Who hasn't heard of the traditional tax havens?
Places such as the British Virgin Islands (BVI), Seychelles, Belize. Small countries or islands usually not too far from the equator with nice sunny climates and not much in the way of high rise buildings.
So what is it that attracts international business to set up in one of these remote, less than prime, business locations? The tax advantages, of course... After all, nobody
would say no to the zero percent tax rate found in these tax paradises.
But traditional tax havens are subjected to massive scrutiny. What was normal five years—tax planning with little substance—is impossible today! Luckily, there are still alternatives.
In this article, we explain how you can use legal tax planning tools by creating economic substance in the UAE. You'll discover exactly how to enjoy the tax benefits of traditional tax havens, while complying with the latest international tax regulations!
Disadvantages of traditional tax havens
The 1980’s and 1990’s were times when not much was regulated. Consequently, tax havens worked well. In today’s global economy and especially after the recent financial problems and scandals, the spotlight has focused on international groups and companies, especially bigger ones, where they pay their taxes.
With the governments of the world needing to increase their own revenue and with a public outcry of double standards and unfairness, the large economies of the world have started to close the loopholes that these international companies are using, therefore making it more difficult to operate out of a traditional tax haven.
Is there an alternative?
If we were to say to you that you could have, as an alternative, an international company based in one of the world’s prime business cities, with nearly 400 high rise office buildings, and in the middle of a global business hub, all this whilst keeping all the tax advantages that you would expect of a traditional tax haven, you probably would not believe this.
The alternative we talk about is the United Arab Emirates, a country consisting of seven Kingdoms known as Emirates.
It is worth noting for the remainder of this article, that the different Emirates are relatively autonomous and have separate economies. Abu Dhabi is the largest and wealthiest Emirate due to its large oil reserves. Dubai's oil is all but dried up and they investment massively in attracting business, trade and tourism. The other Emirates each have various specialties and each tries to make itself attractive for foreign investors. You'll see how this can work to your benefit.
The UAE is a modern, vibrant country with great infrastructure including massive international airports, seaports, rail systems and high speed internet connections. It also has very strict privacy laws. Government paper work that is required, is simple and straight forward and, in most cases, swift (not always).
If visas are required, the process is also straight forward and relatively simple and quick. It has a booming property market. It also boasts a wide variety of options for renting office space. It is a true cosmopolitan country with many nationalities making up the local population and English is widely spoken. The law is civil law.
Geographically it is situated in the middle of Europe, Asia, the Middle East and Africa. This means it is never more than a few hours in front or behind your time zone.
Dubai especially is a world renowned international financial centre with a great reputation and does not appear on any black list, therefore making work with the financial industry much easier.
The Rulers of the UAE are very cautious about their image, and have widely adapted global transparency and regulatory standards. Controls are in place to ensure that whilst attracting international businesses and making a name in international financial services they maintain reputable standards.
But the most important aspect of the UAE is of course: it remains very tax friendly!
Taxation in the UAE
Here is a short overview of the most important taxes in the UAE.
Currently, the UAE federation does not impose a federal corporate income tax.
Under the Emirate based tax decrees, corporate income taxes may be imposed on all companies – including branches and permanent establishments. However, in practice the corporate income tax is currently imposed only on oil and gas companies and branches of foreign banks having operations in the emirates.
In addition, some of the emirates have introduced their own specific banking tax decrees which impose tax on branches of foreign banks at the rates of 20 percent.
Entities established in a free trade zone in the UAE are treated differently than a normal “onshore” UAE entity. Free trade zones have their own rules and regulations and typically, from a tax perspective, they generally offer guaranteed tax holidays to businesses and their employees set up in the free trade zone for a period between 15 to 50 years, which are mostly renewable.
Personal income tax
There are currently no personal income taxes imposed on individuals working in the UAE.
There is a social security regime in the UAE which applies to employees who are GCC nationals. Generally, for UAE nationals the social security payment is at a rate of 17.5 percent of the employee’s gross remuneration as stated in an employee’s employment contract and applies regardless of the free zone tax holidays. 5 percent is payable by the employee and the remaining 12.5 percent is payable by the employer.
