Even in the UAE, managers of companies doing business abroad have to commit to sound planning and implementation to minimise the taxation bill.
In a tax-free country tax is the top priority
You may think that an article about tax does not apply to you. However, there are good reasons why UAE companies pay their tax advisers millions of dirhams every year. Even companies based in the tax-free Emirates could pay way more than 100 per cent of their worldwide profits as foreign taxes if they are not careful. Any risk that could push the bottom line below zero should be a priority for top executives, not just the finance department.
In addition to the direct cost, taxation creates many issues that require management expertise other than tax law mastery. Compliance efforts could become expensive as companies deal with multiple obligations for foreign tax reporting. Executives face further challenges of complexity, risk and even a potential investor relations problem. The first issue is permanent establishment. A nation can tax you if your business is "established" within its borders. Sending a salesman to attend a conference overseas is not a problem, however expect to pay local taxes if your company rents a local office, hires employees, or performs substantial services for clients within the taxing nation's borders. The threshold for permanent establishment varies by country. You should, for example, address this risk before sending employees on a long-term assignment to India.
Once your company is subject to income tax overseas, life gets much more complicated. Good luck figuring out your income tax bill. Even if you know the tax rate, it will be very hard to calculate your income for tax purposes. Most nations impose tax on net income, which equals revenues minus expenses. For UAE-based businesses, revenues will come from around the world. As a rule of thumb, foreign governments will try to tax any income that is connected to their country. They will only allow deductions that are necessary, reasonable and properly documented.
Expenses are only considered necessary if they directly support the goods being sold in a particular market. In addition to local salaries, a company may deduct the overseas costs of manufacturing and shipping. However, a foreign subsidiary might not be able to deduct indirect corporate charges such as marketing, investor relations or executive management at the UAE head office. As a result, a multinational company that is losing money as a whole may still have a liability for taxable profits in its foreign branches.
Even when costs are necessary, tax authorities may disallow a deduction if they consider the amounts are unreasonable. Companies often try to reduce their foreign tax bill by shifting costs to tax-free jurisdictions. The taxable subsidiaries are allocated a large share of overhead expenses from the GCC headquarters. Such costs include services from the accounting, legal and IT departments based in the UAE. However, the tax authorities know that intercompany cost allocations can be abused by overcharging internally. Therefore, rules require arm's length pricing for such services. Basically, you can't charge more internally than the cheapest outsourcing firms. Some services can be provided at cost, with little or no markup for profits.
Even after defining the necessary services and reasonable rates, the deductions may still be disallowed if the documentation is inadequate. There should be detailed service agreements specifying which services will be provided. The agreements should spell out the basis of "transfer pricing" methodology that determines the actual expenses charged to the foreign jurisdiction. This is where the tax issues end and the management challenges begin. Does your company's structure support its strategy? If not, be sure that service agreements are updated to reflect any changes to the organisation, otherwise tax authorities may ignore outdated service agreements and assess taxes and penalties. Management should include tax advisers in their strategic planning to avoid this.
Are all employees strictly following the guidelines in the service agreements? If not, your organisation may be exposed to a massive tax bill. A foreign government may try to tax UAE revenues while disallowing UAE expenses. Are the record-keeping systems capable of tracking information for each country and legal entity? Are employees using them properly? If not, then all the other hard work is wasted. Inaccurate records will fail an audit in any jurisdiction. Even worse, if transactions from one legal entity are commingled with records of another, both could be exposed to taxation. As a separate issue, such poor accounting systems make it difficult to provide proper internal management reports. Your executives could be flying blind.
There are many other opportunities for proactive managers to reduce their company's tax burden. GCC entities have significant amounts invested in foreign partnerships. Many GCC executives leave money on the table because they are unaware of the subtleties of tax law, most notably in the US. Similar considerations apply to partnerships in other countries as well. By failing to negotiate minor terms regarding capital accounts, depreciation elections and liability allocations, GCC companies unwittingly pay tax while shifting the benefits to their more tax-savvy partners. Before entering into a joint venture or property investment overseas, GCC companies need to have the best tax advice possible from someone with transaction experience.
To complicate matters further, taxation has become an investor relations issue. New accounting standards require extensive disclosures around income tax expenses. Bottom line: Taxation is a major issue for companies that operate beyond the UAE. It is made more difficult by the limited number of experts based locally. Executives cannot simply hire someone to sort out the tax problem. This would be like hiring someone to sort out your personal physical fitness: experienced trainers can teach you a proper diet and exercise regimen, but doing the hard work is still up to you.
Tax advisers can translate the rules into plain English, or Arabic. They can recommend ways to make business as tax-efficient as possible. However, they cannot anticipate the changes to business strategy unless, and until, you tell them. Ultimately, taxation is a management issue. Be sure that top executives have the appropriate tax expertise present when making business decisions. Involve other departments in any cross-border arrangements.
To boost the bottom line, business leaders must minimise the tax expense line just above it. This can only be done through sound planning, effective implementation and ongoing vigilance to avoid costly pitfalls in day-to-day operations. Technical tax experts are part of the solution. But tax risk will not be under control until the proper level of commitment from top executives. The stakes are too high to rely on tax advice from a newspaper column. Consult your tax adviser before acting on anything written here. Then, successfully implementing your tax strategy will require a co-ordinated effort to address the specific needs of your business. You will need the right executive leadership, middle managers, accountants, systems and procedures. The end result will be lower costs, higher profits, reduced risk and more reliable financial reporting. Those benefits make it easy to see why tax should be a top priority for senior corporate executives, even in an income-tax free country.
Stephen Stanton is a managing director at Montgomery Woodrow, a management consulting firm based in the UAE and specialising in CFO and governance services, interim management and process improvement.