UAE signs Multilateral Instrument - Impact on UAE's Double Tax Treaties & What does it actually mean for Investors and Businesses
1 July 2018
By Ton van Doremalen
On 27 June 2018 the United Arab Emirates (UAE) signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ("Multilateral Instrument" or "MLI"). The signing of the MLI is an important event for the UAE's double tax treaty network and also an encouraging sign of the country's effective actions to be completely removed from the European Union (EU) Council's lists in relation to non-cooperative jurisdictions for tax purposes.
The MLI is a legal instrument which has been developed to amend and update, at once, countries' bilateral tax treaty networks in order to implement the tax treaty measures developed under various actions of the G20 / Organisation for Economic Cooperation and Development's (OECD) anti-Base Erosion and Profit Shifting (BEPS) project. The MLI has been signed by 81[1] countries and more countries are expected to sign it in the future.
Currently, there are more than 80 double tax treaties in force between the UAE and other jurisdictions and more than 30 are under negotiation or awaiting ratification. For a country which does not currently levy corporate income tax, with the exception of oil and gas companies and branches of foreign banks, this extensive double tax treaty network is an unprecedented achievement and a testament to the jurisdiction's commitment to accommodate internationally active businesses and multinationals. The large number of double tax treaties concluded by the UAE means that the MLI will most certainly have an impact on many of the UAE legal structures currently relying on double tax treaty protection.
Multilateral Instrument in more detail
The BEPS project is, inter alia, aimed at countering the phenomena of tax treaty abuse and tax avoidance. Tax treaties which seek to relieve double taxation of income and capital in cross-border scenarios have sometimes been used by taxpayers to artificially generate low or no taxation, typically by using treaty shopping arrangements. Treaty shopping is a specific form of tax treaty abuse whereby residents of a non-treaty state try to obtain the benefits of a tax treaty by interposing a company in a treaty state which subsequently forwards passive income to the residents of the non-treaty state. In the absence of such interposition, the resident of the non-treaty state would, at best, be entitled to benefits under the tax treaty between the country of its residence and the state of source of income (assuming a tax treaty exists at all) and not of any other tax treaty.
With a view to counteracting these practices, the OECD released, in 2015, recommendations which required a revamp of the existing tax treaty rules. In order to ensure swift and coordinated implementation of these measures, a multilateral instrument was considered to be the instrument of choice as that would update the existing network of more than 2,000 bilateral tax treaties at once, thus avoiding the need to renegotiate each bilateral tax treaty separately.
The MLI contains a number of treaty related measures, each of which constitutes either an optional provision or a minimum standard. Optional provisions[2] offer participating countries choice of adoption which means that countries enjoy the flexibility to adopt (or not) such a provision. Upon signing the MLI the UAE has chosen not to adopt many of the optional provisions. By contrast, minimum standard provisions are those which the participating countries must adopt and incorporate in their tax treaties unless an equivalent provision already exists in those tax treaties. One such anti-abuse measure which is adopted by the UAE is the Principal Purpose Test (PPT).
Principal Purpose Test
With respect to the PPT, that rule looks at the principal purposes for entering into a transaction or arrangement. Where a principal purpose of a transaction or arrangement is to secure the benefits of a tax treaty, the PPT rule will be triggered and the tax authorities will, on that basis, be entitled to deny that treaty benefit. As a quick illustration, ACo, a company tax resident in Country A, wholly owns an operating subsidiary, CCo in Country C. Subsequently, ACo interposes a holding company, BCo in country B solely with a view to benefitting from the more favourable treatment under the B-C tax treaty (for example, an increased reduction of withholding tax on dividend distributions). The interposition of BCo is very likely to be challenged by Country C's tax authorities under the PPT rule.
Under the PPT rule, obtaining the benefit under a tax treaty need not be the sole or main or dominant purpose of the arrangement or transaction in question. For triggering the rule, it is sufficient if one of the principal purposes of the arrangement or transaction was to obtain the benefit.
Impact MLI on UAE double tax treaties
The effect of the UAE having signed the MLI is that its tax treaty network will be updated to include the PPT rule and the other minimum standard provisions. As such, the anti-abuse rule in the form of the PPT will be adopted and will subsequently form part of the UAE's tax treaties. It must be noted that the MLI provision will apply only where the PPT rule is symmetrically adopted for implementation by the UAE and its relevant tax treaty partners. By symmetrical adoption is meant that both tax treaty partners must adopt the PPT rule as opposed to tax treaty partners' asymmetrical adoption[3] which would create an impasse which needs to be resolved in favour of a mutually acceptable solution that meets the (anti-treaty shopping) minimum standard.