This means that there are no personal income taxes for non-uae nationals on UAE sourced income (whether they live in the UAE or not).
In 2018, a 5% VAT was introduced in the UAE, applicable to all corporate structures besides offshore companies. Read more about VAT in the UAE here.
How to Benefit from 0% Taxes in the UAE?
For foreign investors, there are a number of ways benefit from low tax rates in the UAE.
First of all, you can off course move to the UAE. 1000s Of investors have started their tax-free journey by simply moving here and starting successful businesses with less regulations and no taxes. However, even for foreign investors the UAE by using tax treaties.
What are tax treaties? Tax treaties in principle create rights for a tax payer, preventing them from being taxed twice on the same income. Cooperating countries sign these agreement to stimulate investment in between their countries. These treaties often offer a reduce tax rate on for example withholding taxes on dividends paid to shareholders in countries that are part of the treaty. This is absent in traditional tax havens.
The UAE has an extensive -and growing- list of double tax treaties, which currently numbers over 80. Almost 30 new tax treaties are currently being negotiated. This network includes treaties with China, Cyprus, France, Germany, India, Indonesia, Italy, Luxembourg, Malaysia, Malta, the Netherlands, Singapore, South Korea, Russia, United Kingdom, Ukraine and many more!
These double tax treaties aim make the UAE a more attractive territory from which to operate. The following graph demonstrates a number of results the taxes have on the tax rates.
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.
Overview of tax treaties of the UAE and applicable rates:
Tax Treaty Requirements and Obligations
You might be wondering: do I only have to incorporate a company in the UAE to benefit from reduced taxation? The answer: yes and no. You see, in order to benefit from a treaty, a tax payer must be considered resident. It depends a bit on the domestic tax laws and what has been agreed in the treaty if a tax payers is designated as such.
For many of the UAE treaties the “place of incorporation” criterion is leading. Simply put, if a company is incorporated or created in the UAE, then it will be a resident for the purposes of that particular treaty. The treaties with Armenia, Finland, Mauritius, Mongolia, Luxembourg, Sri Lanka, Austria, Switzerland, Mozambique and New Zealand fall within this category.
Some countries impose the additional test of place of effective management. Examples are: Germany, Korea, Spain, Romania, India and Canada. Moreover, an increasing number of tax treaties incorporate anti-avoidance provisions. Corporate arrangements which lack commercial sense (just set-up to obtain a tax benefit) are caught by the provisions.
Credit vs Exemption Methods
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.
A key question is whether domestic anti-avoidance provisions take precedence over the terms of a double tax treaty. The OECD published guidance on this which states “a guiding principle is that the benefits of a DTT 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.”
The first clause is stretching it, as it is difficult to imagine in a world of high taxes, how taxes cannot be a significant reason. It is clear that the OECD maintains the stance that domestic anti-avoidance provisions take precedence over double tax treaties.
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 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 question here is “who is the beneficial owner”? Only a few examples of situations in which the recipient is not considered to be the beneficial owner were included in the OECD commentary to the model tax treaty - namely if the recipient is an agent or nominee, then it is not the beneficial owner of received income. It has been left to case law to fill in the gaps as to whether there are other circumstances in which the recipient is not considered to be the beneficial owner
While countries differ to the extent to which they allow anti-avoidance legislation to take precedence over tax treaties, and case law is still not conclusive on “beneficial ownership”, a clear direction has emerged that if an entity does not have economic substance, there is an increasing risk that it will not hold up upon review by 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 for tax reasons is artificial, or is not set up for bona fide reasons which can trigger the anti avoidance legislation.
It is undeniable 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 any intended tax benefits. Essentially substance is increasingly necessary to refute the argument that an entity or structure is set up solely for tax avoidance 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.
To summarize: you need “substance”.
The first question one must ask in order to understand if economic substance exist, the most logical question is: does any activity take place there. If a company is what is known as an empty "shell" or "mail-box" firm, it is unlikely that any substance requirements can be met. There can still be a use for such registrations, but not when tax planning is an issue.
