In ‘The Psychology of Money’, Morgan Housel coins an interesting concept – ‘appealing fictions’.
This happens when you are smart, you want to find solutions, but face a combination of limited information and high stakes. They can make you believe just about anything.
When it comes to tax laws, there is no doubt the financial stakes are sky high and business owners are currently having limited information. They need to introspect if they have already started believing in ‘appealing fictions’ instead of a robust analysis of the tax laws. Here is a quick refresher of a common issue staring at all business owners.
Scope of wages and employment
Considering that there is no tax on an individual’s salaries, every business owner is contemplating to draw salaries from their companies. The inherent objective is to reduce the net taxable profits of their companies. It is perhaps easier said than done.
The business owners need to first evaluate if they have an employment contract with the company. If available, the next step would require to demonstrate the wages are the remuneration for the owner’s labour. Distinguishing between remuneration for labour and the return on capital (on having created a successful business) requires a thorough economic analysis instead of making wishful arguments.
The FAQs by the UAE Ministry of Finance indicate that employment may require all or most of the income being derived from one customer/employer. Drawing salaries from multiple companies owned by the same owner(s), or their immediate relatives, may violate this essential feature.
Business owners holding Golden Visa would also need to pay attention to these requirements before claiming employment income to plan for tax optimisation.
Benchmarking under transfer pricing
Any payment to owners (or relatives) will be subject to a transfer pricing analysis. Benchmarking of salaries paid to owners could take the following approaches to ensure the salaries are not in excess of:
- What would have been paid to a third-party performing similar functions; or
- What the owner would have earned from an independent company for performing similar functions.
Finding a database to undertake the comparative analysis seems challenging at present. Considering the varying sizes of the businesses in the UAE, the transfer pricing analysis could become highly subjective in arriving at reasonable benchmarks.
UAE corporate tax has pragmatically prescribed thresholds for various items such as transfer pricing documentation, Small Business Relief, interest expenses, etc. to ease the tax compliance. A similar approach by prescribing a ‘safe harbour’ threshold for owners’ salaries – whether based on amount or on percentage of revenue - could immensely help them save on compliance costs and mitigate future risks. A detailed guidance may address owners’ concerns.
Self-employed vs. business owners
A self-employed person would be subject to the UAE Corporate Tax if the total annual turnover derived from his/her businesses or business activities exceeds Dh1 million.
Contextually, a self-employed person could be performing exactly the same functions that an owner would be performing at his/her companies. If so, could an owner justify a tax exempt salary while a self-employed person be subjected to tax (subject to other reliefs)?
This subtle aspect of the tax laws has often been ignored while advocating business owners to draw salaries from their own companies.
Global transfer pricing guidance relating to inter-company services could also be useful in relation to owners’ salaries. An overseas parent company may opt to supervise its global investments by deputing its employee to specific regions or by having a supervisory board at the head office.
The cost of such deputed employee or supervisory board cannot be charged to - and claimed as an expense - by a UAE subsidiary.
On similar principles, the functions performed by the owners need to be evaluated. To the extent that owners are performing the functions of protecting their investments, the expense cannot be claimed by the company as a business expense.
While planning for corporate tax, business owners should also factor in the anti-abuse rules. Anti-abuse rules cover any transaction or arrangement which is not for a valid commercial/non-fiscal reason reflecting economic reality.
If the main purpose - or one of the main purposes - of such transaction/arrangement is to obtain a corporate tax advantage inconsistent with the tax law, the transaction could be disregarded – and result in tax arrears and penalties. Owners’ salaries would require a 360-degree review to ensure that it does not fall under anti-abuse rules.
Witnessing the introduction of a new tax in a country is a thrilling and learning experience. One aspect of such an experience is to observe how skewed perceptions could be created in the light of limited analysis.
Business owners need to ask themselves the right questions to avoid finding themselves under ‘appealing fictions’ at the time of future tax assessments and audits.