UAE's Corporate Tax is clear on usage of borrowed funds and what deductions would be applicable. Image Credit: Shutterstock

Businesses raise funds as equity and debt - the debt may be raised from formal sources such as financial institutions, related parties, family and friends of promoters, and shareholders. Besides simple loans, debt is also raised through instruments such as debentures, bonds, and variations to make them convertible into equity.

Debt capital necessitates interest payments besides the legal fees, bank charges, commissions, and processing fees. Generally, for accounting purposes, these costs are considered as a charge on profits and are usually expensed. Capitalisation of such costs could also be necessary based on timing, purpose, and utilisation of funds.

Going forward, borrowing costs, especially interest, may need a fresh look, including on the accounting treatment, as deductibility could be impacted.

Usage of funds

The deductibility of interest costs would primarily depend on the usage of funds borrowed. Generally, no deduction for tax purposes would be available if the funds have been used for personal purposes or for earning non-taxable income.

Under the Public Consultation Document (Consultation Document) released by the Ministry of Finance, the UAE Corporate Tax proposes to exempt dividends and capital gains on qualifying investments. Currently, it is unclear whether UAE CT will allow deductions for interest on borrowings utilised for earning these exempt incomes. We await clarity on this aspect.

Thin capitalisation rules

It is proposed to place restrictions on the quantum of interest costs deductible. These limits are commonly referred to as ‘thin capitalisation rules’.

As per the Consultation Document, interest costs shall be deductible only to the extent of 30 per cent of Earnings Before Interest Depreciation and Amortization (EBITDA). The limitation is applicable to interest payable on all debts raised, whether from formal or related parties.

If the disallowed interest cannot be carried forward for set-off in future years, then entities with debt are looking at a permanent disallowance, i.e., a non-deductible cost. Accordingly, entities having debt and engaged in capital-intensive industries such as real estate, infrastructure and startups with long gestation periods, should watch out for this provision as this could necessitate a restructuring of capital structure.

The Safe harbour/de minimis threshold will be notified under the UAE CT - i.e., interest costs up to a threshold level would not attract any disallowances. This should help business entities with negative or low EBITDA to claim a deduction for interest costs at least up to the specified threshold.

Also, banks, insurance businesses, certain regulated financial activities and businesses conducted by natural persons will be kept out of the thin capitalisation norms.

Accounting aspects

The accounting standards generally require the interest cost on borrowings utilised for acquisition/construction of capital assets to be capitalised up to the point such assets become ready to use. The Consultation Document has not proposed any variations to the accounting treatment, which is quite welcome.

Similarly, IFRS 16 requires lease rentals to be split between interest cost and repayment of liability. With there being a restriction on the quantum of interest deduction under UAE CT, there may be a need for businesses to reconsider their current leasing arrangements.

To conclude, while debt funding results in interest as a deductible expense vis-a-vis dividend, a permanent disallowance on costs needs to be planned for.