Economic substance means that there must be a substantial purpose for using a specific country of operations (aside from reduction of tax liability), and an economic effect (aside from the tax effect). Economic substance looks at the economic (operational) reality of a corporate structure, especially if it has been put in place because of international tax optimisation reasons. Tax authorities look at the economic rationale behind a company in a particular country.
A considerable number of international tax planning structures (finance companies, holding and sub-holding companies, intellectual property (IP) structures and trading companies) previously established to benefit from tax laws or the favourable conditions of double taxation treaties might not pas the economic substance test.
What does economic substance mean in practice?
There are no fixed lists. It depends highly on the circumstances. For most of our clients, small to medium sized business owners, the most important question is that of management and control. Where is the effective place of management located?
The factors that can determine (there are others) a place of effective management include:
key office location
place where meetings are held or initiated
domicile of controlling individuals
property and IP held
head office mailing address
location of auditor and accounts
residence of the manager or management
In practice, you'll usually see that those enforcing compliance follow similar lists as mentioned above. As you can understand, it isn't easy to proof that a company is run from the Seychelles. However, this is different in the UAE.
Economic Substance in the UAE
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.
This regime makes it possible for multinationals and 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 advantage of UAE is that there are ample non-tax reasons for setting up business there. The strategic location between East and West makes it a logical choice for setting up, say, a customer service, IT support, or a procurement centre. Dubai is the main airline hub connecting East to West. This provides further commercial rationale for establishing a business in the UAE and the fact that it is an international important (regional) financial centre ensures the availability of quality professional services.
The IT infrastructure in the UAE, provides a compelling nontax argument for setting up in the UAE. Asymmetric digital subscriber line (ADSL) technology has now been replaced by fiber-optic connections. This provides a business rationale for operating an e-commerce server in the UAE. The goal is to attribute sufficient functions to the company so that it would amount to a permanent establishment (PE) in the UAE. This would provide the justification for allocating profits to the company.
Substance in Free Zones
By making use of the UAE FZs, there are now opportunities for companies of any size to locate business functions in the country. It is relatively easy and quick to set up a business as it is in a UAE FZ.
A free zone (FZ) entity in the UAE offers many tax and business possibilities. Here they are summarized:
100 Percent foreign ownership
No restrictions on hiring labour
Economic substance is reinforced
Residence permits for the overseas owners and management of the FZ entity
Guarantee for 15-50 years against future imposition of corporation tax
Import of goods is duty free, provided the goods are not supplied to the local market
Streamlined procedures: all formalities are typically dealt with through the FZ authorities instead of the various government apartments
A further possibility available to a FZ is to issue residence permits and obtain tax residence certificates from the UAE authorities for its foreign owners and executives. A FZ company, must have physical presence in the UAE and, in that respect, it must own or hire premises. If only a small office is required the most cost effective options are available by free zones in the northern emirates, notably Hamriyah and Ajman free zones. Physical presence options include flexi desks or flexi offices.
Furthermore, if a local bank account is maintained with some transactions movements, the foreign owners and executives can apply to the Ministry of Finance to receive UAE tax residence certificates. A UAE residence permit and a tax residence certificate can be useful to many foreign owners and executives of FZs who wish to register tax residency in the UAE. Banking institutions in the UAE and many outside consider UAE tax residence certificates as proof of tax residency in the UAE. The advice of a competent tax lawyer must be sought also.
An important aspect for foreign investors and global companies is the use of UAE FZ in establishing UAE presence. The FZ are used by foreign investors to retain 100 percent beneficial ownership and to avoid the 5 percent import duty on goods. The benefits of the double tax treaties also apply to FZ entities established by foreign investors.
Economic Substance for Multinationals?
The FZ regime makes it possible for multinationals and entrepreneurs to establish a foothold in the UAE while transferring genuine economic functions to the newly formed entity. 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 free zone. 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 local professionals who can provide advice, qualified directors and their professional network to assist with the realization of substance in the UAE.
UAE as regional headquarters for European holding companies
The UAE can be interesting to for tax planning in and out of Europe. 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.
Tax Planning in the UAE with Economic Substance
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. But there can be no doubt that the UAE offers significant tax planning benefits!
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 here 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!
Are you interested in moving some of your business functions to the UAE? Do not hesitate to contact us