UAE Corporate Tax - Considerations of Potential Interest to Treasury Functions

Following my brief participation in informal?UAE Corporate Tax discussion groups formed when the consultation document was released in mid 2022, some interested parties have been pestering me for my thoughts on the December 2022 legislation. For some inexplicable reason, they claim the experts on the ground and the published literature aren’t quite meeting their needs. Specifically, the service providers are almost exclusively targeting the CFO/finance function silo focussing on tax accounting, the first tax return filing and signing up taxpayers to extended delivery centres out of low-cost jurisdictions. In their words, classic back-office compliance driven offerings with no thought provoking insights for the wider business to undertake planning and analysis.

None of us has a monopoly of wisdom and knowledge, especially in relation to a new tax system where the rules are literally being written. However, the lack of interest in guiding or assisting tax functions in interacting with other business functions in the critical descriptive analytics and structural reviews anticipating the impact of corporate tax is odd given that the size of the prize completely dwarfs the tax compliance fee pool.

To that end, I will be sharing some brief observations focussing on the issues which were covered by the discussion group as well as things that interest me. I make no great claims to understanding all the relevant aspects of this kind of analysis but for some inexplicable reason, some clients are adamant that I have insights which are valuable. Go figure.

Just to be clear, I will not be addressing anything to do with setting up tax compliance functions or ERP systems for the preparation and lodgement of the tax returns or tax reporting. Look elsewhere for tax accounting, bookkeeping or reporting insights. I will also not address any transfer pricing matters. There are many economists out there ready to regale you with pearls of wisdom. My observations are intended to guide non tax stakeholders as they try to ascertain the impact of the corporate tax regime on business and the adaptations required to adjust to this new normal.

This is definitely not going to appeal to everyone. The primary drivers for writing these observations are to (i) amuse myself, first and foremost; (ii) endlessly irritate those who were forewarned about this gap and failed to act, (iii) as a thank you to those who kept my consultancy going for the last two years. As a rarity in these inflationary times, I am offering unbeatable value, low ball amusement worth infinitely more than the zero cost the reader is expending to access it. ?

Yes, I am still based in Australia. No, I am not relocating to the UAE. No, I am unavailable for engagements until Q2 2023. So please, no calls or enquiries for the next three months. My engagement calendar is full. Play-Doh sessions and kite flying excursions with my niece take priority this summer/autumn before she turns into a world weary 8 year old.

Overview of the Legislation ?

First impressions of the corporate tax legislation are that it is an amalgam of features from a range of tax systems; e.g. it offers foreign dividend participation exemptions, foreign tax credit relief, provides for both group relief and fiscal unity combinations as well as a series of restructuring reliefs for related groups. From a base erosion perspective, it has an earnings stripping regime, a general anti avoidance regime and OECD transfer pricing principles apply. There is acknowledgement by the FTA that much guidance will follow in relation to many aspects of the corporate tax legislation.

Objectively, the corporate tax law should be perceived as a framework in its current form. Detailed guidance will follow to help taxpayers navigate and ascertain their obligations as the FTA works through the needs of the region’s second largest, relatively diverse economy. Fair to say that this is pragmatic acceptance that the corporate tax system is a work in progress rather than the finished article. ?

To this end, industry bodies have a huge role to play in lobbying for guidance on industry specific concerns and needs. It is quite common for industry bodies in mature tax systems to have their own tax committees. No external advisor can surpass your own understanding of your business or your industry sector. They can provide guidance on tax policy, based on experience in other jurisdictions or offer a practitioner’s perspective. However, no advisor or professional body can make a more compelling request to be heard by the FTA and to set out your industry’s perspective on what it needs better than the industry representatives can themselves.

The reality is that the modest size of the UAE advisor pool means that industry bodies will need to do much of the heavy lifting themselves to achieve the outcomes required for continued success of their particular sector. Look upon this as an opportunity to develop collaborative relationships with the FTA and improve their understanding of the sector. ?

