Background: Related-Party Loans and UAE Corporate Tax
Under the UAE Corporate Tax (CT) regime (Federal Decree-Law No. 47 of 2022), transactions between related parties must adhere to the arm’s length principle. This means any financing provided by a shareholder (or other related party) to a UAE company should carry an arm’s length interest rate, similar to what independent parties would agree in comparable circumstances. If a related-party loan has no or below-market interest, UAE tax authorities can adjust the terms for tax purposes to reflect a market rate. Article 34 of the CT Law embeds this requirement, ensuring that intra-group loans are priced fairly to prevent profit shifting. Even if a company falls below documentation thresholds (per Ministerial Decision No. 97 of 2023 on Transfer Pricing), it must still be able to demonstrate that related-party funding is arm’s length (e.g. via benchmarking) upon FTA request.
The CT regime also introduced interest deductibility limits (30% of EBITDA, with AED 12m safe harbor) and anti-avoidance rules for interest. For instance, interest to related parties is only deductible if it serves a genuine business purpose and is not solely to gain a tax advantage. Notably, if the related lender is subject to tax at 9% or higher (in the UAE or abroad), the law presumes no CT advantage arises (after applying arm’s length pricing). However, this presumption does not waive the arm’s length requirement, it simply indicates less risk of abuse when both lender and borrower are taxed at similar rates. In summary, UAE’s transfer pricing rules generally expect that shareholder-to-subsidiary loans carry a reasonable interest rate, unless the funding is truly in the nature of capital rather than debt.
Undercapitalization and Shareholder Funding in the UAE
It is common in the UAE for companies (especially holding and investment entities) to have a small issued share capitalthat is not commensurate with the scale of their business or working capital needs. Historically, before CT was introduced, shareholders often funded their subsidiaries via interest-free or low-interest loans (shareholder advances) instead of injecting formal equity. This provided flexibility in withdrawing funds and avoided formalities of changing share capital. Now, under the CT regime, such practices come under scrutiny. Thinly-capitalized companies, those relying mostly on shareholder debt, may face challenges: excessive interest (if charged) could be disallowed, and interest-free funding might trigger transfer pricing considerations.
For example, if a UAE operating subsidiary is funded predominantly by a parent company loan rather than equity, tax authorities will examine whether an independent lender would have extended such a loan, or whether more equity should have been used. The OECD Transfer Pricing Guidelines (which inform UAE’s approach) emphasize examining the substance of financial transactions. If a purported loan resembles equity funding, the authorities may recharacterize it as equity (in whole or in part), meaning any excessive interest deductions would be disallowed. In practice, the FTA will consider factors like the borrower’s solvency, debt-to-equity ratio, and ability to obtain similar financing externally. A company with a very high shareholder-debt ratio and minimal capital is effectively undercapitalized, signaling that a portion of the “debt” might in reality be performing an equity function.
It’s important to note that UAE CT does not impose a fixed debt-to-equity thin capitalization ratio; instead, it uses the earnings-stripping rule (30% of EBITDA cap) and the arm’s length test to address excessive interest. Thus, companies with heavy shareholder loans must ensure either interest is charged at market rates, or be prepared to justify that those loans are quasi-equity infusions where interest is not economically expected.
Quasi-Capital: Definition and Key Features
Quasi-capital (or quasi-equity) refers to funding instruments that, while structured as debt, essentially function like equity in the business. These are shareholder commitments that provide long-term capital support without the typical fixed obligations of a loan. In other words, the essential “reward” for the investor is the ownership stake or increased value of the company, rather than interest income. Because of this equity-like nature, quasi-capital loans often carry no interest or below-market interest, and may have no fixed repayment date or very subordinate repayment terms.
Common features and conditions that characterize a shareholder loan as quasi-capital include:
- Indefinite or Extended Maturity: The loan has no fixed repayment date, or a very long term (e.g. 10-15+ years) with flexibility on repayment. It may effectively only be repayable at the discretion of the company or upon liquidation. This is akin to equity, since true creditors would demand a clear repayment schedule.
- No or Contingent Interest: There is no obligation to pay interest, or interest is only payable out of profits (similar to dividends). In some cases, the “interest” may be replaced by the shareholder’s expectation of capital appreciation. For example, profit-participating loans or contracts where returns depend on the company’s profitability have equity characteristics.
- Subordination: The shareholder’s loan is deeply subordinated to other creditors. The shareholder often signs a subordination or support agreement committing that their loan will not be repaid (and perhaps not even interest serviced) until all external debts are settled. This means the shareholder loan absorbs loss first (just like equity capital would) and provides a cushion to other lenders.
