Businesses have several financing possibilities available to them, and debt financing is a famous option. This type of financing can take various forms, including loans from financial institutions, preference shares, and overdrafts. The cost of borrowing through debt financing is generally lower than that of equity financing, and the interest payments on the borrowed funds are considered a business expense when used for business purposes.
As a result, interest payments can lower the accounting profits of the business. This reduction in accounting profits can lead to tax savings, as corporate tax is levied on taxable profits, which are calculated after adjusting accounting profits. Nevertheless, it’s crucial to note that the tax authorities must permit this reduction in taxable profits through interest payments.
A company’s cost of debt is usually lower than the cost of equity, making it an attractive option for taxable entities. This could result in an imbalance in the optimal capital structure, as the company may opt for more debt financing without proper consideration. Taxable entities can also take advantage of massive loans from related parties in tax-free jurisdictions and low-tax zones to shift profits from high-tax jurisdictions to those with lower or no taxes.
For instance, a company located on the mainland of the UAE could borrow a significant sum from a related party in a free zone that enjoys a zero percent tax rate. As a result, the free zone company would pay no corporate tax on the interest income it receives.
Meanwhile, the interest expense recorded in the books of the mainland company would reduce its taxable profits, ultimately lowering its tax liability. Thus, interest on debt provides a means to share earnings from a high-tax jurisdiction to a low or zero-tax jurisdiction.
Article 30 of the UAE corporate tax law (UAE CT Law) aims to prevent excessive debt financing and profit-shifting practices by introducing interest-capping rules. These rules ensure that only interest on debt financing used for valid commercial reasons or as a result of specific intra-group transactions will be tax-deductible.
According to the UAE CT Law, interest is defined as any amount incurred to raise finances, whether accrued or paid, for the use of money or credit. It’s essential to note that any expense incurred in obtaining financing, such as initial loan processing costs, is also considered interest under the UAE CT Law.
As per Article 30 of the UAE CT law, a taxable person can claim a maximum net interest of 30% of the adjusted earnings before interest, tax, depreciation, and amortization (EBITDA) during a tax period. If the net interest amount is below the threshold set by the minister, the interest-capping provisions will not apply, and the whole net interest amount can be claimed by the taxable person. However, the remaining net interest amount can be carried forward for ten years.
The term net interest refers to the quantity of interest cost over interest earnings. When calculating EBITDA, exempt income is not considered, and any interest expense or income related to exempt income is also excluded when calculating the net interest amount. This measure is intended to prevent extreme debt financing and to assure that debt financing arising from precise intra-group transactions will only be subtracted in case there is a reasonable commercial reason for getting the loan, and to counter profit-shifting practices.
The provisions of the UAE CT law are in line with Action 4 of the OECD’s Base Erosion and Profit Shifting (BEPS) project, which has been executed by OECD member nations. To calculate the allowable interest amount, taxable persons must follow the steps below if the interest amount exceeds the threshold specified by the minister –
- Firstly, they must calculate their accounting profits in accordance with the International Financial Reporting Standards (IFRS).
- Secondly, the accounting profits are adjusted to arrive at the EBITDA figure, with any exempt income being excluded.
- Next, the net interest amount is calculated by deducting the interest income from the interest expenses.
- Once the net interest amount has been determined, 30% of the adjusted EBITDA is calculated to arrive at the maximum allowed interest.
- If the net interest amount is below this threshold, the interest-capping provisions will not apply, and the entire net interest amount can be claimed by the taxable person.
However, if the net interest amount exceeds the maximum allowed interest, only the maximum amount can be claimed, and the remaining net interest amount will be carried forward for ten years. These steps are in line with the OECD’s BEPS project, and many OECD member countries have implemented similar interest-capping rules.
Article 30(3) of the UAE CT law allows taxable persons to deduct a specific net interest expenditure (known as a safe harbor or de minimis amount) to avoid the burden of tax and administration costs. This fixed amount of interest is permissible only if the net interest falls below a specified threshold. This approach simplifies the calculation process and reduces costs, but it is subject to the decision of the Minister to determine the specific amount.
In cases where a loan is acquired from a connected party to finance revenue that is excused from CT, the interest on a such loan from the connected party will not be subtracted, unless the taxable person can show that the primary objective of getting the loan and taking out the transaction is not to acquire a CT benefit.
For instance, interest on a loan taken from a related party to pay for dividends, profit distribution, the redemption of or contribution to share capital or acquisition of ownership interest in a person who is or becomes a related party following the acquisition. However, if the related party (lender) is responsible to expend a nine percent or more increased tax rate on the interest income gained, no CT advantage will be considered to arise.
Certain industries, such as banks, insurance businesses, and other regulated financial services entities, have different risk profiles and capital requirements. Therefore, the interest capping rules will not be applicable to them. Furthermore, the UAE CT law explicitly states that businesses carried out by natural persons are also exempt from the interest capping rules.
Taxable persons should conduct a thorough impact assessment and arrange for debt financing accordingly to comply with the law’s requirements.
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