Time Frame in which Taxpayers Need to Act

The corporate tax legislation was released in December 2022 and is intended to apply from 1 June 2023. As a sweeping generalisation, businesses in the UAE tend to adopt the calendar year as the financial year (unless they are part of a group which applies a different year end and have applied to change the tax period pursuant to Article 58). The financial year is the assessment year for tax purposes pursuant to Article 57.

In practical terms, for most taxpayers adopting a calendar year as the financial year, the first assessment year will commence on 1 January 2024, with the first corporate tax return due by 30 September 2025. Consequently, the 2023 calendar year is the critical year for taxpayers to evaluate their business, identify and analyse the levers which are material to tax attributes, plan, structure and implement the changes required to optimise their tax profile. Essentially, you need to set yourself up and be ready by 31 December 2023 as your attributes at that date are what you have to work with once you tick over into your first assessment year on 1 Jan 2024.

Delaying action until after 2023 in the hope that things can be rectified in 2024 exponentially increases the degree of difficulty. It’s always easier to maintain and navigate sound, built for purpose vessels out of stormy weather into calmer waters rather than having to patch and make running repairs to an unseaworthy jury-rigged fleet in the hope of making it out intact to the other end.

Group Treasury Considerations

This first note in the series will focus on possible tax considerations for treasury functions as they move from a zero domestic corporate tax environment to a 9% regime (and eventually a 15% regime if the FTA adopts Pillar Two in later years). This note is aimed at non tax practitioner stakeholders of taxable, UAE based corporations (i.e. a Taxable Person as defined in the legislation) with both domestic and overseas operations, comprising both foreign subsidiaries and foreign permanent establishments. The business may have a combination of external debt, shareholder debt (e.g. from a foreign parent) as well as a mix of equity instruments.

One of the first things likely to be of interest to a treasury function is the impact of the introduction of corporate tax on the group’s cost of capital. Specifically, tax relief on the cost of debt capital. Most of the observations are in relation to plain vanilla debt instruments, unless stated otherwise.

Withholding Tax on Foreign Sourced Debt Capital

From a tax cost of funds at source perspective, Article 45 of the corporate tax legislation imposes a 0% rate of withholding tax. This means that the status quo prevails in terms of the cost of sourcing debt funds directly from foreign lenders, i.e. lenders are unlikely to require gross up clauses to preserve their margin. Similarly, there should be no incentive to use of indemnity payment clauses or guarantee fees as de facto interest to ameliorate exposure to UAE interest withholding tax.

Hybrid Instruments and Hybrid Mismatch Rules

My research has indicated that sharia scholars are not in favour of the prolific use of preference shares. This may explain why advisors have been reluctant to use mandatorily redeemable preference shares or partnership interests in the GCC vis-a-vis elsewhere in the world. From my own experience, that reluctance was less evident in structuring sharia compliant investment by GCC investors into the Australian property sector.

The UAE’s corporate tax legislation and the earlier consultation document make no mention of the likely treatment of hybrid instruments with two exceptions. First, Article 33(9) denies a deduction for distributions of profits and secondly, the participation exemption rules in Article 23(6)(a) do not provide for an exemption of dividend income if a deduction is available in relation to the same dividend. Also, GCC member nations do not appear to have introduced hybrid mismatch rules as proposed in Action Item 2 of the first tranche of the BEPS measures. This leads me to (dangerously) assume that exploitation of the debt equity borderline to achieve tax arbitrage is a relatively uncommon practice in the GCC.

Despite this, it may still be necessary to consider whether a global group is affected by these rules if the UAE entity is acting as a financing conduit, i.e. it has parent entities which have enacted hybrid mismatch rules or alternatively, there are subsidiaries in jurisdictions with such rules. The 9% corporate tax rate, the continued existence of tax free entities (via free zones) and the introduction of the fiscal unity concept via the grouping rules in Chapter 12 of the legislation are all new features which may require multinational groups to reconsider the tax effectiveness of financing structures upstream and downstream of the UAE.??

Sukuk and Sukuk SPVs

The standard form of sukuk involves a Special Purpose Vehicle acquiring an asset either from or on behalf of a company. The company then leases the asset from the SPV, making periodical rent payments. The SPV is funded by investors acquiring participation certificates, the Sukuk, in the SPV. The investor then receives over time, his share of the profits of the SPV.

