International tax planning is not as straightforward as it used to be. In order to determine where a company is taxable, onshore tax authorities are increasingly looking further than at the place where central management and control are exercised. They search thoroughly for the economic rationale behind the use of an offshore company. The hot topics in international tax planning circles are therefore ‘anti-avoidance’ and ‘beneficial ownership.
An increasing number of tax treaties incorporate anti-avoidance provisions in their texts and most countries have adopted anti-avoidance provisions in their tax legislation recently. The newest example is India. Its rewritten direct tax code is scheduled to go into effect in April 2012 includes specific anti-avoidance provisions (CFC-rules) and general anti-avoidance provisions. In line with existing anti-avoidance provisions in other countries, transactions that lack commercial substance, or are not entered into for a ‘bona fide’ purpose, will be caught by the provisions.
An important question here is whether domestic anti-avoidance provisions should take precedence over the terms of a tax treaty (in which those anti-avoidance provisions are not included). The OECD has published guidance on this in the 2003 commentary to its model treaty that worryingly states: “A guiding principle is that the benefits of a DTC should not be available where the main purpose for entering into certain transactions or arrangements is to secure a more favourable tax position and obtaining that more favourable treatment would be contrary to the object and purpose of the relevant provisions”. Considering that it is hard to imagine in our world of high taxes how taxes cannot be a main reason, the first clause is very far reaching; the second clause seeds confusion. But in any case, after the publication of this commentary it became very clear that the OECD approves of domestic anti-avoidance provisions taking precedence over tax treaties.
The ‘beneficial ownership’ requirement is a specific anti-avoidance clause. Contrary to modern versions of anti-avoidance clauses, it has been included in tax treaties for a long time, since it has been a feature of the OECD model treaty for a long time. For instance a recipient of dividends, interest and royalties also has to be the ‘beneficial owner’ of the dividends in order to benefit from the tax treaty. The big question here is who is meant by the ‘beneficial owner’. There is one direction emerging in case law. Several examples determining when the recipient is in any case not the beneficial owner have been included in the OECD commentary to the model tax treaty for a long time. One situation is when the recipient is an agent or nominee then the recipient is not the beneficial owner of received income. However, it has been left to case law to describe other cases where this rule would apply. In the well-known Indofoods case beneficial ownership of interest income was found to be lacking because the recipient had no choice but to pass on the income to another company. The recipient did not enjoy the full privilege to directly benefit from the income and was therefore not the beneficial owner, hence could not benefit from reduced treaty withholding taxes.
Emerging ‘Substance’ Tendency
While so far countries differ in the extent to which they let anti-avoidance legislation take precedence over tax treaties and the case law is still not conclusive on ‘beneficial ownership’, undeniably a clear direction is starting to emerge. If an entity does not have clear economic substance there is an increasing risk that it will not hold up upon review by the interested tax authorities and therefore not achieve the intended tax benefits. Essentially substance is becoming increasingly necessary to counter the charge that an entity or structure was set up solely for tax purposes, that it is wholly artificial, or is not set up for bona fide reasons, which can trigger the anti-avoidance legislation in the country that seeks to tax.
Doing Business in UAE
How is this relevant for the United Arab Emirates? It is hard to think of any other place in the world where it is so easy and quick to set up one’s business in one of the free zones and to access the world’s labour pool. It is even more difficult to think of any other traditional zero-tax jurisdiction offering this.
UAE free zones as a concept were pioneered by the emirate Dubai, the first one being Jebel Ali Free Zone. Benefits of operating from a free zone include: 100 per cent foreign ownership, no restrictions on hiring foreign labour, streamlined procedures for dealing with government formalities, and sometimes a guarantee against future imposition of taxation for a specified period. The absence of VAT and restrictions on hiring foreign labour count as important benefits as well.
Ras al Khaimah
Encouraged by Dubai’s success, other emirates quickly followed. Ras al Khaimah (RAK) is today probably the most free-market oriented emirate of all. The emirate markets its free zone in terms appealing to the entrepreneurs and investors in general: lack of red tape, no restrictions on foreign labour, and business friendly policies. The emirate doesn’t have a dormant tax law on its books (unlike Dubai, Abu Dhabi and Sharjah), never instituted rent controls during the property boom, and refused to rescue the loss-making airline RAK Airways. No surprise then that Ras al Khaimah is also the emirate that pioneered low cost free zone setups. While in the Dubai free zones, high office rents had to be paid (although significantly reduced now), Ras al Khaimah introduced the provision of mini-offices, with office space starting from 10 square metres as well as a desk sharing solutions.
