Computation of Taxable Income - Simplifying UAE Corporate Taxation

1.0 Computation of Taxable Income

1.1 How is Taxable Income Computed?

Taxable income is determined by taking a person's accounting net profit and making a series of adjustments. Use the mnemonic to remember, "Uncle Earl Rarely Admits Taxing Incorrectly, Obviously," the adjustments are:
❖ Unrealised gain or loss
❖ Exempt Income
❖ Reliefs
❖ Allowed Tax Deductions
❖ Transfer Pricing Adjustments
❖ Incentives or special reliefs
❖ Other adjustments

A company's accounting income for a tax period is determined from its financial statements. These statements must be prepared in line with the International Financial Reporting Standards (IFRS). 

The scope of a person’s taxable income varies based on their tax residency.
❖ Resident Juridical Person: A company or other legal entity that is a resident of the UAE is taxed on its worldwide taxable income. This means it includes income from both UAE and foreign sources.
❖ Resident Natural Person: An individual who is a resident of the UAE is only taxed on income from the UAE and abroad if it is related to a Business or Business Activity they conduct in the UAE.
❖ Non-Resident Person: A non-resident individual or company is only taxed on income that is sourced from the UAE, specifically:
    ➢ Income from a Permanent Establishment in the UAE.
    ➢ State-Sourced Income not linked to a Permanent Establishment.
    ➢ Income linked to a nexus in the UAE, as defined by a Cabinet decision.

1.2 Unrealized Gain or Loss Adjustments

In simple terms, a company's taxable income is adjusted to remove any unrealized gains or losses, because tax is only due on a gain or loss when it is actually realized (e.g., when an asset is sold).
This applies to gains or losses that are on a company's books but have not yet become final. A common example is a gain or loss from a foreign currency transaction that has not been settled yet.

Here's how the rule works:
● The Choice: A company must make a one-time choice in its first tax period to apply this rule.
● The Scope: The company can apply this adjustment to either:
    ○ All assets and liabilities that are valued at fair market value in its financial statements.
    ○ Only its long-term (capital) assets and liabilities, which are typically a company that holds for a long time and does not trade, such   as property, plant, and equipment.
● The Adjustment: If an unrealized gain or loss is recorded in the accounting books, it must be removed to calculate the correct taxable income.

1.3 Accounting Method Changes

Just a follow up Question!! Can a business change Accounting methods?
● The UAE Corporate Tax Law is based on financial statements prepared according to International Financial Reporting Standards (IFRS). IFRS has strict rules on when a company can change its accounting policies.
● When is a change allowed?
● A company can only change its accounting method if the change:
   ○ Is required by a new IFRS standard.
   ○ Leads to financial statements that are more relevant and reliable.
● The request to change the method must be formally submitted to the FTA for approval. If the change is approved, it will be applied to future tax periods.

1.4 Exempt Income

Exempt Income refers to specific types of income that are intentionally excluded from a company's taxable income. This means no Corporate Tax is due on these earnings, and any related expenses are also not included in the tax calculation.
● The purpose of this exemption is often to prevent double taxation or to support specific business activities.
● Examples of Exempt Income include:
● Dividends and other profit distributions received from a UAE resident company.
● Income from a foreign branch, provided certain conditions are met to qualify for the foreign permanent establishment exemption.
● Dividends and other income from a foreign company in which a UAE company holds a significant ownership stake.
● Income of non-residents from international shipping or air transport.

2.0 The Participation Exemption

2.1 What is a Participating Interest?

A Participation Interest is a significant ownership stake in a foreign company that, when it meets specific conditions, allows the income from that foreign company to be considered tax-exempt in the UAE.
To be considered a Participation Interest, all of the following conditions must be met:
❖ Ownership: You must own 5% or more of the shares or capital of the foreign company. 
❖ Holding Period: This ownership must be held (or intended to be held) for a continuous period of at least 12 months.
❖ Foreign Tax Rate: The foreign company must be subject to Corporate Tax in its home country at a rate that is not lower than the UAE's 9% tax rate.
❖ Profit Rights: Your ownership must give you the right to receive at least 5% of that foreign company's profit distributions and liquidation proceeds.
❖ Asset Test: Less than 50% of the foreign company's assets can consist of non-exempt items located in the UAE. 

