UAE Corporate Tax: Ministerial Decision No. 116 Of 2023 Release Participation Exemption

Brief

Decision No. 116 of 2023 was released by the Ministry of Finance on May 10, 2023, specifically addressing the Participation Exemption under Federal Decree-Law No. 47 of 2022, which pertains to the taxation of corporations and businesses (referred to as the ‘CT Law’ hereafter). This decision became effective the day after it was published. One of the key provisions outlined in Article 23 of the CT Law is an exemption on income derived from a Participating Interest, provided certain conditions are met. The Ministerial Decision that has been issued further elaborates on the guidelines and regulations pertaining to the application of the Participation Exemption for taxable individuals. The detailed provisions are highlighted below.

Key Highlights

The Decision provides a clear definition of a ‘Participating Interest’ as an ownership stake in the shares or capital of a legal entity, satisfying the conditions outlined in Article 23 of the Corporate Tax Law. These conditions broadly include the following:

• Ownership interest: The ownership interest must be equal to or greater than 5%.
• Holding period: There should be a continuous ownership period of 12 months or an intention to hold the interest for at least 12 months.
• Taxation in country of residence: The Participating Interest must be subject to taxation in its respective country or territory of residence at a rate that is not lower than 9%.
• Composition of assets: The direct and indirect assets of the Participating Interest should not exceed 50% of ownership interests that would have been exempt from taxation if held directly by the Taxable Person.

These conditions provide clarity on the requirements that need to be fulfilled for interest to qualify as a Participating Interest eligible for exemption under the Participation Exemption provisions

Ownership Interest

The Decision provides a comprehensive definition of ‘ownership interest’ within the context of the CT Law. According to the Decision, an ownership interest encompasses various holding interests, including ordinary, preferred, and redeemable shares, membership and partner interests, and other types of securities, capital contributions, and rights that entitle the owner to receive profits and liquidation proceeds. This definition includes Islamic Finance Instruments or arrangements associated with Islamic Finance Instruments

Importantly, an ownership interest must be classified as an equity interest under the applicable accounting standards to qualify for an exemption. This highlights the significance of considering the relevant accounting standards by Taxable Persons when determining the eligibility for exemption.

Furthermore, the Decision emphasizes that the Taxable Person should exercise control and have the right to the economic benefits generated by the ownership interest. This implies that the Taxable Person should be the beneficial owner of the ownership interest, rather than merely the legal owner. This aspect emphasizes the importance of genuine ownership and economic entitlement for the application of the Participation Exemption.

Aggregation of Ownership Interests

One of the conditions provided under the CT Law for participation exemption is a minimum of 5% ownership in the shares or capital of a juridical person (i.e. ‘Participation’). The Ministerial Decision provides that in order to determine whether the ‘5%’ has been met, a Taxable Person should aggregate the different types of ownership interests (as provided above) in the Participation.

Moreover, with regards to entities that form part of a Qualifying Group, the 5% ownership interest is considered to be met in the event the total amount of ownership interest from all Group members in the same Participation adds up to at least 5%.

Transfer of Ownership Interests

For a Taxable Person who exchanges their ownership interest in one legal entity for an ownership interest in another legal entity, there are specific conditions that must be satisfied in order for the exchanged ownership interests to be considered as continuous ownership interests. These conditions include:

• Exchanging ownership stakes in compliance with Article 27 of the CT Law’s provisions for corporate restructuring relief.
• Confirming that the ownership stake in the legal entity satisfies the requirements for a participating interest under Article 23 of the CT Law.

Debt Instruments Issued by the Participation

Income derived by a Taxable Person from their Participation, specifically related to debt instruments classified as an equity interest according to the Accounting Standards adopted by the Taxable Person, will be considered income from a Participating Interest. This treatment applies even if the debt instruments do not meet the definition of ownership interest.

Subject to Tax’ Test

The Ministerial Decision reinforces the requirement that the Participation must be subject to taxation in its respective jurisdiction at a rate that is not lower than 9%, using a similar basis as the Corporate Tax (CT) in the UAE. To provide further clarity, the Decision outlines the conditions that need to be met for the “subject to tax” test:

• Application of a 9% effective tax rate (ETR) on the income or profits generated by the Participation.
• If the relevant jurisdiction’s tax regime does not have a 9% ETR, the test can still be satisfied by recalculating the ETR based on the provisions of the UAE CT Law.