Many sukuk mirror conventional bond characteristics to improve investor appeal such as distributing profits at a fixed percentage, using a base rate as well as guaranteeing the return of principal at maturity via a binding promise from the sukuk issuer or manager to repurchase the sukuk assets at the price they were originally purchased by the sukuk holders, regardless of their market value at redemption. It is assumed that in most cases, the fund raising SPVs would be DIFC based (for regulatory purposes), with funds subsequently on lent to taxable mainland businesses.

It would be interesting to understand the FTA’s intended approach with the tax status of sukuk and the SPVs which have been used to issue the instruments in financial markets. It is noted that the tax regimes of neighbouring GCC jurisdictions (e.g. Qatar) and countries further afield (e.g. Luxembourg and the UK), treat sukuk murabaha as the equivalent of conventional bonds. Accordingly, the UAE tax status of existing instruments and their issuing SPVs are somewhat in limbo.

The consultation document expressly set out that returns paid on instruments held by free zone entities would not be deductible to taxable mainland companies (see Section 5.32) in order for the free zone holder of the instrument to retain its tax free status. Interestingly, these deduction limits do not appear to have transitioned into the corporate tax law explicitly, which raises a number of questions:

(1)??Has the tax neutrality of the SPV been maintained even if the borrower is a mainland taxable company despite Article 13 (2)(g)); i.e. does its tax free status remain intact on the basis that the income is passive income and thus qualifying income?

(2)??Is tax neutrality maintained under the auspices of the Investment Fund or Investment Manager exemptions in Articles 10 or 15 respectively?

(3)??Is the intention that the return essentially be treated as a profit distribution and hence, it is non deductible to the borrower pursuant to Article 33 (4) or (5)?

(4)??Where does this leave the borrower in terms of tax relief for the return paid on the instrument, i.e. is it to be treated as deductible interest pursuant to Article 29?

If the cost of raising finance via sukuk does not give rise to an interest tax shield vis-à-vis a conventional bond or loan, it puts the viability of future raisings into question in addition to leaving issuers of existing instruments in an unfavourable position as their cost of financing via sukuk much higher than anticipated. Also, if the return on the sukuk is taxable to the holders of the instrument as it is deemed to be state sourced income (and thus outside the free zone), lenders may seek to gross up the return to preserve margins.

Additionally, where asset transfers occur between the SPV and the borrower, it will be necessary to consider the corporate tax implications upon initial transfer and subsequent repurchase (assuming the reliefs in Chapter 10 of the law are inapplicable), with even more complications arising when dealing with cross border transactions as well as transactions across the State and free zones. It will be also interesting to understand if and how the concept of quasi-ownership interest in depreciable property will be administered as there is no legislation or guidance on how leases are to be treated or the impact of income assignment on deductibility.

This is a complex area as there are substantial term sheet variations within a particular sukuk class as well as the various different types, granting different exposures such as assets (Sukuk Al Ijara), projects (Sukuk Al Istisna), business (Sukuk Al Musharakah), or investment (Sukuk Al Istithmar). There will be many interested parties seeking to clarify where they stand from a corporate tax perspective either as issuers or holders of existing instruments and as well as SPV managers of SPVs operating within the State or in the free zones.

Deductibility of Interest and Earnings Stripping Limitations?

Pursuant to Article 28, interest is deductible as long as it is incurred on revenue account (i.e. it is not capital in nature), for a taxable purpose and not to derive exempt income. No doubt more guidance is likely to follow in terms of the revenue vs capital distinction to determine deductibility. Article 31 then imposes further limitations by essentially requiring third party debt to be used to fund dividends, undertake capital management or to fund the acquisition of ownership interests by related parties. There is however, an exception to allow the use of related party debt if the interest on the debt is taxed at least 9% in the hands of the lender.

