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The Principal purpose test or the value of Substance

According to Article 7 (Prevention of Treaty Abuse) of MULTILATERAL CONVENTION TO IMPLEMENT TAX TREATY RELATED MEASURES TO PREVENT BASE EROSION AND PROFIT SHIFTING (BEPS) “Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement”.

Thus, if the company incorporation does not have any other purpose, except for tax minimization, the benefits under the tax agreement will not be applied. This applies not only to passive income, but also to any benefits. The refusal of tax authorities to apply benefits and banks in opening accounts for “shell companies” is additional evidence of this. The term of “shell-company” means the lack of “substance”.

The terms “tax substance” or “economic substance” refer to the requirement for an entity to have an actual economic presence in the jurisdiction where it is established to qualify for the benefits of a tax treaty. Substance attached to structures has become a key theme in regulatory tax circles at all levels – domestic (anti-avoidance provisions), regional (EU’s aggressive tax planning and harmful tax competition) and global (BEPS).

Below are number of evidence sufficient substance for tax authority and banks on the example of the United Arab Emirates (UAE) free zone company:
• To maintain a permanent, dedicated and identifiable office in the jurisdiction;
• To employ qualified personnel working physically in the company’s local premises;
• To have a dedicated telephone, fax, internet lines, as well as a website and e-mail address(es);
• To make use of local providers (e.g. bank(s), accounting firm, audit firm, law firm, IT firm, marketing firm);
• To be effectively managed in the UAE – e.g. board meetings should be held regularly and minutes of meeting duly documented, and all key decisions should be taken in the jurisdiction;
• To document the operations at the company’s local premises (e.g. books of accounts, minutes’ books, banks accounts, commercial contracts).

Taking into consideration the above, business needs to be transformed in the field of substance creation. Free Zone Company registration in UAE satisfying the above criteria of evidence sufficient substance will not be considered as “shell-company”.
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