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The next phase of UAE taxation | Global Law Firm

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Posted in Islamic Finance News on May 31, 2023

June 2023 will mark another phase in the evolution of the UAE tax regime. It has been five years since VAT was introduced in the UAE; by then, businesses, including Islamic ones, had operational procedures in place to deal with the tax. Now, with the introduction of corporate income tax in the UAE, they will have to adapt even further.

At first glance, it may seem surprising that a business-friendly jurisdiction like the UAE imposes taxes. However, this must be understood in the context of broader tax reforms taking place around the world. Countries are under pressure (led by the G7 and G20) to move away from low or tax-free regimes, culminating in OECD Pillar 1 and 2 projects.

Related to these purposes is the second pillar. The second pillar, which proposes a global minimum tax regime, has been adopted by most major tax jurisdictions, with the EU and the UK seeking to do so by early 2024; the US position has yet to be finalized.

Under the second pillar, countries are encouraged to impose a minimum 15% tax on corporate income; holding company jurisdictions can impose a so-called top-up tax if the group operates in a country with lower taxes. The UAE has proposed a tax rate of 9%, and its introduction must be done in this context.

Full details of the new UAE corporate income tax rules have yet to be released, but the framework is clear. UAE business operations not located in free zones, including Islamic ones, will be subject to corporate income tax at the rate of 9% for the first accounting period commencing after June 2023.

In practice, this means that, for example, businesses with a December year-end, including Islamic ones, must register and pay taxes in 2024. Typically, the starting point for determining taxable profits will be the financial position. Entity’s statements, and more detailed rules to determine when an item is tax-exempt. Many features of other international tax regimes have been included; there may be tax groups and businesses will have to comply with transfer pricing rules.

These stipulate that arrangements with related parties must be on “arm’s length terms” – much the same as arrangements that apply between third parties. Likewise, there are detailed rules for the tax deduction of interest and the use of tax losses. There are also reliefs for holding companies, possibly exempting dividends and participations.

Particular attention is paid to free zones; these may continue to be exempt from corporate income tax provided they meet appropriate substance requirements that may emulate existing economic substance requirements.

Free zone exemptions apply only to “qualifying income”, the exact extent of which is unclear, so businesses (conventional and Islamic) may be required to pay some tax on income outside the exemption.

It is possible for an operation to opt for a tax-free zone exemption, so it is taxable. It seems counterintuitive, but it might make sense (and probably be easier to administer) for an international group that might be subject to top-up tax rules.

Where does that leave UAE-based businesses and the businesses that fund them? As a starting point, it is important to note that the new rules apply to all lenders operating in the UAE; there are no specific rules that apply to Islamic finance. However, it is believed that the new rules will not have a significant impact on the competitiveness of the region; as mentioned earlier, this is part of the move to harmonize corporate tax rates globally.

In the short term, many groups are evaluating their structures and considering the impact of the new rules. For many, the starting point will be understanding which entities are caught and what the likely tax liability is. Restructuring and merging of businesses (which may require the consent of lenders) is possible. New reporting systems had to be created and financial models built.

The good news for UAE group lenders is that there is no proposal to impose a withholding tax on financing returns, so they can continue to receive gross payments. However, they will need to consider whether it is appropriate to introduce a covenant into the documentation relating to tax liabilities and risks, and also need to consider which tax assumptions are central to deciding whether to advance funds.In other (taxing) jurisdictions, most financing documents contain
Guarantee regarding tax compliance and ongoing obligations.

What is clear is that 2023 is going to be a busy year for those doing business in the UAE, and for those funding them (or indeed advising them). They’d better start now, though the details of the system and how it will actually work are unclear.

However, it is expected that initial impact studies will yield specific areas of concern for businesses. For some groups, the impact may be modest, requiring taxes to be paid and returns filed, but no structural or equivalent changes. For others, more work is required; setting priorities may take time, but it’s unlikely to be a waste of effort.

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