- Lack of Security or Covenants: Unlike an independent lender, the shareholder-lender may not require collateral or strict covenants. The absence of security suggests the shareholder is taking on equity-like risk (they stand behind other creditors).
- Thin Initial Capitalization or Regulatory Constraints: Quasi-equity loans often arise when the subsidiary’s formal share capital is very low (for licensing or historical reasons), but the business requires much larger funding. The shareholder injects funds as “loan” due to ease or legal limits, but in substance those funds are intended as risk capital. In some cases, regulatory or legal constraints might prevent immediate issuance of shares (e.g. awaiting approval, or foreign ownership caps), so the interim funding is given as a loan with the clear intention to convert it to equity once feasible. In such scenarios, the loan is essentially a placeholder for capital, a classic quasi-capital situation.
- Documented Intent of Capital Support: There may be board resolutions or agreements indicating that the loan is provided to support the company long-term, with no expectation of regular interest or near-term repayment. For instance, if a bank’s covenant letter requires the company to maintain a certain capital level above its formal share capital, the shareholder might declare their loan as part of that capital base. A common real-world example is when a bank financing the subsidiary stipulates a maximum debt-to-equity ratio or a minimum net worth: the shareholder then issues a letter of support confirming that their loan will not be withdrawn and can be treated as quasi-equity for the duration of the bank loan. This effectively transforms the shareholder loan into “permanent” capital from the perspective of creditors.
In summary, a shareholder loan can be viewed as quasi-capital if it behaves more like an equity infusion, providing open-ended, subordinate funding without guaranteed returns. The concept of quasi-capital is recognized in transfer pricing and tax discussions because it influences how the arm’s length principle is applied to related-party financing.
Accounting and Tax Treatment of Quasi-Capital Loans
The UAE CT law does not explicitly spell out “debt vs equity” reclassification rules, but it is understood (in line with OECD standards) that the FTA can re-delineate a transaction based on substance. If a shareholder loan’s terms make it indistinguishable from an equity injection, the FTA could treat it as equity for tax purposes, meaning no interest deduction for the borrower (since an arm’s length investor would have provided those funds as equity). In such a case, not charging interest is acceptable because an independent party would not have lent money on those terms at all (they would demand an ownership stake instead). On the other hand, if the loan, despite some equity-like aspects, is still something a third-party lender might have extended (perhaps at high interest given the risk), the tax authority may insist on an arm’s length interest charge or impute one for tax calculations.
In practice, each situation must be assessed case-by-case. The UAE’s guidance (and international TP principles) indicate that there is no one-factor test, a combination of indicators will determine how a shareholder loan is classified. Companies should document the commercial rationale for interest-free or ultra-long-term shareholder loans. If the rationale is that the funds are effectively additional equity (for example, to fulfill regulatory capital requirements, or because the subsidiary could not obtain any external debt), this should be evidenced clearly.
Transfer Pricing Considerations for Quasi-Capital Funding
When dealing with shareholder-to-subsidiary funding, one must ask: what would independent parties have done in similar circumstances? If a UAE subsidiary is thinly capitalized and no bank would lend it the amount that the parent provided (especially not without interest or security), the logical arm’s length outcome is that a market investor would have injected equity, not given a generous loan. In transfer pricing terms, this supports treating the transaction as an equity contribution. The OECD Transfer Pricing Guidelines 2022 (adopted by many countries and informing UAE practice) allow tax authorities to accurately delineate a loan as equity if the purported debt terms deviate excessively from commercial reality. Key TP implications include:
- No Arm’s Length Comparable for Zero-Interest Long Term Loans: In a competitive market, a lender requires compensation (interest) and a reasonable assurance of repayment. A loan with no interest, no maturity, and no security would simply not be offered by any genuine lender. Thus, insisting on an “arm’s length interest rate” for such an instrument is arguably moot, an unrelated lender’s rate would be infinite or they would refuse to lend. The arm’s length principle in this case might lead to recharacterizing the advance as capital because that’s what an unrelated party would have provided (i.e. funds in exchange for ownership or future profit share, not as debt). Tax authorities in the borrower’s jurisdiction often take this approach, disallowing interest deductions on the portion of a shareholder loan deemed excessive or equity-like.
- Partial vs. Full Recharacterization: It’s possible only part of a loan is treated as equity (for instance, up to a debt/equity ratio that a bank might have tolerated). Any interest on the recharacterized portion would be disallowed, with only the arm’s length interest on the genuine debt portion allowed. However, if a loan is entirely non-commercial (e.g. a perpetual zero-coupon loan), authorities could treat it fully as equity, meaning no interest should be charged or deducted at all.