Logic of the Asset Test
❖ The rule is straightforward: not more than 50% of the foreign company's assets can consist of ownership interests or entitlements that would not be tax-exempt if you held them directly in the UAE.
❖ In simple terms, you are allowed to own a foreign company to receive tax-exempt dividends, but that foreign company cannot be primarily a shell for holding assets that would be taxable in the UAE. If the test is failed, the ownership does not qualify as a Participation Interest, and any income you receive from it (dividends, etc.) would be taxed at the standard 9% rate. 

Example: Let's consider InvestCo, a UAE company that holds a 6% ownership stake in Global Property Inc., a foreign company.
   ● Global Property Inc.'s assets consist of:
   ● AED 100 million in residential properties in Dubai (these would be taxable if held directly by InvestCo).
   ● AED 80 million in commercial property in London.
The Result: The value of the UAE-based, non-exempt assets (AED 100 million) makes up 55.5% of Global Property Inc.'s total assets (AED 180 million). 

Because this is more than 50%, the asset test failed. InvestCo's ownership in Global Property Inc. is not considered a Participation Interest. Therefore, any dividends or other income InvestCo receives from Global Property Inc. will not be tax-exempt and will be subject to the standard 9% Corporate Tax.

2.2 The 50% Asset Test: Assessment Methods and Requirements

A company can choose to assess its assets using either of two methods: 
     ● The Balance Sheet Method (Accounting Value): A company can use its standard consolidated balance sheet to prove that less than 50% of its assets consist of non-exempt, UAE-based items. This is often the most straightforward method as it uses the company's existing financial records.
    ● The Market Value Method: If the book value on the balance sheet is not an accurate reflection of the assets, a company can use a market value assessment. This allows it to get an updated valuation of the foreign company's assets to prove that the 50% test is met. 

The Logic of Continuous Compliance: The law requires that this condition be met continuously throughout the entire tax period. The logic behind this rule is to prevent a company from temporarily meeting the asset test on a specific date (like at the end of the tax period) just to gain an exemption. It ensures the business structure is genuinely compliant throughout the year. 

2.3 What Income from a Participating Interest is Exempt from Tax?

Once a foreign ownership stake is considered a "Participating Interest," the following types of income and gains/losses from it are exempt from Corporate Tax:
     ● Dividends: Any dividends or other profit distributions you receive from that foreign company are tax-free.
     ● Gains and Losses: Any gain or loss from selling, transferring, or disposing of that ownership stake is also tax-exempt, provided you have held it for the required 12-month period.
     ● Foreign Exchange Gains/Losses: Any gains or losses due to currency fluctuations related to the investment are not included in your taxable income.
     ● Impairment Gains/Losses: Any gains or losses resulting from changes in the value of the investment on your financial statements are also excluded from the tax calculation. 

2.4 When is the Condition for Foreign Jurisdiction Tax Automatically Met? 

The condition for the foreign jurisdiction tax rate is automatically met in two specific scenarios, avoiding the need for a company to prove that a foreign entity pays at least 9% tax. 

This logic is an anti-avoidance and simplification measure to prevent businesses from being unfairly taxed and to streamline compliance.
 ● When the Foreign Company is a Holding Company
This condition is automatically met if the foreign company's main business is simply holding shares or ownership interests and most of its income comes from other qualifying Participating Interests.
Logic: The law treats this as a "look-through" approach. If the foreign company is just a vehicle for holding other investments that would already be tax-exempt in the UAE, it would be unnecessarily complex to prove its own tax rate. This rule prevents a company from having to prove the tax rate of a foreign entity that is essentially a pass-through for other qualifying investments.
Example: A UAE company, "Investments LLC," has a 5% stake in a foreign holding company, "Global Assets Inc." Global Assets Inc.'s only business is holding shares in other international companies that meet all the conditions to be "Participating Interests." When Investments LLC receives a dividend from Global Assets Inc., the income is automatically considered tax-exempt. It does not need to prove that Global Assets Inc. itself pays 9% tax.

● When the Foreign Company is a QFZP or Exempt Person
The condition is also automatically met if the foreign company is a Qualifying Free Zone Person (QFZP) or an Exempt Person under the UAE's own Corporate Tax Law.
Logic: This rule simplifies the tax treatment for intra-UAE groups. Since a QFZP or an Exempt Person is already deemed "tax-compliant" and has a 0% tax rate under UAE law, there is no need to prove it is subject to a 9% tax rate. The UAE tax system recognizes its own entities' tax status as sufficient.
Example: A mainland UAE company, "Mainland Ventures," has a 6% ownership stake in its sister company, "Trade FZCO," which is a Qualifying Free Zone Person and therefore pays 0% tax. When Mainland Ventures receives a dividend from Trade FZCO, the dividend is automatically tax-exempt because Trade FZCO is a QFZP. Mainland Ventures doesn't need to check its tax rate as the condition is automatically fulfilled. 

