GCC Tax Theatre | UAE Corporate Tax | BFSI Series | DFSA Vs. BFSI | Episode 01 | 22 June 2024

So, Dubai Financial Services Authority (DFSA) licenses different types of financial institutions? Big deal!! O' wait! Isn't this the same regulator that has won awards like the best regulator for Islamic funds in 2007 and isn't its financial hub, the DIFC, the most in-demand corporate registrar for companies planning to set up base in GCC? Oops!!! Perhaps, it is a big deal!!!

Yup, DFSA is the regulator for companies set up in DIFC, which is, so to say, the Camelot of financial services in the world in general and GCC in particular. The Authority has stipulated certain categories of financial institutions carrying on certain authorized activities, which are summarized below. If you're not already sleepy, then I suggest you grab a cup of coffee and read on... Cuz in the ensuing paragraphs, we shall see the most prominent tax consequences of these financial businesses... Oh, and BFSI sector is a big area to cover... There's no way in hell that I can sum it up in just one episode... So stay tuned during the next few weeks.... After all, it is a new series that I've just aired...

I'll summarize these authorized activities under 08 different license types for your quick overview:

• Accepting deposits
• Investments as Principal/Matched Principal and managing Profit Sharing Investment Accounts on Restricted and Unrestricted Basis
• Administration of schemes and funds
• Acting as Money Service Providers
• Advising on money services, credit and products?
• Trusteeship
• Lending
• Custodianship
• Insurance intermediation and management
• Operating a Crowdfunding Platform
• Operating an Alternative Trading System
• Dealing as Agent
• Assets Management

To make your lives miserable... errr ... easier, we shall use alphabet "C" for the abbreviation of "Category" of license, which means that C1 and C2 would denote Category 1 and Category 2, and so on. Similarly FI will refer to the term Financial Institution. Got it? Ok then... Here we go....

Deposits, lending and interest payouts:

Cash is king, right? Makes sense, cuz accepting deposits and extending credit has been included in the Category 1 (we'll call it C1) license for the DFSA regulated FIs. Saving accounts usually result in interest payouts to the depositors for which interest deduction safe harbor rule of AED 12 million and 30% of Tax EBITDA threshold as maximum deduction limit for Net Interest Expenditure ....................................... "would've applied" ('gotcha didn't I?) under UAE Corporate Tax had these NOT been FIs with all the features of banking entities, which are not subject to these limitations. Besides, these are financial institutions for cryin' out loud! They lend the money they borrow in the form of deposits!!!! There is huge arbitrage of interest-spread involved (i.e. interest income minus interest expense)... The interest income they generate is far more than the interest expense they pay out... So why even bother to discuss Net Interest "Expenditure"... Get it???

Investment:

Well! These FIs in DIFC do a lot of other stuff than only borrowing and lending... For example investments... DFSA Rule Book defines an Investment as either a Security or a Derivative. So what would they get out of these investments? Mmmmm... Capital gains and distributive share of profits aka dividends? Yup... Now, dividends are taxed in a multidimensional way under UAE Corporate Tax. If they're from a UAE Resident Company then they're exempt. But if they're received from a UAE-Non-Resident Company then we have to see if Participation Exemption is available for such dividends. Can you recall the rules for Participation Exemption? I believe if the investor holds 5% controlling stake in the foreign investee or AED 4 million, whichever is less, then the first criterion of Participation Exemption is met. There are a couple of other conditions as well. Refer Article 23 of the UAE Corporate Tax Decree and UAE Ministerial Decision 116 of 2023 please. Or simply use the Corporate Tax Guide titled "Exempt Income: Dividends and Participation Exemption" by clicking the URL https://bit.ly/3RH9Szj.

Regarding capital gains, Article 20 of the Decree talks about the option to tax unrealized gains and losses on realization basis allowing two alternative treatments. Go figure (haha). So that's that... Guys this article is aimed to point you in the right direction rather than reproducing the Decree law. If you have academic questions such as what is Participation Exemption, then feel free to message me. :)

However, the DFSA framework does not impose a condition that the Securities or Derivatives in which investment is to be made must be traded on a Recognized Stock Exchange. This has far reaching consequences in case of Investment Funds.... Read on....

PSIAu / PSIAr:

PSIAu and PSIAr as defined as Profit Sharing Investment Account received on an unrestricted basis and Profit Sharing Investment Account received on a restricted basis respectively. For C1 FIs, DFSA grants to the financial institutions discretionary powers to manage PSAIu's, allowing investment of the investor funds as the FIs please. However, restricted basis investments accounts are granted to C2 type FIs.

Investment as Principal Vs. Investment as Matched Principal:

Going a little deeper into the investment business, while C2 licensees have been granted authority to invest as Principals, C3A type FIs have been granted the authority to invest as "Matched Principal" only. Matched Principal Trading is an interesting execution strategy where the FI acts as principal in relation to all client trades, whilst simultaneously matching these trades with a counterparty. This is also known as 'riskless principal' since the FI does not take any exposure in its proprietary book.

