Calculation of taxable income in UAE Corporate Tax

This section sets out the proposed approach to determining the amount of income that will be subject to tax under the UAE CT (corporate Tax) regime.

Basis of calculating taxable income

To reduce complexity and compliance costs, the UAE CT regime proposes to use the accounting net profit (or loss) as stated in the financial statements of a business as the starting point for determining their taxable income.

Using accounting standards provides for a common definition of income, which reduces compliance costs and provides a base that follows international standards. Aligning the calculation of taxable income to accounting profits (where possible and appropriate) limits book-tax differences and prevents businesses from having to maintain two sets of records: one for financial reporting purposes and the other for CT purposes.

The financial statements should be prepared using accounting standards and principles that are acceptable in the UAE and businesses will use their financial accounting period as their (annual) tax period. Where a business does not have a financial accounting period, its default tax period will be the Gregorian calendar year.

Although International Financial Reporting Standards are commonly used in the UAE, consideration is being given to allowing alternative financial reporting standards and mechanisms for determining taxable income to accommodate and reduce the compliance costs for certain taxpayers (e.g., startups and small businesses).

Treatment of unrealized gains and losses

Unrealized gains or losses arise in instances where an asset or liability held by a business has changed in value but no transaction to generate a gain or loss has yet taken place. For example, when a business property increases in value, but the property is not sold, the gain would be unrealized. These gains or losses may be recorded for accounting purposes even though they are not yet realized.

The UAE CT will have specific rules to determine whether an unrealized gain or loss should be taken into account when calculating taxable income. These relate to whether the gain or loss is related to capital items or revenue items.

Capital items are items that have a long-term impact on a business. They include assets, such as machinery, and long-term liabilities, such as loans to buy property. Unrealized gains or losses on capital items are not taken into account when calculating taxable income.

Revenue items are items that have a short-term impact on a business. Revenue assets are items other than capital items and can include items such as the goods a business sells. Unrealized gains or losses on revenue items will need to be taken into account when calculating taxable income.

Exempt income

As discussed in section 4.1, UAE resident companies will be subject to UAE CT on their worldwide income, including capital gains.

However, to avoid instances of double taxation, and to recognize the UAE’s position as an international business hub and leading holding company location, the UAE CT regime will exempt certain forms of income from taxation.

The main exemptions from UAE CT relate to income earned by UAE companies from investments in other companies, and from operations conducted outside the UAE through foreign subsidiaries or foreign branches.

Exemption for dividends and capital gains

In line with many other countries and leading international financial centers, a UAE corporate shareholder will generally be exempt from CT on dividends received, and capital gains earned from the sale of shares of a subsidiary company. The purpose of this so-called participation exemption is to avoid double taxation of corporate profits, first when they are earned by the subsidiary company and second when the profits are distributed to, or the shares in the subsidiary company are sold by, the UAE shareholder company.

The proposed UAE CT regime will exempt all domestic dividends earned from UAE companies, including dividends paid by a Free Zone Person that benefits from the 0% CT regime.

Dividends paid by foreign companies, and capital gains from the sale of shares in both UAE and foreign companies will also be exempt from CT, provided certain conditions are met.

The main condition to benefit from the participation exemption is that the UAE shareholder company must own at least 5% of the shares of the subsidiary company. Further, to prevent income from being shifted to a subsidiary in a no- or low-tax country, the participation exemption will only be available if the foreign subsidiary is subject to CT (or an equivalent tax) at a rate of at least 9%.

Despite benefitting from a 0% CT rate, capital gains on the disposal of shares in a Free Zone Person will be exempt from CT where the Free Zone Person is a holding company and substantially all of its income is derived from shareholdings in subsidiary companies that meet the participation exemption conditions discussed above.

Foreign branch profit exemption

UAE businesses may structure their foreign operations either through a foreign subsidiary or through a foreign branch. A foreign branch would typically constitute a PE in the foreign country and be subject to CT (or an equivalent tax) on its profits in that foreign country.

The main difference between operating abroad through a foreign subsidiary or a foreign branch is that a subsidiary is a separate legal entity, with its own books and records, and transactions between the UAE parent company and its foreign subsidiary would generally be clearly documented and recorded.

The main difference between operating abroad through a foreign subsidiary or a foreign branch is that a subsidiary is a separate legal entity, with its own books and records, and transactions between the UAE parent company and its foreign subsidiary would generally be clearly documented and recorded.

Recognizing the potential complexities associated with attributing income and expenses to foreign branches, UAE companies can either (i) claim a foreign tax credit for taxes paid in the foreign branch country, or (ii) elect to claim an exemption for their foreign branch profits.

