Residency : The first step towards taxation - tie- breaker rule

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Determining the residential status of a person is the first step to going ahead with the tax obligations in any country. The UAE has signed and is still signing Double Taxation Agreements (DTAs) with several countries that specify Residency tests for the person doing business in the UAE as well as another country. This Article aims to provide an overview of the interpretation of the ‘Residency Test’ specified under DTAs with specific reference to the UAE.

What is DTA?

Double taxation is defined as when similar taxes are imposed in two countries on the same taxpayer on the same tax base, which harmfully affects the exchange of goods, services and capital and technology transfer and trade across the border.

A Double Taxation Agreement is an International Agreement signed by two or more countries to avoid double taxation and prevent fiscal evasion of income and capital.

The primary purpose of a DTA is to ensure that the same income is not taxed twice in two different countries. This situation typically arises when an individual or entity is a resident of one country (the residence country) but earns income in another country (the source country).

The UAE Model:

The United Arab Emirates (UAE) has long been known as a Zero Corporate Tax Jurisdiction. However, this was changed with the Ministry of Finance's (MOF) announcement on January 31, 2022, that the UAE introduced a Federal Corporate Income Tax (CT) effective for financial years starting on or after June 1, 2023. The announcement of the CT has now increased the relevance of DTAs. Public and private companies, investment firms, air transport firms and other companies operating in the UAE, as well as residents, benefit from Avoidance of Double Taxation Agreements (DTA). With the purpose of promoting its development goals, the UAE concluded 137 DTA with most of its trade partners.[1]

Organisation for Economic Co-operation and Development (OECD) Model Convention is followed by developed countries which advocates the Residence Principle. The UAE generally follows the OECD Model Tax Convention as a basis for its Double Taxation Agreements. The OECD Model generally provides the right to the Residence Country to tax the income.

Principle of Residency Test:

Residency refers to the status of an individual or entity as a resident of a particular country for tax purposes. This status determines which country has the ultimate right to tax the individual's or entity's income and gain access to a DTA and avail the benefits thereunder.

The concept of ‘resident of a Contracting State’ has various functions and assumes significance in the following three scenarios:

• In determining a DTA’s scope of application
• In solving cases where double taxation arises as a consequence of double residence
• In solving cases where double taxation arises as a consequence of taxation in the state of residence and also in the state of source of income.

As specified above, Resident of a Contracting State means any person who is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature and also includes that State and any political subdivision or local authority. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

Example: A Company which is having its place of management in UAE will be considered as a Resident of the UAE.

The Tie-breaker Rule:

Let’s take an example of Mr. Ahmed who is domiciled in UAE (primary place of residence) but is currently staying in India for his business purpose. He would be considered as Resident in UAE as well as India. To solve this issue, DTAs have Tie-breaker Rules.

If the person is a resident of both Contracting States (CSs) as per domestic tax laws of both the CSs, then the following provisions shall apply:

For Individual (to be followed chronologically)

a) Permanent Home: The first test is based on where the individual has a permanent home i.e., a dwelling place available to him at all times continuously and not occasionally.

b) Personal And Economic Relations: If the individual has permanent home available to him in both Contracting States, he will be considered a resident of the Contracting State where his personal and economic relations are closer, in other words, the place where lies his centre of vital interests. Thus, preference is given to family and social relations, occupation, place of business, place of administration of his properties, political, cultural and other activities of the individual.

c) Habitual abode: In a case where the individual has a permanent home available to him in both Contracting States and it is not possible to determine in which one he has his centre of vital interests; and in a case where the individual has a permanent home available to him in neither Contracting State, preference is given to the Contracting State where the individual has an habitual abode.

d) Nationality: If the individual has habitual abode in both Contracting States or in neither of them, he shall be treated as a resident of the Contracting State of which he is a national.

e) Decision by Competent Authority: If the individual is a national of both or neither of the Contracting States, the matter is left to be considered by the competent authorities of the respective Contracting States.

Persons other than Individuals

If a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident of the State in which its place of effective management is situated.

Example on Tie Breaker Rule

Case: Aamir is a resident of both the UAE and India as per the Tax Laws of both the countries. He owns immovable properties (including residential house) in both the countries. He earns income from business in India; Aamir has an office in in New Delhi i.e. permanent establishment in India. Aamir has no permanent establishment of business in the UAE. However, he has a house in Dubai Marina where he stays during his visit to UAE.

Analysis: Aamir has residential houses both in India and the UAE. Thus, he has a permanent home in both the countries. Since he has a permanent home in both the countries, he shall be deemed to be resident of that country, which is the centre of his vital interests i.e. the country with which he has closer personal and economic relations. Aamir has no permanent establishment of business in the UAE. But Aamir has derived business income in India. Therefore, his personal and economic relations with India are closer. Since India is the place where –

a) the property is located and

b) the permanent establishment (PE) has been set up

Therefore, he shall be deemed to be a Resident of India for that year.

Conclusion 

In short, once the Residency is determined through the above rules, the Individual or Entity is considered a resident of only one country for the purposes of taxation under the DTA. In the context of the United Arab Emirates, Residency plays a significant role in determining tax obligations for corporations engaged in activities within the country. Residency is primarily determined by physical presence, though other factors like domicile and economic ties may also be considered. Once residency is established, individuals and entities become subject to UAE tax laws, including obligations such as filing tax returns and potentially paying taxes on worldwide income depending on their tax status. Understanding these concepts is essential for complying with UAE tax regulations, optimizing tax planning strategies, and leveraging benefits under DTAs where applicable.

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https://mof.gov.ae/double-taxation-agreements/  (as of June 2024)

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