- Lender’s Perspective and Imputation of Income: In some cases, a tax authority where the lender is resident might try to impute interest income on an interest-free loan (treating the uncharged interest as a taxable gain to the lender). For example, if a UAE company lent money interest-free to a foreign subsidiary, the foreign country might tax an imputed interest. In the UAE context (shareholder-to-UAE-subsidiary), if the parent company is UAE-resident and did not charge interest, the FTA might consider whether the parent provided a service or benefit to the subsidiary. Generally, however, the UAE would prefer to see transactions at arm’s length rather than impute income. A taxpayer can argue the “equity function” argument: i.e. the parent acted as an equity investor, so no interest income should be imputed. This argument is bolstered if the borrower was so undercapitalized that no bank would lend to it, meaning the only rational way the funds could have been provided is via a capital investment. In essence, the parent didn’t earn interest because it anticipated returns via the subsidiary’s growth (like any equity holder).
- Documentation – Ministerial Decision No. 97 (2023): For companies meeting certain thresholds, UAE TP documentation rules require a Local File analysis of material intercompany loans. Even if below thresholds, the FTA can request justification for any interest-free or low-interest related-party loan. Taxpayers should be ready to present evidence (board minutes, agreements, financial analysis) if they position a loan as quasi-capital. Useful documentation might include: a comparison of the debt-to-equity ratio before and after the loan, any bank correspondence or covenants treating the shareholder loan as equity, and explanations why issuing new shares was impractical at the time. All these help demonstrate that an independent party would view the advance as a form of equity investment, supporting a conclusion that no interest was warranted at arm’s length.
One caveat: if the shareholder and subsidiary are in different tax positions (e.g. the parent is in a no-tax jurisdiction or a UAE free zone at 0% while the subsidiary is taxable at 9%), authorities will be particularly alert. An interest-free loan in such a case might actually increase UAE’s tax revenues (since the subsidiary forgoes a deduction). There is technically no tax avoidance in not charging interest when the lender is untaxed, it results in more profit taxed in the UAE. However, if the roles were reversed (subsidiary in 0% zone and parent taxable, or parent abroad with lower tax), an inappropriate interest rate could be used to shift profits. The FTA’s stance is that all related-party pricing should be arm’s length, irrespective of immediate tax benefit, to prevent any future manipulation. Thus, even with no obvious tax advantage, companies are advised to either charge a fair interest or have solid grounds to treat a loan as quasi-equity.
Examples and Scenarios in the UAE Context
Example 1: Long-Term Shareholder Loan with Conversion Intent – Holding A (UAE) establishes Subsidiary B in the UAE mainland to run a manufacturing business. Due to licensing deadlines, B is incorporated with only AED 100,000 share capital. A injects AED 20 million as an interest-free loan to fund factory construction, with the understanding that once B has the necessary approvals, the loan (or a large portion of it) will be converted into equity shares. Here, the loan is essentially a bridge to equity. The terms: no fixed repayment date and no interest. At arm’s length, no third-party would extend such financing purely as a loan, they would require either interest or equity. Since A fully intends to capitalize B properly (and only used the loan form due to timing/regulatory constraints), this loan can be viewed as quasi-capital. In line with an Indian tribunal ruling on quasi-capital loans, such advances meant to be converted to equity are not comparable to ordinary interest-bearing loans. The appropriate arm’s length price for this “loan” could be considered nil interest because the true benefit to A is the eventual ownership (not interest yield). B’s financial statements would likely classify the initial loan recognition difference as equity. For UAE CT, as long as the conversion happens or the intent is clear, the FTA would likely accept that no interest was charged because this was effectively an equity infusion in substance. If, however, the loan remains on the books indefinitely without conversion, the company should periodically re-evaluate if conditions still justify treating it as quasi-equity.