Accounting for Investment as Principal and Its Corporate Tax Consequence:

When a financial institution acts as Principal while making these investments, the accounting for it is straight forward because the income belongs to the the FI, which is the Ultimate Beneficial Owner (UBO) of the investments. The FI will recognize the income in its books in its own name. The income will be subject to UAE Corporate Tax. There is no doubt about it.

Accounting for Investment as Matched Principal and the UAE Corporate Tax Consequence thereof:

The tricky part of accounting is when the FI makes the investment as a Matched Principal, whereby the UBOs are both the FI who poses as the pseudo principal and the real behind-the-scene investor, whose funds are being invested by the FI on discretionary or non-discretionary basis. This begs the million dollar question if the FI should recognize the portion of income of the original investor in its books with a corresponding financial asset or financial liability.

Guidance on this accounting question can be obtained from a March 2017 IFRS Committee Staff Paper titled "IFRS 9 Financial Instruments—Principal versus Agent Treatment of a Clearing Broker of Centrally Cleared Client Derivatives" (URL: https://bit.ly/3Xw983S). I'm screenshotting the decision to save your time. In simpler words, the DFSA regulated financial institutions investing as Matched Principals ought to recognize the back-to-back positions whether in securities or derivatives along with their corresponding financial assets and/or liabilities. The capital gains and losses would be subject to tax under Article 20 on the basis of net outcome. In case of dividends, the usual Resident Dividend and Participation Exemption provisions of UAE Corporate Tax would apply at entity level. Furthermore, unless these investments are made by way of a Qualifying Investment Fund arrangement meeting all the conditions of UAE Corporate Tax, the flow-through taxation exemption would not be available to the financial institutions undertaking such transactions.

UAE Corporate Tax Consequence of Natural Person's Investment Income:

Under UAE Corporate Tax law, any income generated by such investments for an individual investor would undergo the litmus test of active (i.e. business) income or passive income, the latter scoping out the said income from the ambit of UAE Corporate Tax.

UAE Corporate Tax Consequence of Juridical Person's Investment Income:

For businesses introducing their funds in such investments managed by these FIs, any income generated would remain subject to UAE Corporate Tax unless specifically exempted e.g. Resident dividends, etc.?

Investment Manager's Exemption under UAE Corporate Tax Law:

Moreover, from the perspective of the Non-Resident investors who entrust their money to the DIFC FIs to invest in the authorized activities, these FIs don't end up as Permanent Establishments of those Non-Residents. The Corporate Tax law calls this as "Investment Manager's Exemption". There are quite a few conditions laid down by Article 15 of the UAE Corporate Tax Decree to claim this exemption.

Collective Investment Fund and Flow Through Taxation:

C3C licenses are issued to FIs which manage Collective Investment Funds e.g. Real Estate Investment Trusts, Mutual Funds, etc. UAE Corporate Tax law has granted exemption to such funds provided that there is regulatory oversight on these funds, which holds true for all DFSA registered entities. However, UAE Corporate Tax law also imposes a condition of securities in which the investor funds are invested to be traded on a Recognized Stock Exchange. This can be a tricky situation as the DFSA framework does not impose a condition that the Securities or Derivatives in which investment is made must be traded on a Recognized Stock Exchange. Therefore if an Investment Fund meets both the conditions it would become a Qualifying Investment Fund and enjoy flow through taxation, under which the income earned by the fund would be evaluated for being subject to tax or not in the hands of the investors.

Islamic Financial Institutions (IFIs):

Under the DFSA rules, C5 type licenses are issued to IFIs which manage unrestricted PSIAs. The viewpoints of income recognition under IFRS may differ from those of the Islamic Financial Reporting Standards. However, UAE Corporate Tax Law has upheld IFRS as the governing framework for ascertaining Taxable Income, and, accordingly, while share of profits from Islamic financial instruments such as Mudarabah, or Musharakah, etc may be seen as equity distributions under the Sharia, these would be considered in the exact same manner as treated by the IFRS. In simpler words, IFRS compliant financial statements audited by reputable independent external auditors would suffice as reference for calculating Taxable Income for the purposes of UAE Corporate Tax instead of referring to the financial statements prepared under Islamic Financial Accounting Standards as issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

Stay tuned for exciting and insightful new episodes of the 2024 released series of #GCCTaxTheatre | UAE Corporate Tax | DFSA Vs. BFSI...

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Altaf is an avid writer of Tax Frameworks around the world, has been a Managing Partner and Senior Partner Tax & Advisory for multiple MNC firms in GCC region. If you find any aspects misleading or contrary to the provisions of the legal framework referred in the above article, have a business query or require free consultation or guidance, please send a message on LinkedIn or email Altaf at [email protected].

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