Interest Limitation Rules And Thin Capitalisation In The Context Of UAE Corporate Tax

Interest Limitation Rules And Thin Capitalisation In The Context Of UAE Corporate Tax

What is Thin Capitalisation?

Thin Capitalization Norm, as recommended by the OECD's BEPS Action Plan 4, is a set of guidelines aimed at preventing multinational companies from excessively using debt to reduce their taxable profits and shift income to low-tax jurisdictions. It focuses on the balance between debt and equity in a company's capital structure.
In simple terms, thin capitalization occurs when a company relies heavily on debt financing compared to equity financing. Debt interest is tax-deductible, making it an attractive option for reducing taxable profits. Multinational companies often use this strategy to their advantage, structuring their finances to minimize tax liabilities.
For instance, a company (B) operating in a high-tax jurisdiction borrows from another company (A) within the same multinational group, which is located in a low-tax or tax-exempt jurisdiction. B pays interest to A and claims deductions on these interest payments, reducing its taxable profit. The interest income received by A may be subject to a low tax rate or even no tax at all.
However, the impact on tax revenue depends on withholding taxes in B's jurisdiction and any applicable tax treaties. Many countries tax interest on a source basis, meaning that the lender (A) is taxed in the borrower's (B) country. Tax treaties often lower withholding tax rates for non-resident lenders.
To address this profit-shifting practice, tax authorities often implement rules limiting the amount of interest that can be deducted for tax purposes. These rules aim to protect a country's tax base and prevent excessive debt from eroding taxable profits.
In summary, thin capitalization norms are designed to maintain a fair and balanced tax system by preventing multinational companies from using excessive debt to manipulate their taxable income and reduce their tax obligations. These rules help ensure that companies contribute their fair share of taxes in the countries where they operate.

General Interest Deduction Limitation Rule

The tax law provides that a taxable person may deduct their net interest expenditure up to 30% of their earnings before interest, taxes, depreciation, and amortization (EBITDA) Excluding Exempt Income.
However, the tax law also allows the Minister to specify a limit on the amount of net interest expenditure that can be deducted. If the amount of net interest expenditure exceeds the limit, the excess amount is disallowed as a deduction. The disallowed amount or the balance of the net interest expenditure that cannot be deducted in the current period can be carried forward for up to 10 tax periods, and deducted in the order in which it was incurred.
It is important for taxpayers to carefully consider their net interest expenditure and the impact of these limitations on their tax liability. Proper tax planning and compliance can help taxpayers maximize their deductions and minimize their tax liability within the framework of the tax law.

What is Net Interest Expenditure?

Net Interest Expenditure (NIE) refers to the amount of interest expenses that a taxpayer has incurred in a given period, minus the taxable interest income earned during the same period. It is a key metric used to determine the tax liability of businesses, particularly those that borrow heavily to finance their operations.
Here's an example to help illustrate the concept:
Suppose Company ABC borrowed AED 1,835,000 to finance its business operations in the year 2023. The interest rate on the loan was 5%, resulting in interest expenses of AED 91,750 for the year. During the same period, the company earned AED 36,700 in interest income from its cash reserves and other investments.
Using the formula for Net Interest Expenditure, we can calculate the taxable person's NIE for the year 2022 as follows:
NIE = Interest expenses - Taxable interest income
NIE = AED 91,750 - AED 36,700
NIE = AED 55,050
Therefore, Company ABC's NIE for the year 2022 is AED 55,050.

General Interest Deduction Limitation Rule not applicable to the following persons:
a) A Bank.
b) An Insurance Provider.
c) A natural person undertaking a Business or Business Activity in the State.
d) Any other Person as may be determined by the Minister.

Other Points:
The Minister may issue a decision to specify the application of Clauses 1 and 2 of Article 30 to a Taxable Person that is related to one or more Persons through ownership or control and there is an obligation on them under applicable accounting standards for their financial statements to be consolidated.

For the purpose of General Interest Deduction Limitation Rule, interest includes :-
# Interest component on the returns from a financial asset or financial liability
# Amount incurred in connection with raising finance including guarantee, arrangement or commitment fees.
# Interest component on financial derivative instruments
# Finance element of a finance or non-finance lease payments
# Interest equivalent component on Islamic Financial Instruments
# All Foreign exchange gains or losses accruing from Interest.
# Interest capitalized in accordance with applicable accounting standard.

Interest Limitation rule not applicable if your Net Interest Expenditure is below 12 Million AED.

The limitation on the deductible Net Interest Expenditure (30% limit) is not applicable where the Net Interest Expenditure for the relevant Tax Period does not exceed AED 12,000,000 (twelve million dirhams).
Where the Net Interest Expenditure exceeds 12 Million Dirhams, a Taxable Person may deduct the higher of AED 12,000,000 (twelve million dirhams) or the 30 percentage of the Net Interest Expenditure
If the tax period is more than or less than 12 months, the de minimis amount of AED 12 million will be
adjusted in proportion to the length of tax period.

Specific Interest Deduction Limitation Rule – Article 31

Article 31 of the Decree Law sets out rules regarding the deduction of interest expenses incurred on loans obtained from related parties. The main provisions of this Article are as follows:
No deduction shall be allowed for interest expenses incurred on a loan obtained from a related party in connection with certain transactions, namely:
a) The payment of a dividend or profit distribution to a related party;
b) The redemption, repurchase, reduction or return of share capital to a related party;
c) The provision of a capital contribution to a related party;
d) The acquisition of an ownership interest in a person who is or becomes a related party following the acquisition
This means that if a company takes a loan from a related party to carry out any of the above transactions, it cannot claim a deduction for the interest expenses incurred on that loan.
However, the above provision will not apply if the taxable person can demonstrate that the main purpose of obtaining the loan and carrying out the transaction referred above is not to gain a corporate tax advantage. This means that if the purpose of obtaining the loan and carrying out the transaction is not to avoid paying corporate tax, then the company may be allowed to deduct the interest expenses.
Finally, for the above purposes, no corporate tax advantage shall be deemed to arise where the related party is subject to corporate tax or a tax of a similar character under the applicable legislation of a foreign jurisdiction on the interest at a rate not less than the rate specified in paragraph (b) of clause 1 of Article 3 of the Decree-Law. This means that if the related party is subject to a tax rate that is equal to or higher than the 9% Tax, then the company may still be allowed to deduct the interest expenses.

Disclaimer: The information provided in this article is for general educational purposes and is not intended to serve as professional advice, whether financial, legal, tax-related, or any other field. Laws and regulations can change, and individual circumstances can vary widely. Relying solely on the information in this article for making important decisions is not recommended, and we disclaim any liability for actions taken without seeking appropriate professional consultation.
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