Subsequent to the MLI taking effect for the UAE and its tax treaty partners, the tax authorities of the UAE tax treaty partner will likely scrutinize a transaction or arrangement against the PPT rule and potentially deny treaty benefits where the taxpayer fails to meet those tests. It should be noted that upon signing the MLI, the UAE also indicated its choice for an optional mechanism where taxpayers can request the competent authority of the tax treaty partner country, from which the relevant income is sourced, to assess the case and consult with the other treaty country (i.e. the UAE) before rejecting any such request.
Historically, the UAE has been used by non-resident investors and businesses not only as the destination country for their investments and business operations but also to structure their investments into the region. The impact of the new rules will very likely be felt in the latter set of cases where a UAE tax treaty partner country is the state of the source of income. In order to ensure that the tax treaty benefits are not granted in inappropriate circumstances, tax authorities of the UAE tax treaty partner country will test an arrangement or transaction in question against the parameters of the PPT rule.
Where, in a case, tax treaty benefits are denied and these cannot be used effectively to generate (higher) foreign tax credits in the home country of the taxpayer, these will end up becoming a permanent tax cost for the taxpayer.
It is worth noting that these new anti-abuse rules do not replace the existing treaty requirements found in the concepts of residence and beneficial ownership but are in addition thereto which means that the taxpayers will need to satisfy these (also) before they can be held entitled to tax treaty benefits. As it is, both residence and beneficial ownership requirements can present difficulty of application in a tax treaty context. This difficulty is accentuated due to the fact that the concept of residence takes a variety of forms under the UAE's double tax treaties which employ, for companies, criteria such as place of incorporation, place of management, liability to tax, subject to tax, to name a few.
What should investors and businesses do
The adoption of the new anti-abuse rule, in the form of the PPT, will constitute a serious concern for businesses and investors investing in or through the UAE. That concern seems even more pertinent as the PPT rule uses a relatively low threshold for perceived abuse. As noted earlier, to trigger the application of the PPT rule it is sufficient that at least one of the principal purposes of an arrangement or transaction is to obtain the benefit under a tax treaty. The presence of this lower threshold increases the likelihood of an arrangement or transaction being found to be abusive by a foreign tax authority and consequently being denied treaty benefits by one of the UAE's tax treaty partners.
Taxpayers are therefore advised to revisit and review their existing investment and legal structures to determine if and to what extent the newly introduced anti-treaty shopping rules will impact those structures. This assessment should be followed, where necessary, by steps to revamp (or even overhaul) existing structures so that they do not fall foul of these new rules. In addition, taxpayers considering to make investments out of or through the UAE should take these new anti-treaty shopping rules into account to ensure that the structures being put in place will withstand the scrutiny of the PPT rule.
In the context of the PPT rule, structures that are founded on commercial objectives, with business motives and operational substance at their core, are more likely to pass the stringent standards under the new anti-treaty shopping rules. Where taxpayers can demonstrate economic substance and commercial reasons for setting up a structure, it is very likely to successfully meet the challenges posed by the new anti-abuse rules.
The adoption and use of the PPT rule is likely to encourage centralization of activities, in one place or a few places globally by businesses, for example in the form of global or regional investment platforms. Centralization and the related concentration of substance will be instrumental for demonstrating commercial reasons and economic substance for a structure to counter another country's tax authorities' challenge under the PPT rule. Businesses will naturally be inclined to consider, for this purpose, jurisdictions which have the necessary legal environment and the appropriate infrastructure in this regard. Because the UAE has an ideal infrastructure, including an extensive tax treaty network, to accommodate the creation of such regional platforms (specifically focusing on the Middle East, Africa and South East Asia), it would be advantageous for businesses and investors to use a UAE platform for their multinational operations and investments.
A word of caution
One word of caution regarding the way the MLI instrument has been developed to function: which is to operate alongside the existing tax treaties instead of directly amending (the text of) those tax treaties. This will require a meticulous handling of the two instruments, i.e. the MLI and the relevant tax treaty to ensure proper interpretation and correct application of the newly adopted provisions. The approach is far from straightforward (as is the case with tax treaties and amending protocols) and will be best handled with the assistance and advice of experts who have ample experience with (the application of) tax treaties.
[1] Number of signatories as on 27 June 2018.
[2] An example of an optional provision is the anti-abuse rule concerning permanent establishments, or 'taxable presence' in other jurisdictions, which seeks to lower the threshold to create such taxable presence.
[3] For example, where the UAE chose to adopt the PPT rule (which is the default rule) whereas its tax treaty partner notifies adoption of the detailed LoB provision together with the anti-conduit rules.