As a general concept, the cost of borrowing funds to be on lent to foreign subsidiaries is usually deductible as the interest income received is assessable. Similarly, borrowing to fund equity investment in foreign operations is also deductible in most jurisdictions. To this end, Article 29 implies that it is still tax effective to have a taxable UAE company borrow to fund equity investment in domestic entities as well as international investments such as subsidiaries which qualify for participation exemption in Article 23 or investing in foreign permanent establishments which are exempt pursuant to Article 24. However, the concessionary nature of Article 29 starts to unravel once the effect of the earnings stripping regime is taken into account.

Article 30 sets out an earnings stripping regime which limits deductibility of interest to 30% of EBITDA. The critical detail is the exclusion of exempt income from the EBITDA base in working out the interest deduction cap. This means that unless the relevant entity has a substantial domestic income base, there is limited to no relief available for interest incurred for foreign investment which gives rise to exempt income. A business with a large domestic income base will manage this limitation and look to borrow further downstream where it engages in foreign expansion. Also any excess non deductible interest can only be carried forward for a maximum of 10 years; i.e. the loss of interest deduction relief could be a permanent loss rather than just a deferral of the deduction.

Assuming my interpretation of the earning stripping regime is correct, the question of where to locate headquarters of a primarily international business has become more complex. Some bright spark will no doubt point out that the solution is obvious, only invest offshore via free zone companies. That works, for now. However, the question then arises as to how long that is likely to be viable with the proliferation of hybrid mismatch rules, targeted integrity rules, the eventual emergence of the subject to tax regime as well as the imminent introduction of the GLoBE rules.

Businesses should also be aware that earnings stripping regimes defer the interest tax shield for capital intensive projects. Relief only becomes available once the asset has been commissioned and generates revenue. When coupled with the 10 year limitation on the carry forward of excess deductions, this can materially impact the financial outcomes for projects with long construction periods or lead times to full ramp ups. The financial models of any such projects which are already underway and also being contemplated in the future will need to be examined to factor this into consideration. One would hope that affected parties would lobby the authorities to consider concessionary measures such as allowing the unutilised excess deferred interest on these type of projects to be capitalised in the depreciation base of the asset constructed or at a minimum, be capitalised into the cost base of the assets to provide relief on disposal of the asset.

The effect of interest relief limits are magnified across non wholly owned large groups or conglomerates with a range of businesses and assets at varying stages of maturity and profitability. Consider the two scenarios below:

(1)??Say a group comprises many subsidiaries that are less than 80% commonly owned. The level of common ownership is insufficient to form a single tax group but does allow for transfer of excess losses pursuant to Article 38. The rub, however, is that any subsidiaries that are heavily leveraged and not generating income will not have excess tax losses which can be shared with the rest of the group; i.e. the deduction for interest is essentially deferred and trapped. This is despite the lenders having assessed debt serviceability on a group basis rather than the particular project entity.

(2)??Now compare this against a 95% commonly owned group that is able to form a single tax group pursuant to Article 40. As a result of this, the earnings stripping calculation analysis is undertaken as a single calculation using consolidated group EBITDA, resulting in interest deduction relief being available to the group, assuming there are sufficient total earnings to absorb the deductions.?

As a consequence, capital intensive project structuring and financing is likely to change substantially in the UAE with joint venture type arrangements becoming more attractive where multiple strategic partners are involved in large projects.

It is interesting that despite having introduced a loss transfer regime, consortium group relief (a feature of the UK’s group relief for losses) was not part of the consultation. This may be something which industry bodies may want to engage with the authorities on.

Equity Capital Management

Post 1 January 2024, capital management will have tax consequences. These consequences include the previously mentioned limitation on deductions for debt funding a capital reduction or restructure. Also, capital raising which introduces new investors can affect the ability to carry forward tax losses, the ability to form or join a tax group, the ability to transfer losses as well as access to business restructuring reliefs.

To that end, thought needs to be given to current and future capital needs of the business and where possible, it may be preferable to undertake some pre-emptive capital raising in 2023. This could include exploring options such as issuing partly paid shares or instalment warrants as a way of bringing in new investors onto the share register with the option of calling in the required equity at a later date. Bankers and finance lawyers will no doubt be salivating over the prospect of offering a range of possible options.?