How anti-avoidance provisions can curtail the application of Double Tax Treaties, including in the UAE?

The Ministry of Finance (MoF) of the United Arab Emirates (UAE) recently announced that the draft Corporate Tax (CT) law is going to be released soon, and likely within the month of September. This is impactful news for businesses in the UAE. Many businesses are already in the process of taking steps to plan their affairs in such a way that their operations are tax compliant and tax optimized at the same time.

The UAE’s international position will change after the implementation of corporate tax. Some jurisdictions may no longer view the UAE as a tax haven (although the Free Zone businesses may still benefit from a 0% rate). Other tax authorities may therefore change their perspective on the UAE and be more inclined to grant the benefits under the double tax treaties.

Businesses on the other hand, will no longer view the UAE as a conduit jurisdiction with an extensive treaty network, through which they can avail tax treaty benefits. While the 9% headline rate is still comparatively low, the implementation of CT may also discourage taxpayers seeking out the UAE solely for tax purposes.

A recurring point of dispute between the tax authority and businesses in almost every country having a CT regime has been drawing the line between tax planning, tax avoidance and tax evasion. Once the UAE CT regime settles, the Federal Tax Authority (FTA) of the UAE may indeed pay more attention towards countering tax avoidance and tax evasion arrangements or transactions.

In this article, we will revisit the evergreen discussion of tax planning, tax avoidance and tax evasion, with an emphasis on the Gulf Cooperation Council (GCC). To begin, let us examine the meaning of the terms tax avoidance and tax evasion and the differences between the two terms.

Tax avoidance has traditionally been considered as lawful. It can be described as planning for the purposes of minimizing the tax burden within the legal framework. Tax evasion on the other hand is considered unlawful, and often requires an intentional and a potential fraudulent element.

In the GCC, tax authorities resort rather quickly to suggesting a taxpayer has committed tax evasion, even when the situation concerns simple non-compliance.

While not considered unlawful, tax avoidance has been considered harmful. This is why countries around the world, including the GCC Member States, are implementing domestic rules to counter aggressive or harmful tax planning in line with international standards.

The OECD tried to address this point by way of the ‘Main Purpose Test’ (MPT). The MPT was included in the OECD’s Model Tax Convention in its 2003 version. We are paraphrasing, but the principle stated that benefits under a double tax treaty should not be granted where the main purpose of setting up a structure was for tax purposes as the tax benefits resulting from that structure would go counter the object and purpose of those treaties.

Another common mechanism proposed in tax treaties to avoid the improper use of tax treaties, is the ‘Beneficial Ownership’ (BO) requirement. It mainly applies to passive income (e.g., dividends, interests, and royalties). The BO concept provides that where an item of income is paid to a resident of a Contracting State acting in the capacity of an agent or a nominee, it would be inconsistent with the object and purpose of the source state to grant an exemption or relief, merely because the direct recipient is a resident of the other Contracting State. In such a case, the direct recipient, on account of being merely an agent, nominee, conduit, fiduciary, or administrator, would not be able to obtain the benefits of the treaty. This is especially evident if such recipient is legally or contractually bound to pass on the payment received to another person. BO disputes often end up before the courts, because the burden of proof for the taxpayer is not easily met. 

The 2008 Financial Crisis put the discussion on tax avoidance and aggressive tax planning firmly on governments’ agenda. Following the Financial Crisis, public opinion shifted towards ensuring that big corporations pay their fair share of taxes and pressured countries to implement rules to discourage such behaviors.

As a result, the OECD established what is known as the ‘Inclusive Framework’ (IF), which was open to both OECD and non-OECD members (currently at 141 members) to engage in discussions and create rules for countering Base Erosion and Profit Shifting (BEPS). It is formally known as the OECD/G20 BEPS Project (BEPS Project 1.0) which identified 15 Action Points in 2015.

Out of the 15 Action Points, one of the most important action plans was BEPS Action 6 – Prevention of Tax Treaty Abuse, which also formed one of the four minimum standards. BEPS Action 6 addresses treaty shopping activities that would be viewed as avoidance.

BEPS Action 6 requires IF members, amongst others, to include an express statement in their treaties that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements.

Anti-avoidance rules aim amongst others to avoid conduit arrangements. For example, State A has a domestic withholding tax rate for dividends of 25%. State A and State B have negotiated a tax treaty where the source withholding tax rate for dividends is reduced to 5%. A resident in State B receives dividends from State A and claims the reduced treaty rate of 5% source withholding.

However, the resident in State B has an obligation to redistribute the dividend income to a resident in State C. State A and State C do not have a tax treaty in place. It can be observed that there is no BO in State B due to its obligation to pass the payment onto another party. Clearly, such payment is not made for the benefit of any resident in State B nor for enhancing economic cooperation between States A and B. Instead, the benefit would be received by the resident of a third State (i.e., State C). This clearly shows that the treaty has been misused or abused by the resident of State B, against the intention, object, and purpose of the treaty between States A and B.  

To combat misuse of the treaty like the case described above, BEPS Action 6 seeks IF members to implement a ‘minimum standard’ in all its treaties. The minimum standard can be either of the following:

1. The combined approach of a Limitation of Benefits (LOB) and a Principal Purpose Test (PPT) rule,
2. The PPT rule alone, or
3. The LOB rule supplemented by a mechanism that would deal with conduit financing arrangements not already dealt with in tax treaties.

As a consequence, many IF members’ tax treaties have been updated to include, at least, a PPT rule. This is done by way of signing and ratifying the Multilateral Instrument (MLI) as it allows IF members to update multiple bilateral tax treaties simultaneously. The PPT rule looks a lot like the MPT. True to its name, if one of the principal purposes of an arrangement is to obtain a benefit, the PPT rule may be triggered. This clear intention has also been expressed in the wordings of the preamble incorporated in the OECD Model Tax Convention 2017.

Due to the lack of case law, the impact of the PPT rule is rather uncertain for now and the interpretation of the PPT rule may vary across jurisdictions. It may be possible that the cases that were successfully tested before the courts of law earlier may not survive the PPT rule if they were to be presented before the courts today, provided that the PPT rule was applicable at the time of the transaction or arrangement.

What is certain is that taxpayers ought to be very careful in tax planning so that the structures do not fall foul of the PPT rule. When deciding on the country to make an investment in or the structure of a transaction or arrangement, taxpayers ought to clearly record the non-tax reasons (main/principal purposes) for selecting a certain jurisdiction over another. Evidence can be maintained through internal emails, memos, and minutes outlining the reasons for selecting a country. For example:

• A country is preferred due to a favourable corporate law regime.
• A country is preferred due to the presence of multilingual or highly qualified employees.
• A country is preferred as it is politically and socially stable.
• A country is preferred as it has a strong banking infrastructure where it is easy to obtain credit.

Despite the above safeguards, if the tax authority does reasonably conclude that one of the principal purposes of invoking the treaty was to obtain a tax benefit, the taxpayer ought to ensure that it can establish (i.e., prove) that the benefit obtained was indeed within the object and purpose of the tax treaty.

Finally, as mentioned before, public opinion against tax avoidance is stronger than ever. The relevance of the PPT to future transactions cannot be overstated. Arrangements that may have been successfully litigated before the courts of law until a few years ago, may not be as successful from now on. Therefore, taxpayers may find advance rulings to be attractive as it is important to avoid future issues.

It will be interesting to see how the UAE and the other GCC countries will approach such abusive arrangements and its possible disputes. In the meantime, it is apparent that either through the MLI or through bilateral double tax treaties, the PPT continues to be important. It is vital to consider such anti-avoidance provisions now in order to create future proof structures.