The UAE has concluded nearly 80 double tax treaties, many of them with OECD countries. Some of the treaties are not so attractive due to limitation of benefits and liable to tax clauses.
In many other treaties, however, especially with European countries which have adopted the exemption method there are ample opportunities for UAE subsidiaries or regional centres of European holding entities to set-up, meet substance criteria, become tax efficient and reduce substantially overall group taxation. Free zone entities in Dubai are the ideal vehicles for this purpose and, remember, the UAE is an acclaimed IFC and its geographical location.
The UAE offers an extensive double tax treaty network, enabling investors to reap the tax benefits of using a UAE based entity to hold investments worldwide, while also increasing the attractiveness for foreign investors to set up business in the UAE.
While countries in the past were often reluctant to allow significant benefits in treaties with low or zero tax countries, many recent treaty partners have realized the advantages of making it attractive for inward investments. Some of the UAE’s recent treaties have been very favourable for the UAE investor, despite UAE being a tax free country.
Double tax treaties
The UAE has concluded nearly 80 double tax treaties, many of them with OECD countries.
Some of the tax treaties are not attractive because of the limitation of benefits clauses and inclusion of liable to tax clauses.
However, there are several treaties which are attractive. For example, the treaties with New Zealand, Austria and the Netherlands. None of these have a liability to pay tax. The treaty with the Netherlands was ratified in June 2010. Its most important effect for outbound investment (from the perspective of the UAE) is that it limits the dividend withholding tax rate to 5%. The Netherlands is a particularly attractive country for inward investment into the UAE now, because for most items of income the Netherlands will exempt Dutch companies from corporation tax on UAE income even though it has not been subject to tax in the UAE.
Cyprus also concluded 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 still an attractive option.
Inbound UAE and anti-avoidance
Domestic tax regimes of high tax jurisdictions often comprise provisions for the avoidance of domestic and international double taxation. Generally there are two main methods to avoid double taxation: the credit and exemption methods.
Countries that apply the credit method, in principle, include all items of income in their tax base, both from domestic sources and foreign sources, but allow a credit for foreign taxes against the domestic tax liability. This usually leads to taxation of income from foreign sources at the applicable tax rate of the state of residence of the company carrying out the foreign activities.
For countries that apply the exemption method, it may be somewhat more complex to determine the tax consequences of a foreign investment, but the outcome is usually more beneficial. Common exemptions in many tax regimes are exemptions for profits derived from a so called permanent establishment (“foreign branch exemption”), and exemptions for profits derived from a qualifying subsidiary (“participation exemption”).
For an investment in a tax free country like the UAE, the application of an exemption in the country of residence would clearly be beneficial over the application of a credit system, as the company will effectively benefit from the fact that there is no domestic taxation of its business profits derived from the UAE.
In general, exemptions are subject to criteria that are aimed at the avoidance of abuse or unintended use of the exemption. For example, in order to benefit from a participation exemption, many countries apply a combination of requirements, which may include a minimum percentage of shareholding in a subsidiary, a minimum holding period, activity tests, asset tests or tax tests. Transactions which lack commercial substance, or are not entered into for a bona fide purpose, would be caught by the provisions. Another method used to counter allocation of profits to companies resident in low tax countries is the application of CFC (ie controlled foreign company) rules. CFC rules generally aim to include the profits of a subsidiary in a low tax country in the tax base of the parent company (in a high tax country). In case of non-applicability of the participation exemption only profits that are distributed are included in the parent company’s tax base, whilst in case of CFC rules the subsidiary’s profits may be included in the parent company’s tax base even if no dividend has been distributed.
The beneficial ownership requirement is a specific anti-avoidance clause that, in contrast to newer versions of anti-avoidance clauses, has been a feature of the OECD model treaty for a long time.
For beneficial ownership a clear direction is beginning to emerge that if an entity does not have clear economic substance, there is an increased risk that it will not hold up upon review by the tax authorities and therefore will not achieve the intended tax benefits. Essentially substance is increasingly necessary to counter the charge that an entity or structure was set up solely, or even mainly, for tax reasons, is wholly artificial, or has not been set up for bona fide reasons, which may trigger the anti-avoidance legislation in the country which seeks to impose taxation.
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, even for small companies, to locate business functions there and realize the promised tax savings, even if the structure is reviewed by onshore tax authorities.
It is hard to think of a place where it is so uncomplicated and quick to set up in business in one of its free zones and to access the world’s labour pool as the UAE. It is even more difficult to think of any other traditional zero tax jurisdiction offering this. Free zones as a concept were pioneered by Dubai, the first one being Jebel Ali free zone. Benefits of operating from a free zone include: 100% 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 any restrictions on hiring foreign labour are also very important benefits.
Tax residence certificates
A tax residence certificate is a statement that a treaty partner considers a person qualified to enjoy the benefits of a tax treaty. It is sometimes one of the administrative requirements of a source state that the person based in the other state is required to show a tax residence certificate before the source state will grant the benefits agreed on in the treaty.
It is important to check beforehand, when one is going to rely on the treaty, whether the source state imposes this requirement and what the policy of the UAE Ministry of Finance is regarding the issue of tax residence certificates in the context of this treaty. For instance, the Ministry does not issue tax residence certificates for international companies, but it does issue for mainland and free zone entities.
UAE as regional headquarters for European holding companies
We append a table comparing certain features of holding companies in European jurisdictions with which UAE has double tax treaties in force today.
At a first glance, it is clear that many European countries have adopted the exemption method of taxation. As previously indicated, the application of the exemption method can be beneficial for businesses deriving profits from a subsidiary or their regional centre in UAE when fulfilling economic substance and pertinent criteria. The overall taxation for a holding group or company in Europe can be mitigated substantially if a subsidiary or regional centre is set-up in a free zone in Dubai. Business profits of the subsidiary in Dubai are not taxed and for tax purposes when repatriated to the holding company in Europe are treated preferentially.
Over the past years, the UAE has concluded a substantial number of tax treaties. Some of these treaties belong to the most efficient tax treaties in the world. However, other treaties contain restrictions that limit the scope of application of the relevant tax treaty. The broad variety of the provisions of the tax treaties concluded by the UAE requires a proper analysis of availability of treaty benefits on a case by case basis.
The UAE is particularly well positioned to cope with the increasing pressure from onshore tax authorities to provide real economic substance. Utilizing the UAE as a tax efficient jurisdiction, there are now opportunities available, even for medium sized companies, to locate business functions there and realize substantial tax savings.
One should carefully consider the preferred investment structure, both for business activities inbound the UAE as well as for outbound investments. When given due attention, a highly tax efficient structure may often be within reach!