Holding Companies

The Ministerial Decision includes provisions for waiving the requirement of a 9% effective tax rate in the case of a holding company Participation. To qualify for this waiver, the Participation must fulfill the following conditions:

• Directed and managed in its relevant foreign jurisdiction: The Participation should be controlled and managed in the foreign jurisdiction where it is established.
• Compliance with administrative requirements: The Participation must adhere to all administrative obligations, such as document submissions, imposed by the relevant jurisdiction.
• Adequate substance: The Participation should have sufficient substance to acquire and hold shares or equitable interests. This ensures that it is not merely a shell company.
• Limited activities: The Participation should only engage in ancillary activities, specifically the holding of shares, and should not conduct any other substantial business activities

Minimum Acquisition Cost

The Ministerial Decision introduces certain provisions related to the minimum ownership criteria for the participation exemption:f the ownership percentage.

• Disregarding the 5% ownership threshold: The minimum ownership requirement of 5% can be disregarded if the aggregated acquisition cost of the ownership interest is equal to or exceeds AED 4 million. In such cases, the Taxable Person can qualify for the participation exemption regardless of the ownership percentage.
• Quantifying acquisition cost in UAE Dirhams: When determining the acquisition cost of a foreign ownership interest, the amounts should be converted into UAE Dirhams using the applicable exchange rate at the date of acquisition. This ensures consistency in evaluating the acquisition cost threshold.
• Failure to meet the acquisition cost threshold: If the minimum acquisition cost threshold is not met for an uninterrupted period of 12 months, any income that was not considered for the participation exemption during that period will be included in the Taxable Income for the corresponding Tax Period. This requirement ensures that the participation exemption is only applicable when the acquisition cost threshold is consistently maintained for the specified duration

Assets of the Participation

In order to avoid abuse of the Participation Exemption, the CT Law provides that no more than 50% of the assets directly or indirectly owned by the Participation may consist of an ownership interest or entitlements that would not qualify for the Participation Exemption if these assets were held directly by the Taxable Person.

• The determination of compliance with this requirement can be based on either of the following methods:
• Carrying value: The calculation can be based on the carrying value of the assets as presented in the consolidated balance sheet of the Participation. This involves considering the recorded value of the assets for accounting purposes.
• Market value: Alternatively, the determination can be made based on the market value of both the direct and indirect ownership interests, along with other assets held by the Participation. This method takes into account the fair market value of the assets.

By employing either the carrying value or market value approach, it becomes possible to assess whether the 50% asset composition threshold is met. This provision aims to ensure that the Participation primarily holds assets that would qualify for the Participation Exemption if held directly by the Taxable Person, thereby preventing potential misuse of the exemption.

Expenditure in relation to the Acquisition and Disposal of the Participating Interest

Expenses associated with the acquisition, sale, transfer, or disposal of a Participating Interest will not be deductible since they are related to exempt income. These expenses include professional fees, due diligence fees, litigation costs, commission and brokerage fees, stamp duty or any other irrecoverable taxes, appraisal and valuation costs, and refinancing costs.Instead of being deducted as expenses, these costs will be capitalized and added to the acquisition cost of the Participating Interest. Regarding interest expenditure, it will be subject to the general and specific deduction rules outlined in Chapter 9 of the CT Law. This means that the deductibility of interest expenses will be determined based on the specific provisions and limitations set forth in the law.

Income from Ownership Interests in a Participation

The participation exemption applies only to income received directly as the owner of the Participation. Income derived indirectly or related to the ownership interest is not eligible for the exemption and will be subject to Corporate Tax.

Liquidation Proceeds and Losses

According to the CT Law, the participation exemption does not apply to losses incurred during the liquidation of a Participating Interest. The calculation of such liquidation losses should be done as follows:

Liquidation losses = Acquisition cost of Taxable Person – [partial] disposal made in the Participation – fair value of the liquidation proceeds received by the Taxable Person

However, adjustments need to be made for the following:

• Tax losses transferred by the Participation to the Taxable Person.
• Exempt dividends or profit distributions received.
• Gains recognized by the Taxable Person on any transfer of assets or liabilities to the Participation that was not taken into account under Transfers Within a Qualifying Group or Business Restructuring Relief.

These adjustments ensure that relevant factors are considered when calculating liquidation losses, taking into account tax losses, exempt dividends, and gains from asset or liability transfers.

Foreign Permanent Establishment Tax Losses

When a Taxable Person utilizes a tax loss from its foreign permanent establishment, the loss must first be offset against future profits of the PE before applying a Foreign PE exemption or the participation exemption provisions under the CT Law.

KCG Insights

• The adoption of the participation exemption in the UAE is a crucial tax policy that supports a competitive tax environment in the region. By eliminating double taxation of corporate profits, the CT regime facilitates cross-border investments and incentivizes companies to invest in foreign entities. This reinforces the UAE’s role as a hub for companies looking to expand and establish international operations.
• Moreover, the proposed participation exemption regime simplifies compliance requirements by reducing the complexities associated with foreign income and intricate double tax treaties for CT purposes. This streamlines the tax compliance process for businesses operating internationally.

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