Impact of Deleting Article 42(2)(i): Simplifying VAT Treatment of Interest, Principal, and Dividends in UAE's Amended Regulations

Fallout of Deleting Article 42(2)(i) in the Amended Regulations

One significant change in the new Executive Regulations is the deletion of Article 42(2)(i), which previously addressed the treatment of interest, principal, and dividends on debt securities, equity securities, and life insurance contracts. This deletion has several implications for how businesses, particularly financial institutions, report interest income, especially in the context of domestic loan portfolios.

Interest on Domestic Loans – Out of Scope

In the UAE VAT system, interest earned on loans provided to domestic customers is considered 'out of scope.' This means that the interest earned from such financial transactions is not considered a taxable supply and does not fall under the purview of VAT. Since interest is generally seen as a passive income flow tied to financial instruments, it is not regarded as a supply of goods or services. As a result, interest earned on domestic loans does not need to be reported in the VAT return.

This treatment is consistent with the global approach to VAT in financial services, where payments of interest, dividends, and principal are typically outside the scope of VAT. By deleting Article 42(2)(i), which previously specified the treatment of such payments, the UAE's VAT system simplifies reporting for financial institutions by reaffirming that interest income, particularly from domestic loans, is not subject to VAT reporting.

VAT Return Implications for Financial Institutions

For financial institutions that earn interest on domestic loans, the deletion of Article 42(2)(i) confirms that they do not need to report this interest income in their VAT returns. Since it is classified as out of scope, the interest income remains outside the VAT system. However, institutions should still track this income for internal financial accounting purposes.

Interest on International Loans – Zero-Rated under Article 31(1)(a)(1)

While domestic interest income is out of scope, interest earned on loans provided to customers outside the UAE may be classified as zero-rated under Article 31(1)(a)(1) of the Executive Regulations. This provision allows financial institutions to classify their export of financial services as zero-rated, including interest earned on international loan portfolios. In this case, the loan service is treated as a taxable supply at a 0% VAT rate, enabling the institution to recover input VAT on related expenses. Thus, even though the interest component itself is not taxed, it is considered part of the broader zero-rated financial service.

Conclusion

The removal of Article 42(2)(i) in the updated regulations reflects a shift towards a simplified VAT framework for financial services in the UAE. For domestic interest income, this change confirms that such payments are out of scope and do not need to be reported in VAT returns. However, interest earned from international loan portfolios can still qualify as zero-rated under Article 31(1)(a)(1), giving financial institutions clarity on their VAT obligations and recovery opportunities. As the UAE's VAT system continues to evolve, financial institutions must stay informed about regulatory changes to ensure compliance and optimize their tax position.

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