can prove that it is indeed active in the country where it wants its revenues to be taxed. As such, the notion of substance is paramount since it indicates that the company really operates in the country. For example, if you own a subsidiary with tax substance in Andorra, its revenues will then be taxed according to the Andorran tax regime.

Does tax substance definitively solve taxation problems?

In reality, things are sometimes more complicated than in the situation we just used as an example.

Initially, you must prove the reality of tax substance in the country where your company’s subsidiary is installed, which is not always obvious.

Then, it must be understood that the country claiming the return of these revenues to its territory can bring the matter to court. In this case, it is essential that the tax substance of your subsidiary in the foreign country be solid.