How will debt financing be treated under the UAE corporate tax system?

UAE corporate tax is clear on the use of borrowed funds and applicable deductions.
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Companies raise funds in the form of equity and debt – debt can be raised from formal sources such as financial institutions, related parties, family and friends of promoters and shareholders. Apart from simple loans, debt is also raised through instruments such as debentures, bonds and variations to make them convertible into shares.

Debt principal requires interest payments in addition to legal fees, bank charges, commissions, and processing fees. Typically, for accounting purposes, these costs are considered a charge to earnings and are generally expensed. Capitalization of these costs may also be necessary depending on the timing, purpose and use of the funds.

Going forward, borrowing costs, particularly interest, may require a fresh look, including accounting treatment, as deductibility may be affected.

Use of funds

The deductibility of interest costs would depend primarily on the use of the borrowed funds. Generally, no tax deduction would be available if the funds were used for personal purposes or to earn non-taxable income.

The public consultation paper (consultation paper) issued by the federal tax authority, UAE Corporation Tax, proposes to exempt dividends and capital gains on qualifying investments. Currently, it is unclear whether the UAE TB will allow deductions for interest on loans used to earn such exempt income. We await clarification on this aspect.

Thin capitalization rules

It is proposed to impose restrictions on the amount of deductible interest expense. These limits are commonly referred to as “thin capitalization rules”.

According to the consultation document, interest costs will only be deductible up to 30% of the profit before amortization and depreciation of interest (EBITDA). The limitation applies to interest payable on all debt incurred, whether from formal or related parties.

If the disallowed interest cannot be carried forward for set-off in future years, then indebted entities consider a permanent disallowance, i.e. a non-deductible cost. Accordingly, indebted entities engaged in capital-intensive sectors such as real estate, infrastructure and startups with long gestation periods, should pay attention to this provision as it may require a restructuring of the structure of the capital.

The safe harbor/de minimis threshold will be notified as part of the UAE TC – i.e. interest charges up to a certain threshold will not result in any denials. This should help business entities with negative or low EBITDA to claim an interest expense deduction at least up to the specified threshold.

In addition, banks, insurance companies, certain regulated financial activities and companies run by natural persons will be kept out of the thin capitalization standards.

Accounting aspects

Accounting standards generally require that interest expense on borrowings used for the acquisition/construction of fixed assets be capitalized until such assets become available for use. The consultation paper did not propose any change in accounting treatment, which is very welcome.

Similarly, IFRS 16 requires lease payments to be allocated between interest expense and debt repayment. Since there is a restriction on the amount of interest deduction under the UAE TRQ, it may be necessary for companies to reconsider their current rental agreements.

To conclude, while debt financing results in interest as a deductible expense against the dividend, a permanent denial on cost should be expected.

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