As corporate tax is levied on taxable profits, which are calculated after adjusting accounting profits, interest payments can reduce taxable profits, leading to tax savings if permitted by tax authorities.
Businesses have access to different modes of financing, and debt financing is a popular option. Debt financing can take various forms, such as standard loans from financial institutions, preference shares, and overdrafts. The cost of borrowing through debt financing commonly referred to as interest is typically lower than the cost of equity. When the borrowed funds are used for business purposes, the interest payments are considered a business expense, which lowers the accounting profits. As corporate tax is levied on taxable profits, which are calculated after adjusting accounting profits, interest payments can reduce taxable profits, leading to tax savings if permitted by tax authorities.
The cost of the debt is lower than the cost of the equity, so a taxable person can opt for more debts without considering the optimum capital structure. Taxable persons can take massive loans from related parties in tax-free jurisdictions and lessor tax zones to shift their profits from high tax jurisdiction to low or no tax jurisdiction.
Like, a company on the mainland of the UAE can take a massive loan from a related party in the free zone whose income attracts zero per cent tax. The interest income in the hands of free zone companies will be subject to zero per cent corporate tax. Equally, interest expense in the mainland company's books will reduce the mainland company's taxable profits. Consequently, the interest on debt facilitates the transfer of profits from a high-tax jurisdiction to a low or zero-tax jurisdiction, thereby reducing the mainland company's tax liability.
To discourage excessive debt financing and to ensure that debt financing used or arising as a result of certain specific intra-group transactions will only be deductible if there is a valid commercial reason for obtaining the loan, and to counter profit shifting practices, interest capping rules have been introduced in article 30 of the UAE corporate tax law (UAE CT Law).
As defined in the UAE CT law, interest is the amount incurred to raise finances and accrued or paid to use money or credit. This is important to note that any amount incurred to raise finances has also been classified as interest in the UAE CT law; usually, it is a loan or debt initial processing cost.
Article 30 of the UAE CT law states that taxable can claim a net interest maximum of 30 per cent of adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) during a tax period, and the remaining net interest amount will be carried forward for a further period of ten years. However, if the net interest amount is below the threshold specified by the minister, then the interest capping provisions will not apply, but the whole amount of net interest will be claimed by the taxable person.
The word net interest is excess of net interest over interest income. While calculating EBITDA, exempt income will not be included. Similarly, any interest expense or income related to the exempt income will also not be considered while calculating the net interest amount.
These provisions of the UAE CT law align with Action 4 of the OECD's Base Erosion and Profit Shifting (BEPS) project, and the member countries of the OECD have implemented it. Taxable persons are required to follow the below steps to calculate the allowable interest amount if the interest amount is above the threshold specified by the minister.
- Taxable persons are required to calculate the accounting profits as per IFRS (International Financial Reporting Standards).
- These accounting profits will be adjusted to arrive at the EBITDA (exempt income will not be considered).
- Net interest (interest expenses less interest income) will be calculated.
- 30 per cent of the adjusted EBITDA is to be determined [adjusted EBITDA *30%]
- The maximum allowed interest is calculated in the above point. Any net interest above 30 per cent of EBITDA will be carried forward for ten years.
As mentioned above, to avoid the tax burden and administration cost, taxable persons are allowed under article 30(3) of the UAE CT law to deduct up to a specific net interest expenditure (safe harbour or de minimise amount). This means a fixed amount of interest is allowed if the net interest is below the threshold. This would make the calculation very simple and cost-effective, but we will have the wait for the Minister’s decision to have this specific amount.
If a loan is acquired from a related party to finance income that is exempt from CT, interest on such loan from the related party will not be deductible unless the taxpayer can demonstrate that the primary purpose of obtaining the loan and carrying out the transaction is not to gain a CT advantage. For example, interest on a loan taken from a related party to pay the related party 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. No CT advantage shall be deemed to arise if the related party (lender) is liable to pay a nine per cent or higher tax rate on the interest income earned. If the interest income in the hands of the lender is not subject to at least nine per cent tax, any interest paid to the related party will only be considered a deductible expense if there is a commercial reason.
Some industries have various risk profiles and capital needs, like banks, insurance businesses, and certain other regulated financial services entities, so interest capping rules will not apply to such entities. Moreover, it has been mentioned in the UAE CT law that interest capping rules will not apply to businesses carried on by natural persons.
Taxable persons are required to have proper impact assessment, and debt, if required, should be arranged keeping in view the exact requirements of the law.
News Source: Khaleej Times