Interest Component of Interest-Free Loans

Facts

A borrower company registered in the UAE received an interest-free loan from its foreign sister company. Both companies are wholly owned by the same 100% parent entity.

Question

Will the benefit derived from saving on interest expenses under such a loan be subject to UAE Corporate Tax?

Summary

Based on the facts and analysis below, we conclude that:

1. There is a high probability that the interest savings will be subject to Corporate Tax in the period when the loan is received.
2. This amount will then be amortized through the gradual recognition of interest expense.
3. The situation may differ in cases where the loan is issued by the sister company at the direction of the common shareholder and/or where the loan is issued without specifying a fixed repayment date. An analysis of such situations should be conducted separately.

Analysis

Under UAE Corporate Tax Law, the starting point for calculating taxable income is the company's accounting net profit or loss as reported in the financial statements prepared under IFRS.

Unless specific adjustments are mandated by the law, what is included in the profit or loss statement (P&L) will flow through to the tax base.

According to IFRS 9:5.1.1, ‘at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the ac­quisition or issue of the financial asset or financial liability’. For an in­terest-free loan, fair value is determined as the present value of future cash flows discounted using a market interest rate (IFRS 9:B5.1.1). Thus, the borrower must recognize a loan liability not at its nominal amount, but at its discounted (present) value.

The difference between the nominal amount received and the recog­nized fair value satisfies the definition of income under Conceptual Framework (CF) paragraphs 4.68 and 4.70, which states ‘income is increases in assets, or decreases in liabilities, that result in in­creases in equity, other than those relating to contributions from holders of equity claims’.

In this case:

• The borrower received a financial benefit through interest savings.
• Cash assets increased by the full nominal amount received.
• Liabilities increased only by the discounted amount.
• As a result, equity increased.
• The loan was not received from a shareholder.

Therefore, the economic benefit (interest savings) should be recognized as income at the time the loan is received.

According to IFRS 9:5.3.1, 4.2.1, 5.4.1, and Appendix A, the loan is subsequently measured at amortized cost using the effective interest method (EIR).

Interest revenue shall be calculated by using the effective interest method (see Appendix A and paragraphs B5.4.1–B5.4.7). This shall be calculated by applying the effective interest rate to the gross carrying amount of a financial asset except for:

Thus, the difference between the initial recognition amount and the re­payment amount is amortized through the recognition of interest ex­penses over the term of the loan.

Example

• Loan Amount: 1,000,000
• Loan Fixed Term: 5 years
• Market Interest Rate: 5% per annum

The fair value (present value, PV) of the loan, that is, the value of the debt at the time of its receipt, will be:

PV= (1,000,000/(1+0.05)⁵)=783,526

At initial recognition (upon receipt of the loan), the amounts received are recorded as follows:

• Debit to the cash account in the amount of 1,000,000; and
• Credit to the financial liabilities account in the amount of 783,526, meaning the financial liability is recognized at its discounted value; and
• Credit to other income in the amount of 216,474, representing the difference between the discounted value of the loan and the actual amount received.

Amortization Over Loan Term (Effective Interest Recognition)

Interest expenses are recognized by debiting the interest expense ac­count and crediting the loan liability account.

While the initial recognition of the economic benefit increases taxable income, the future recognition of interest expense reduces it. Thus, the taxable base is, in effect, spread over the life of the loan.

However, Article 30 of the Corporate Tax Law limits the deductibility of interest expenses through the General Interest Deduction Limitation (GIDL). To apply this limitation:

• The net interest amount (interest income minus interest expense) for the tax period must be determined. If the net interest amount does not exceed AED 12 million, the limitation does not apply, and the full amount of interest can be deducted. If it exceeds this threshold, a further comparison must be made with another limi­tation.
• The base for calculating the second limitation is EBITDA (earnings before interest, taxes, depreciation, and amortization). If the net interest amount does not exceed 30% of EBITDA, the full amount of interest can be deducted. If it exceeds 30% of EBITDA, the deductible amount will be the greater of:
  • the amount of interest that does not exceed the AED 12 million threshold, or
  • the amount of interest that does not exceed 30% of EBITDA.

Any excess interest that cannot be deducted in the current period may be carried forward and deducted in any of the following 10 years where no excess exists.

GIDL is not the only applicable limitation. A Special Interest Deduction Limitation (SIDL) is established under Article 31 of the Corporate Tax Law.

SIDL applies specifically to loans obtained for the purpose of acquiring shares in related parties or in entities that will become related parties as a result of the acquisition (Article 31(1), paragraphs (c) and (d)).

Where the lender is not subject to tax on the interest income in its ju­risdiction at an effective tax rate of 9% or more, the taxpayer must demonstrate that obtaining a tax advantage was not one of the main purposes of the transaction in order to qualify for the deduction of such interest expenses.

It is submitted that, in the present case, the company should be able to successfully argue that SIDL does not apply. In particular, the borrower recognizes both the interest expense and the corresponding income from the interest savings, with the income being recognized in an earlier period and the expense being recognized in a later period.

It should be noted that each situation must be assessed on a case-by-case basis.

This case study does not consider scenarios such as:

• The issuance of an interest-free loan to a sister company at the direction of the common shareholder; or
• The issuance of an interest-free loan without a specified repay­ment date (repayment upon demand or within a set period after a demand is made).

For such scenarios, and others not considered herein, the outcome may differ.

The disclaimer

Pursuant to the MoF’s press-release issued on 19 May 2023 “a number of posts circulating on social media and other platforms that are issued by private parties, contain inaccurate and unreliable interpretations and analyses of Cor­porate Tax”.

The Ministry issued a reminder that official sources of information on Federal Taxes in the UAE are the MoF and FTA only. Therefore, analyses that are not based on official publications by the MoF and FTA, or have not been commis­sioned by them, are unreliable and may contain misleading interpretations of the law. See the full press release here.

You should factor this in when dealing with this article as well. It is not com­missioned by the MoF or FTA. The interpretation, conclusions, proposals, sur­mises, guesswork, etc., it comprises have the status of the author’s opinion only. Furthermore, it is not legal or tax advice. Like any human job, it may contain inaccuracies and mistakes that I have tried my best to avoid. If you find any inaccuracies or errors, please let me know so that I can make cor­rections.