The election to claim a branch profit exemption is proposed to apply to all foreign branches of the UAE Company and will be irrevocable. An exemption for foreign branch profits may not be available where the foreign branch is not subject to a sufficient level of tax in the foreign jurisdiction in which it is located.

Other exempt income

As a major logistics center and international travel hub, the UAE CT regime will exempt income earned by a non-resident from operating or leasing aircraft or ships (and associated equipment) used in international transportation, provided the same tax treatment is granted to a UAE business in the relevant foreign jurisdiction under the reciprocity principle.

Expense deduction limitations

The calculation of taxable income will largely follow accounting rules, but the UAE CT regime will disallow or restrict the deduction of certain specific expenses. This is to ensure that relief can only be obtained for expenses incurred for the purpose of generating taxable income and to address possible situations of abuse or excessive deductions.

Interest capping rules

While some minimum level of share capital or equity reserves may be required under UAE company regulations, business owners will generally have flexibility as to how they finance their business.

Interest and other similar financing costs are considered a cost of doing business and will accordingly be deductible for UAE CT purposes. However, the deductibility of interest and other similar financing costs could give rise to opportunities to erode the UAE CT base and arbitrage the UAE CT regime unless appropriate measures are in place (see below). An obvious example of tax arbitrage would include the reduction of taxable profits through the use of deductible interest payments, where the recipient of the interest income is not taxed (e.g., an individual shareholder or a Free Zone Person).

To prevent the different tax treatment of equity and debt from being exploited through the use of excessive levels of debt, the proposed UAE CT regime will cap the amount of net interest expense that can be deducted to 30% of a business’s earnings before interest, tax, depreciation, and amortization (EBITDA), as adjusted for CT purposes. This is in line with the interest limitation rules proposed by Action 4 of the OECD’s Base Erosion and Profit Shifting project which have been implemented by countries around the world.

To reduce the administrative burden, businesses may be allowed to deduct up to a certain amount of net interest expenditure (safe harbor or de minimis amount) irrespective of the interest deductibility limit based on the EBITDA rule.

Recognizing that different industries have different capital needs and risk profiles, the interest capping rules will not apply to banks, insurance businesses, and certain other regulated financial services entities. Additionally, the interest capping rules will also not apply to businesses carried on by natural persons.

Consideration is being given to allowing businesses that are a part of a consolidated group to apply a different interest capping threshold by reference to the group’s overall position.

In addition to requiring interest paid on related party borrowings to be at arm’s length, where such borrowings are used for certain specific intra-group transactions (e.g., to pay a dividend or capitalize a group company), related party interest will only be deductible if there is a valid commercial reason for obtaining the loan. A valid commercial reason will be considered to exist if the related party lender is subject to CT (or an equivalent tax) of at least 9% on the interest income earned.

Non-deductible expenses

As discussed in previous sections, related party payments made to a Free Zone Person that is taxed at 0% on receipt of the income will not be deductible for CT purposes. However, the related party will be allowed to claim a deduction if the payment is attributed to a mainland branch of the Free Zone Person.

Businesses will be allowed to deduct up to 50% of the expenditure incurred to entertain customers, shareholders, suppliers, and other business partners, to acknowledge that these types of expenses often also have non-business or personal elements.

No deduction will be allowed for certain specific other expenses such as administrative penalties, recoverable VAT, and donations paid to an organization that is not an approved charity or public benefit organization.

Losses

Businesses typically have variations in profit levels over time, and it is not uncommon for a business to incur losses during the start-up phase or because of market circumstances.

A fundamental principle behind the UAE CT regime is that CT is meant to be paid on the total profit of a business over its entire life cycle, as opposed to a single financial period.

Accordingly, and in line with international best practices, a business will be able to offset a loss incurred in one period against the taxable income of future periods, up to a maximum of 75% of the taxable income in each of those future periods.

Tax losses can be carried forward indefinitely provided the same shareholder(s) hold at least 50% of the share capital from the start of the period a loss is incurred to the end of the period in which a loss is offset against taxable income. If there is a change in ownership of more than 50%, tax losses may still be carried forward provided the same or similar business is carried on by the new owners.

The continuity of shareholder or business requirements does not apply to businesses that are listed on a recognized stock exchange.

No tax-loss relief will be available for the following losses:

• Losses incurred before the effective date of CT;
• Losses incurred before a person becomes a taxpayer for UAE CT purposes;
• Losses incurred from activities or assets which generate income that is exempt from UAE CT; or
• Losses incurred by a Free Zone Person that is not attributable to a PE in the mainland

For more information on these services, please contact us:

News Courtesy: Public Consultation Document UAE Corporate Tax