Example 2: Shareholder Loan Subordinated for Bank Covenants – Company X LLC (UAE) is a trading company with a small paid-up capital (say AED 500k). Its parent company, Foreign Co, has over the years extended AED 50 million in loans to X to support working capital and expansion. A local bank extends credit to X but imposes a covenant: X must maintain a debt-to-equity ratio not exceeding 2:1, and shareholder loans must be subordinated to bank debt. In response, Foreign Co provides a letter of undertaking to the bank, confirming that its AED 50m loan will not be recalled and is subordinate to the bank’s facilities until the bank loan is repaid. In effect, the shareholder loan takes on the characteristics of equity from the bank’s perspective (it props up X’s balance sheet as quasi-capital). Given that subordination and the lack of any enforceable right to demand paymentuntil conditions are met, this loan can be seen as quasi-equity financing rather than a normal commercial loan. If Foreign Co also chooses not to charge interest on the loan (perhaps to avoid draining X’s cash), can this be justified under UAE CT? At arm’s length, no outside lender would agree to postpone its rights and charge zero interest without compensation; only an equity investor (the shareholder) would do so, expecting returns via future profits or appreciation. Thus, X can argue the loan is in substance an equity contribution by Foreign Co (a classic case of “thin capital, bulk via shareholder current account”). The arm’s length principle, in this scenario, might not require any interest because a comparable uncontrolled transaction is actually an equity infusion (which carries no guaranteed interest). However, X should document the commercial rationale (e.g. minutes noting that increasing share capital was less practical than a shareholder loan, the bank’s requirement, and Foreign Co’s commitment letter). If X were ever audited, these facts would support the position that the funds were quasi-capital, and the absence of interest is consistent with arm’s length behavior for such a high-risk, subordinate investment.
Example 3: Intra-Group Investment Holding Structure – UAE HoldCo is a holding company with subsidiaries in the UAE mainland (trading and manufacturing) and abroad (shipping business). UAE HoldCo itself is funded by its shareholder through a mix of equity and loans. Suppose the shareholder (perhaps a family office) provided a long-term interest-free loan of USD 10 million to UAE HoldCo to acquire these subsidiaries. UAE HoldCo’s share capital is only USD 100k, so the loan constitutes the bulk of its funding. Here, the entire business of HoldCo is financed by the shareholder’s “quasi-equity”. The expectation is that the shareholder will earn a return via dividends from the subsidiaries (and ultimately appreciation in HoldCo’s value), not via interest on the loan. Under the new CT rules, UAE HoldCo must consider whether it needs to impute interest on this related-party loan. If UAE HoldCo and the shareholder are both UAE taxable persons, charging interest would just move taxable profits from one to the other with no net tax change (and potentially create nondeductible interest if HoldCo has low EBITDA). There is also a practical preference in UAE groups to keep such loans interest-free, as charging interest could complicate cash flows and tax compliance in multiple jurisdictions. In this scenario, UAE HoldCo can take the position that the USD 10m is in substance a capital contribution from its shareholder, akin to “other equity” on the balance sheet. The loan has no maturity and no interest, indicating the shareholder’s intent is long-term investment. From a transfer pricing standpoint, one would argue that an independent investor would not lend $10m to a thinly-capitalized holding company with no interest, they would only inject equity or perhaps expect a higher ownership stake. Therefore, arm’s length pricing of this funding is effectively a 0% interest because it’s not a loan an outsider would make. UAE HoldCo should nonetheless prepare a transfer pricing analysis describing the business rationale and perhaps benchmarking that shows no comparable debt exists for such a situation. Additionally, if any part of that loan is later repaid or if the relationship changes, they should revisit the classification.
Conclusion
In the UAE’s corporate tax framework, shareholder loans to subsidiaries are in principle subject to arm’s length interest requirements to prevent tax base distortion. However, in practice many UAE firms are funded by shareholder “loans” that function as equity. The concept of quasi-capital allows recognition of these arrangements: when a loan’s terms (no interest, no fixed repayment, deeply subordinated) indicate that it is essentially risk capital, it can be treated as such for tax purposes. In these cases, no interest need be charged, because an independent party wouldn’t have charged interest on a deal that is fundamentally an equity investment.
That said, the burden is on the taxpayer to substantiate the quasi-capital nature of the funding. Clear evidence, such as documentation of intent to convert to equity, bank covenant letters treating the loan as capital, or proof that the subsidiary could not obtain external loans, will bolster the position. Companies should also be mindful that if circumstances change (e.g. the subsidiary becomes well-capitalized and still retains an interest-free loan indefinitely), the justification for not charging interest may weaken. The UAE’s transfer pricing rules will continue to apply the arm’s length test, so accurate delineation of the transaction is critical. By carefully structuring and evidencing shareholder loans as quasi-equity where appropriate, groups can comply with the new tax law without being forced into economically unwarranted interest charges.
In summary, long-term shareholder commitments can be viewed as quasi-capital, and thus exempt from interest, under conditions where an independent investor would have provided equity rather than debt. This treatment aligns with both the spirit of the arm’s length principle and the commercial reality of funding in many UAE groups, as long as it is properly documented and consistently applied.
