Determining the tax residence of individuals – a complicated task 

T

he reality is that tax residence matters are often around the corner, and sometimes individuals do not know how close they are. Article 4 of the Model Convention of the OECD ("MC" or "Model Convention") deals with the tax residence of both individuals and artificial persons. The scope of this note is only individuals and some of the possible issues individuals may confront when looking at where they should pay taxes.

The issue is firstly in defining where a person should pay taxes for activity performed in a specific State, and secondly in which State that person should be regarded as tax resident. Being a resident for tax purposes in one State means a person has "full tax liability" therein and will be obliged to report all their income in that State.

It is possible that an individual liable to tax on a worldwide basis in one State may qualify as tax resident in another State too. In that situation, a person will have dual tax residence and, technically speaking, two different States in which to pay taxes. Hence, that person may be faced with double taxation.

How do these issues arise? The simple answer to that is that each State is free to define its own tax framework, and the criteria among States can vary subtly. For instance, one State may consider that citizenship is the basic criterion when defining residence, while a second State may define tax residence as habitually living in the State. This diversity of criteria may create a double residence.

Obviously, a person in such a situation will have a dual tax residence if they are a citizen of the first State but live in the second one. To solve these matters the MC and DTAs (double tax agreements) have introduced tie-breakers to avoid potential double taxation.

The following is a hypothetical case where a person (X) is a tax resident in two States at the same time according to their domestic laws – State A and State B.

In our example, State A considers all of its citizens as tax residents, while State B automatically considers as tax resident any person whose permanence has been longer than 183 days per year. Hence, X has a dual residence in both State A and B.

The DTA brings in tie-breakers to resolve the question, in this order:

• Permanent home
• Habitual abode
• Centre of vital interests
• Nationality
• Mutual agreement

It is clear that State A will aim to apply the nationality tie-breaker given that X is only a national of that State, but to get to that stage, X needs to tie in the three previous tie-breakers.

X has a permanent home at their disposal in both States. However, X considers their 'real' home to be the one in State B where they live with their second spouse. Given that X spends substantial amounts of time in both States - broadly half of the year in each - X may be deemed to have a habitual abode in both States.

So far, the assessment of X in both States is tied, so the next step in defining their tax residence is to determine where their centre of vital interests (CVI) is located. If, after analysing their centre of vital interests, X is still tied, then they will be a tax resident of State A given that they are a citizen of that State. In this situation, there is no need to apply the last tie-breaker regarding mutual agreement, which is always hard to obtain in any event.

In our hypothetical case, the CVI will be the last tie-breaker rule to define the tax residence of X before applying the nationality tie-breaker, which clearly leads to State A becoming the winner State.

The question of permanent home or habitual abode is an objective test, and similarly nationality is usually a matter of fact and easy to confirm. Conversely, the CVI looks at different elements - objective and subjective - to define where a person has a stronger attachment. It involves a full interpretation of facts, economic matters, personal matters, and even personal feelings.

Crucial to the application of Article 4 is the need to understand someone’s circumstances in the round and not just gather facts as if filling out a questionnaire. In this example, we can say that X is a resident of State B according to the corresponding DTA and the tie-breaker of article 4 because:

• They spend most of the year in that State,
• They have a business to attend to there,
• They have their new family (i.e. their current spouse), and
• Investments have been made in that State.

All elements fulfil the scheme determined by the CVI and therefore we could conclude that X is or should be resident of State B.

However, we could also conclude that X is resident of State A given that:

• It is the place where they were born and they are still a citizen of that country;
• They do not spend most of the year in State A but they spend a considerable part of it there (almost half);
• X founded a permanent business in State A before their entrepreneurship activity in State B, and
• Their children live there.

  
  

As such, there are sufficient elements to determine that X is resident of either State A or B. The key to applying a dual residence tie-breaker in circumstances such as this is to look at where the strongest attachment of the individual lies.

In the case of X, if the CVI is still tied, State A would be the governing jurisdiction, given that the following tie-breaker corresponds to nationality and X is a citizen of that State. However, the examination of X’s circumstances has not yet concluded, as we have not yet asked what X plans to do in the near future, and whether they intend to continue dividing their life between two countries. These elements may not be definitive but may have a bearing. We need to ask questions such as:

• Do they expect to split their time between both countries for the rest of their life? Or is this just a transition?
• Will business in State A be carried on permanently or will the new economic activity in State B substitute the activity in State A when the entrepreneurship activity has matured?
• How closely involved in the lives of their children is X?

To conclude, tax residence is a legal issue that must be solved by a proper analysis of the facts and context, having sufficient evidence to support the case, and making a reasonable interpretation of all elements. In this scenario, having analysed all the facts, evidence, and features of the specific case, it is likely that X is a tax resident of State B, despite earlier indications to the contrary.

The determination of tax residence will have significant consequences for individuals, determining as it does where tax liability will lie. If an assessment is later found by tax authorities to be incorrect, the implications could be catastrophic. That is why any person with complex circumstances should make a thorough analysis of the facts and features that may define their tax situation.