Welcome to the 9th installment of our series offering comprehensive insights into UAE corporate tax. The introduction of corporate tax in the United Arab Emirates (UAE) has brought a wave of questions for businesses operating within its borders. One crucial aspect to understand is what income streams are exempt from this tax. This blog post dives into the intricacies of income exempt from UAE Corporate Tax, providing a clear and concise guide for businesses to navigate this new landscape.
If you’re just joining us, we recommend starting from the beginning of our series to get a full grasp of the insights we’ve shared so far. You can find the first blog post here.
Demystifying Exempt Income Categories
The UAE Corporate Tax regime offers exemptions for specific types of income, reducing the overall tax burden for qualifying businesses. Here’s a breakdown of the key categories:
- Dividends and Profit Distributions: Dividends and other profit distributions received from companies incorporated or residing in the UAE are exempt from Corporate Tax. This applies regardless of the ownership stake in the dividend-paying entity, including those benefiting from a complete tax exemption or a 0% Free Zone Corporate Tax rate. Additionally, professional fees incurred for due diligence before investing in a company are deductible if they are a business expense and not capital in nature.
- Profits from Foreign Participating Interests: The Participation Exemption regime offers a tax shield for dividends and profit distributions earned from qualifying foreign investments. To qualify, a business needs to hold a minimum 5% ownership stake or have an investment exceeding AED 4 million in the foreign entity. However, there are additional conditions to meet, which we’ll explore further. We don’t take into account in determining Taxable Income expenses directly related to a Participating Interest, like management and administration costs.
- Capital Gains and Other Income: Under the Participation Exemption regime, capital gains earned from selling shares in both domestic and foreign companies can be exempt from Corporate Tax. Additionally, specific other income categories, such as foreign exchange gains/losses and impairment gains/losses, might also be exempt when associated with a Participating Interest. Expenses related to the acquisition of shares in a juridical person that is a Resident Person may be considered as common expenses towards earning Exempt Income and Taxable Income.
- Foreign Branch or Permanent Establishment Exemption: Businesses can potentially claim an exemption for income generated by a foreign branch or Permanent Establishment if they meet the permanent establishment (PE) test and elect the “Foreign Permanent Establishment” exemption. This exemption comes with specific criteria that need evaluation. Interest paid in relation to Exempt Income, such as that which benefits from the Participation Exemption, is prima facie deductible unlike other expenditure incurred in deriving Exempt Income.
- International Transportation Income: Non-resident companies earning income from operating or leasing aircrafts or ships used in international transportation might be eligible for an exemption. However, we must fulfill specific conditions as outlined in the regulations for this exemption to apply.
Delving Deeper into the Participation Exemption Regime
The Participation Exemption regime plays a significant role in exempting income from foreign investments. Let’s break down the key aspects of this regime:
- Preventing Double Taxation: This regime aims to eliminate double taxation within a corporate group structure. It ensures that profits already taxed at the subsidiary level aren’t taxed again when distributed as dividends to the parent company.
- Qualifying as a Participation: We define Participation as a foreign juridical person where the UAE shareholder company holds a minimum 5% ownership stake or has an investment exceeding AED 4 million for at least 12 months. Additionally, the foreign entity must meet specific criteria outlined in the Participation Exemption regime.
- Minimum Ownership Threshold: While we generally prefer a 5% ownership stake, businesses can still qualify for the exemption if their investment cost in the foreign entity is at least AED 4 million.
- UAE Resident Companies and the Participation Exemption: Dividends received from companies residing in the UAE are automatically exempt under a separate article of the Corporate Tax Law. There’s no need to claim an exemption through the Participation Exemption regime for these dividends.
Addressing Specific Scenarios
The UAE government has established clear guidelines to address various scenarios businesses might encounter:
- Foreign Company “Subject to Tax” Test: For a foreign company to qualify under the Participation Exemption regime, it typically needs to be a resident of a country with a corporate income tax system similar to the UAE’s, with a headline tax rate of 9% or higher. The company can also demonstrate an effective tax rate of at least 9% on its profits.
- Minimum Ownership Interest Determination: A business meets the minimum ownership requirement for the Participation Exemption if it holds either a 5% stake or has an investment exceeding AED 4 million in the foreign entity. Different ownership interest types (ordinary shares, preferred shares, etc.) aggregate to determine the total ownership stake.
- Ownership Interest Definition: The Participation Exemption regime recognizes various ownership interests, including ordinary shares, preferred shares, redeemable shares, memberships, and other instruments that entitle the holder to receive profits and liquidation proceeds. However, these instruments must be classified as equity under International Financial Reporting Standards (IFRS).
- Branches and Option Rights: Branches operating as Taxable Persons under the Corporate Tax Law can potentially claim the Participation Exemption for qualifying ownership interests in a Participation. We also can consider option rights as ownership interests if they meet specific IFRS criteria regarding control and beneficial ownership of the underlying shares.
- Islamic Financial Instruments: Financial instruments compliant with Shariah principles can also benefit from the Participation Exemption if they’re classified as equity under the accounting standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions.
Business Reorganizations and Exemptions:
Exchanging an ownership interest for another one during a business restructuring can still qualify for the Participation Exemption, provided the new ownership meets the regime’s criteria. The new ownership will be treated as a continuation of the original holding.
Holding Company Requirements:
For a holding company to qualify under the Participation Exemption, it must meet specific criteria:
- Principal Objective and Activity: The holding company’s primary purpose and activity should be acquiring and holding shares or equitable interests.
- Directed and Managed Locally: It is essential that the managing and directing of the holding company is within the relevant country or territory.
- Compliance and Resources: The company must comply with documentation and record-keeping requirements set by the relevant authorities. Additionally, it should have adequate personnel and office space to conduct its activities.
- Limited Activities: The holding company cannot engage in any significant non-incidental activities beyond acquiring and holding shares or equitable interests.
Substantial Income from Participating Interests:
One can consider a holding company’s income to “substantially” consist of income from Participating Interests if, on average, at least 50% of its income over the current and preceding tax periods comes from dividends, capital gains, and other income derived from Participating Interests.
Determining the Minimum Acquisition Cost Threshold:
Determining The AED 4 million minimum acquisition cost threshold for a Participation by considering the combined value of:
- Equity or capital contribution made (including cash payments)
- Any subsequent equity or capital contributions to the Participation
- Expenditure related to the acquisition
If the acquisition involves a currency other than UAE Dirhams, we use the exchange rate applicable on the acquisition or formation date of the ownership interest for conversion. It’s important to note that the cost isn’t adjusted for inflation or any increase in the underlying ownership interest’s value. Furthermore, if a portion of the ownership is sold or disposed of, the acquisition cost is reduced proportionally based on the disposed-of portion’s average acquisition cost.
Conclusion
Understanding income exempt from UAE Corporate Tax, particularly the intricacies of the Participation Exemption regime, is crucial for businesses operating in the UAE. This blog post has provided a comprehensive overview of the key aspects. However, consulting a qualified tax advisor like AM Audit to ensure proper interpretation and application of the regulations specific to your business situation is essential.
To stay updated with Corporate Tax Law and related implementing decisions you can visit this link.