Qualifying Participating Interests
Qualifying foreign investments are specific types of investments in foreign companies that are considered to be tax-exempt for a UAE company. These investments must meet a set of strict conditions to prevent double taxation and ensure they are not part of a tax avoidance scheme.
These include: 

● A "Participating Interest": This is the most common form of a qualifying foreign investment. It's a significant ownership stake in a foreign company (typically 5% or more of its shares or capital) that is held for at least 12 months and meets several other conditions, such as the foreign company being subject to a Corporate Tax rate of at least 9%.
● A "Qualifying Foreign Permanent Establishment": If a UAE resident company has a branch or fixed place of business in another country, and that branch's income is taxed at a rate of at least 9% in that foreign jurisdiction, the UAE company may elect to have that income be tax-exempt in the UAE as well. This prevents the same income from being taxed in both countries. 

2.5 When Does the Participation Exemption not Apply?

The exemption on income from a Participating Interest does not apply in specific cases, primarily to prevent a company from getting a double tax benefit on the same transaction.
 ❖ No Exemption on Deducted Losses
      ➢ The exemption is voided to the extent that you have already claimed a tax deduction for a loss in the value of the investment or a loan to the foreign company. You cannot claim a deduction for a loss and then an exemption for a subsequent gain on the same investment.
      ➢ For example, if you claimed a tax-deductible loss on an investment and later the investment's value goes back up, the gain will be taxed up to the amount of the previous deductible loss.
❖ When the Other Party Gets a Deduction
      ➢ The exemption does not apply if the foreign company can claim a tax deduction in its home country for the dividends it pays out. This is an anti-avoidance rule that prevents the income from being "tax-free" on both sides of the transaction.
❖ Losses from Liquidation
      ➢ The exemption does not apply to a loss you realize from liquidating the foreign company. This means that a loss from liquidation is tax-deductible.
❖ For Tax-Free Transfers
     ➢ The exemption may not apply for a period of two years if you acquired the Participating Interest through a tax-free transfer, such as a business restructuring. This prevents businesses from getting a double benefit from the transfer and the subsequent exemption. 

2.6 What if the Participating Interest Falls Below 5% Threshold?

If a company's ownership stake in a foreign company drops below the 5% threshold before it has held it for at least 12 months, it will lose the tax exemption.
Any income from that investment that was previously considered tax-exempt will be added back and treated as Taxable Income in the tax period when its ownership falls below 5%.

2.7 Can Participating Interest be Based on Monetary Value Instead of Percentage?

Yes, a Participation Interest can be based on a monetary value instead of a percentage.
● In addition to the rule about having a 5% or greater ownership stake, a participation will also qualify as a Participating Interest if its acquisition cost is equal to or greater than AED 4,000,000.
● All other conditions, such as the 12-month holding period and the foreign tax rate, still need to be met.

2.8 Non-Deductible Costs Related to Buying or Selling a Participation

Expenses for acquiring, transferring, or selling a Participating Interest are generally not deductible for Corporate Tax purposes.
● Instead of deducting these costs from your income, you must capitalize them, which means they are added to the cost of the investment on your balance sheet.
● However, interest on any loan used to buy or hold the Participating Interest may still be deductible, provided it meets the specific conditions and limits set by the law.

2.9 When Income from a Participation is Exempt?

The exemption on income from a Participation only applies to income that you receive specifically for being an owner of the foreign company. Any income you earn in a different capacity is not exempt.
Logic: The law makes a clear distinction between income from investment and income from business activity. The purpose of the participation exemption is to prevent taxing passive investment income (like dividends) twice. However, if you are actively providing services or performing business activities for the company you have invested in, that is considered regular business income, which is subject to tax.
Example
❖ Let's say a UAE company, "Global Holdings LLC," owns a 5% stake in a foreign company, "Tech Innovations Inc."
❖ Exempt Income (As an Owner): If Global Holdings receives dividends of AED 100,000 from Tech Innovations, this income is exempt. It is a direct return on its investment and is received simply for being an owner.
❖ Taxable Income (As a Service Provider): If Global Holdings also charges Tech Innovations a management fee of AED 50,000 for consulting services, this income is not exempt. It's a fee for a business activity, not for owning shares, and will therefore be included in Global Holdings' taxable income. 

