The days of “brass plate” registrations are coming to an end. An increasing number of double tax treaties incorporate antiavoidance provisions.
One such example is India. The recent direct tax code includes specific anti-avoidance (CFC rules) and general anti-avoidance provisions. In line with similar provisions in other countries, transactions that lack commercial substance or those which are not entered into for a bona fide purpose, will fall under these provisions.
The OECD in its commentary to its model treaty states “A guiding principle is that the benefits of a DTC (Double Tax Convention) should not be available where the main purpose for entering into certain transactions or arrangements was 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”.
It is difficult to imagine how taxes cannot be a main consideration! It is also clear that the OECD approves of domestic anti-avoidance provisions taking precedence over double tax treaties.
The “beneficial ownership” requirement is an anti-avoidance clause which is normally included in double tax treaties. It has been a long standing assumption that the recipient of dividends, interest and royalties is the beneficial owner. A new direction now is emerging, no longer agents and nominees can qualify as beneficial owners of received income. In the well-known Indofoods case, beneficial ownership of interest income was found to be lacking because the recipient had no alternative but to pass on the income to another. The recipient did not enjoy the privilege to benefit from the income.
Countries differ to the extent to which they allow antiavoidance legislation to take precedence over tax treaties and case law is still not conclusive on beneficial ownership. It is undeniable, however, that a clear direction has emerged that if an entity does not have economic substance, it will not hold up upon review by Tax Authorities and may not achieve the intended tax benefits.
Essentially substance is increasingly necessary to refute the argument that an entity or structure is set up solely for taxavoidance purposes, or is artificial, or is not set up for bona fide reasons. Such reasons trigger the anti-avoidance legislation in the country that seeks to tax the company and individuals.
How about the UAE and in particular, the emirate of Ras al Khaimah? It is easy to set up in this emirate and to access
the world’s labour pool. It is hard to think of another zero tax jurisdiction which offers so many business and tax incentives. Free zones (FZ) were introduced in Dubai, the first one being Jebel Ali free zone. Benefits of operating from a FZ include 100 percent foreign ownership, guarantee against future imposition of tax and no restrictions on hiring foreign labour. There is currently no direct taxation, no VAT imposed and continuity and investor security are guaranteed. Furthermore, a local sponsor, one who otherwise could wield significant power is not needed, another advantage of setting up in a FZ is that the Authorities provide a one-stop shop for dealing with government formalities which makes it fast and easy to get started.
Ras al Khaimah is to a great extent a free market orientated emirate. The Ras al Khaimah Investment Authority (RAKIA) markets its FZ to the investors with lack of red tape, no restrictions on foreign labour and business friendly policies. RAK international business/ offshore (a company registry for IBCs) is marketed under the slogan“an entrepreneur’s paradise”.
Ras al Khaimah introduced the provision of mini offices (and the other FZ in Dubai followed) with office space starting from 10 sq m, as well as desk sharing solutions. RAKIA is currently the only FZ in the UAE that does not require minimum capital. It is easy to see how this regime makes it possible for multinationals 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 with many traditional offshore jurisdictions is that there are abundant non tax reasons for setting up a business. The strategic location between east and west makes it a natural choice for setting up customer service centres, IT support or a procurement centres. Dubai is the main airline hub on 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.
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 having to be put back onshore, which entails increased risk if these structures were to be reviewed and scrutinized. The de facto free immigration for anyone willing to work is really key to realizing and meeting the economic substance criterion.
A presence can be established in the UAE by incorporating a FZ company with an overseas allocation of one or two persons and by renting a small office space from the FZ. The overseas parent company could then possibly send one or more well-trained staff to the UAE to carry out specific corporate functions possibly assisted by a corporate service provider who provides qualified directors, has a professional network and assists with the realization of substance in the UAE to make sure that the structure will withstand the scrutiny of Tax Authorities when reviewed.
The IT infrastructure in the UAE, now provides a compelling non-tax argument to set up in the UAE. ADSL has now mostly been replaced by 40Mbps fiber optic connections. This provides a business rationale for operating an e-commerce server from the UAE. The purpose is to establish a permanent establishment (PE) in the UAE, attribute specific functions to this FZ company and justify it as a PE in the UAE. This would justify allocation of profits to the company.
The UAE has concluded approximately 80 double tax treaties, many of these with OECD countries. Some are not very attractive because of the limitation of benefits clauses, inclusion of tax liability clauses and uncertainty as to whether UAE residents are liable to tax in the context of the treaty. For example, some treaties restrict the benefits to individuals to UAE nationals, and some other to government organizations. However, there are several double tax treaties of UAE that are favourable including the treaties with New Zealand, Austria and the Netherlands. None of these has a liable to tax requirement.
The most important effect for outbound investment from the UAE perspective is that it limits the dividend withholding tax rate to 5 percent. The Netherlands is a particularly attractive country for inward investments into the UAE, as most types of income that can be attributed to the UAE are exempt from Dutch corporation tax, even if they are not taxed in the UAE.
In particular, UAE real estate gains 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 they do not result from passive investments.
Another country that can be beneficially used for inward investment into the UAE is Cyprus. Cyprus also has a tax treaty with the UAE but has an even more favourable participation exemption system than the Netherlands and it exempts profits made by permanent establishment abroad under domestic legislation.
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 in the UAE.