Non-Tax Reasons to Choose UAE
It is easy to see how this regime makes it possible for multi-nationals or entrepreneurs to establish a foothold in the UAE, while transferring genuine economic functions to the newly formed entity, thus countering anti-avoidance charges. The main difference compared to many traditional offshore jurisdictions is that there are many non-tax reasons for setting up in business. The strategic location between East and West make it the logical choice for setting up any customer service, IT support, or a procurement centre. Dubai is the main airline hub en route from East to West and vice versa which provides further commercial rationale. The fact that it is a main business centre ensures the availability of a wide array of professional services. Historically the provision of administration services offshore has often been difficult, particularly in the provision of staff to undertake more complex functions, this often necessitated elements of the administration being placed back onshore, entailing increased risk if these structures were to be reviewed.
The fact that there is de-facto free immigration for anyone willing to work without minimum wage requirement is really the most important enabling factor for realising substance. A foothold can be established in the UAE by incorporating a RAK free zone company with a visa allocation of one or two persons and rent a small office space from the free zone. The parent company could then send one or a few well-trained staff to the UAE to carry out specified corporate functions; possibly assisted by a corporate service provider who provides qualified directors, has a professional network, and assists with the realisation of a maximum of substance in the UAE in order to maximise the chance that the structure will withstand the scrutiny of tax authorities when reviewed.
The IT infrastructure in the UAE, while not ideal in the past, now also provides an additional compelling non-tax argument to set up in the UAE. ADSL has now mostly been replaced by 40Mbps fibre-optic connections. This provides a business rationale for operating an ecommerce server from the UAE. The purpose would be to positively establish a permanent establishment (PE) in the UAE or in case the company is to be managed and controlled from the UAE to attribute those functions to this company that would otherwise amount to a PE in the UAE. This would provide the justification for allocating profits to the company. The PE concept applied to e-commerce is generally applied as follows:
Data and software do not constitute a PE, ie, a website does not constitute a PE.
Computer equipment may constitute a PE. This would be the case when the company owns the server (as opposed to renting space from an ISP) and transacts business through it.
These activities are not of an auxiliary nature.
The PE does not necessarily need personnel if no personnel are required to carry out the business.
The server could, for example, host a website selling digital products, such as downloadable music or an online social networking community. In order to maximise the profit that can be attributed to the e-commerce operation, one could consider sourcing maintenance and development locally and have order processing and customer service provided by local staff. A RAK free zone company would be an ideal low cost vehicle to operate an e-commerce operation as well.
Double Tax Treaty Network
The UAE has concluded approximately 50 tax treaties, many of them with OECD countries. Many of the tax treaties are not very attractive because of the limitation of benefits clauses, inclusion of liable to tax clauses, and uncertainty as to whether UAE residents are considered to be liable to tax in the context of the treaty. Also some treaties restrict the benefits of the treaties for individuals to UAE nationals, and some can only be accessed by government entities.
However, there are several treaties that stand out: the treaties with New Zealand, Austria and the Netherlands. None of these are liable to tax requirement.
Treaty with the Netherlands
The treaty with the Netherlands was ratified in June 2010. Its most important benefit for outbound investment (from the perspective of the UAE) is it that it limits the dividend withholding tax rate to five per cent. The Netherlands is a particularly attractive country for inward investment into the UAE now because for most items of income the Netherlands will exempt a Dutch company from corporation tax on UAE income even though it has not been subject to tax in the UAE. In particular UAE real estate gains and income and income from a UAE permanent establishment are exempt from tax in the Netherlands. Employment income derived by a resident of the Netherlands from a UAE employer follows the exemption with progression method. Gains and dividends derived from a UAE subsidiary are exempt under domestic legislation in the Netherlands, provided it is not mainly holding passive investments.
Cyprus is the latest country to conclude a tax treaty with the UAE. It has a similar participation exemption system regime as the Netherlands and exempts profits made by permanent establishments abroad from tax under domestic legislation. So even before the tax treaty was concluded setting up a branch of a Cyprus company in the UAE was an attractive option.
Business with substance
The UAE is particularly well positioned to cope with the increasing pressure from onshore tax authorities to provide real economic substance. By making use of the UAE there are now opportunities available for even small companies to locate business functions there and realise the promised tax savings even if the structure is reviewed by onshore tax authorities.