2.10 Treatment of Liquidation Proceeds and Losses from a Participation

When a foreign company where a UAE company has a "Participation" is closed down, the tax law ensures that any resulting loss is calculated fairly to prevent a double tax benefit.
❖ Calculating the Liquidation Loss
A liquidation loss is the difference between the original cost of your ownership stake and the value of any assets or proceeds you receive when the foreign company legally ceases to exist.
❖ Adjustments to the Loss 8
❖ The final loss that you can claim for tax purposes must be adjusted to account for any tax benefits you have already received from that company. This is to ensure you do not get a tax deduction for a loss that has already been offset. The loss must be reduced by:
       ➢ Tax-Exempt Income: Any tax-exempt dividends or profits you have received from the foreign company.
       ➢ Transferred Tax Losses: Any tax losses that were transferred to you from the foreign company.
       ➢ Previously Ignored Gains: Any gains from previous transactions between your company and the foreign company that were not included in your taxable income. 

3.0 Deductible & Non-Deductible Expenditures

3.1 What is Deductible Expenditure?

A deductible expenditure is a business cost that can be subtracted from a company’s revenue to lower its taxable income.
● To be considered a deductible expenditure, a cost must meet two main conditions:
● It must be for business only. The expense must be incurred entirely for the purpose of your business and not for personal use.
● It must not be a capital expense. This means the cost is for day-to-day operations, not for acquiring long-term assets like buildings, vehicles, or machinery. (These long-term assets are depreciated over time rather than being deducted all at once).
● The cost is typically deducted in the tax period in which it was incurred. 

3.2 General Rule for Non-Deductible Expenses

A person or company cannot deduct expenses that are not for a genuine business purpose. This rule is in place to ensure only business-related costs are used to reduce taxable income.
● Here's a simple breakdown of the main types of non-deductible expenses:
● Non-business expenses: A person cannot deduct any expenses that are not directly incurred for their business. For example, personal expenses are not deductible.
● Costs for tax-free income: A person cannot deduct expenses incurred to earn income that is already considered tax-exempt. This prevents a person or company from getting a tax benefit twice.
● Unrelated losses: A person cannot deduct losses that are not a direct result of their business operations.
● Disallowed by law: There are other specific expenses that are formally disallowed by the Corporate Tax law.

3.3 What If an Expense has Multiple Purposes?

If an expense is incurred for both business and personal purposes, you can only deduct the portion that is used for business.
Here's a breakdown of how it works:
● If the parts are identifiable: You can only deduct the portion of the expense that was wholly and exclusively for business. For example, if a company pays for a business trip and a personal vacation on the same trip, only the costs directly related to the business portion are deductible.
● If the parts are not identifiable: You must make a fair and reasonable estimate of the business portion of the expense. For example, if you use your personal phone and internet for both business and personal use, you can deduct a reasonable proportion of the bill based on your business usage.

3.4 What is Entertainment Expenditure?

Entertainment expenditure refers to the costs a business incurs to entertain its clients, suppliers, or other business contacts.
Examples of these costs include:
● Meals and drinks.
● Accommodation and transportation.
● Admission fees to events or venues.
● The use of facilities for entertainment purposes.

3.5 Deductible Entertainment Expenditure

When it comes to deducting entertainment expenses, the rule depends on who is being entertained.
● For business contacts: Only 50% of the expenses incurred for entertaining customers, suppliers, shareholders, or other business partners can be deducted.
● For employees: Entertainment expenses incurred for a company's employees are fully deductible

3.6 Non-Deductible Expenditure

There is a specific list of expenses that a business is never allowed to deduct from its taxable income. Here is a simplified breakdown of these non-deductible expenditures:
● Fines and Illegal Payments: Fines, penalties, and any bribes or illicit payments are not deductible.
● Payments to Owners: Dividends, profit distributions, and withdrawals of funds by a natural person from their business are not considered expenses for tax purposes.
● Other Taxes: The Corporate Tax itself and any foreign income taxes you may have paid are not deductible.
● VAT: Input VAT that you can recover from the FTA is not considered an expense and is therefore not deductible.
● Unapproved Donations: Donations, grants, or gifts are only deductible if they are made to an officially approved Qualifying Public Benefit Entity.

Author: CA Mustafa G Daudi

Disclaimer: Content posted is for informational and knowledge sharing purposes only, and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/interpretation of the publisher is based on the available Law, guidelines and information. Each reader should take due professional care before you act after reading the contents of that article/post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide, and should not be relied on for tax or accounting advice.