GCC Tax Theatre | International Tax | Policy Considerations for Bilateral Tax Treaties under OECD Model Tax Convention

(Source of this article is OECD's Model Tax Convention on Income and on Capital.)

Main purpose of bilateral tax treaties

The main objective of tax treaties is the avoidance of double taxation in order to reduce tax obstacles to -

-?????????cross-border services,

-?????????trade, and

-?????????investment.

Such risks of double taxation will generally be more important where there is a significant level of existing or projected cross-border trade and investment between two States.

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Allocation of taxing rights

Most of the provisions of tax treaties seek to alleviate double taxation by allocating taxing rights between the two States and it is assumed that where a State accepts treaty provisions that restrict its right to tax elements of income, it generally does so on the understanding that these elements of income are taxable in the other State.

UAE-KSA Perspective: For example, under the UAE-KSA Tax Convention, payment of interest on loan by a taxpayer in KSA to a UAE lender is subject to zero percent withholding tax deduction in KSA. However, when the lender records this interest income, the default treatment is that such interest income is subtracted from interest expense giving rise to net interest expense, which is deductible from taxable income. In this manner the said income is effectively taxed in UAE instead of KSA; hence the self-restriction by KSA to tax this income, source of which is originally KSA.

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No-/low-tax jurisdictions

Where a State levies no or low-income taxes, other State should consider whether there are risks of double taxation that would justify, by themselves, a tax treaty.

Risk of non-taxation and ringfencing

States should also consider whether there are elements of another State’s tax system that could increase the risk of non-taxation, which may include tax advantages that are ringfenced from the domestic economy.

Note: A ringfence is a virtual barrier that segregates a portion of an individual's or company's financial assets from the rest. This may be done to reserve money for a specific purpose, to reduce taxes on the individual or company, or to protect the assets from losses incurred by riskier operations. An example of ringfencing could be creation of a trust structure in those GCC countries (e.g., Kuwait or KSA) which exempt the tax base of a national/citizen. To create such a structure, a national shareholder is appointed as a trustee of majority shares on behalf of taxable foreign investors but prohibited from participating in profits, control and liquidation proceeds, thereby “ringfencing” majority profits, so to say.

Assessing the actual risk of double taxation

Accordingly, two States that consider entering into a tax treaty should evaluate the extent to which the risk of double taxation actually exists in cross-border situations involving their residents.

Domestic level relief from residence-source juridical double taxation

A large number of cases of residence-source juridical double taxation can be eliminated through domestic provisions for the relief of double taxation (ordinarily in the form of either the exemption or credit method) which operate without the need for tax treaties.

UAE Perspective: UAE Corporate Tax Law provisions related to Foreign Permanent Establishment provide both options of credit and exemption upon the discretion of the taxpayer. Similarly, exemptions are also available to foreign Participation income.

Significant differences between source rules of taxable income

Whilst these domestic provisions will likely address most forms of residence-source juridical double taxation, they will not cover all cases of double taxation, especially if there are significant differences in the source rules of the two States or if the domestic law of these States does not allow for unilateral relief of economic double taxation (e.g. in the case of a transfer pricing adjustment made in another State).

Risk of excessive taxation

Another tax policy consideration that is relevant to the conclusion of a tax treaty is the risk of excessive taxation that may result from high withholding taxes in the source State. Whilst mechanisms for the relief of double taxation will normally ensure that such high withholding taxes do not result in double taxation, to the extent that such taxes levied in the State of source exceed the amount of tax normally levied on profits in the State of residence, they may have a detrimental effect on cross-border trade and investment.

UAE-KSA Perspective: For example, under the UAE-KSA Tax Convention, Saudi dividends remitted to UAE investors are subject to a lower withholding tax rate of 5% compared to the default withholding tax deduction rate of 10%.

Further tax considerations of viability of bilateral tax treaties

Additional aspects should be taken into account when considering entering into a tax treaty include the various features of tax treaties that encourage and foster economic ties between countries, such as

-?????????protection from discriminatory tax treatment of foreign investment that is offered by the nondiscrimination rules of Article 24 of OECD's Model Tax Convention,

-?????????the greater certainty of tax treatment for taxpayers who are entitled to benefit from the treaty and

-?????????the fact that tax treaties provide, through the mutual agreement procedure, together with the possibility for Contracting States of moving to arbitration, a mechanism for the resolution of cross-border tax disputes.

Tax treaties as a measure for preventing tax avoidance and evasion

An important objective of tax treaties being the prevention of tax avoidance and evasion, States should also consider whether their prospective treaty partners are willing and able to implement effectively the provisions of tax treaties concerning administrative assistance, such as the ability to exchange tax information, this being a key aspect that should be taken into account when deciding whether or not to enter into a tax treaty.

Measures alternative to tax treaties

The ability and willingness of a State to provide assistance in the collection of taxes would also be a relevant factor to take into account. It should be noted, however, that in the absence of any actual risk of double taxation, these administrative provisions would not, by themselves, provide a sufficient tax policy basis for the existence of a tax treaty because such administrative assistance could be secured through more targeted alternative agreements, such as the conclusion of a tax information exchange agreement or the participation in the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.

To date UAE has entered into bilateral Tax Treaties with only two GCC States, which are KSA and Kuwait.