In commercial practice, contracts frequently contain clauses that impose charges on debtors who fail to meet payment deadlines. These charges can appear under a variety of names: interest, late payment fees, contractual penalties. The classification of such amounts holds significant implications under both UAE Corporate Tax rules and financial reporting standards, particularly International Financial Reporting Standards (IFRS).
The UAE Federal Tax Authority (FTA) has addressed this issue in its Interest Deduction Limitation Guide No. CTGIDL1 released this month. The FTA draws a distinction between interest and penalties in the context of late payments. The guidance appears to place emphasis on the contractual wording used to describe the charge. However, an example provided in the same context clarifies that what ultimately matters is not what the charge is called, but how it functions. This position mirrors the approach under IFRS, where the economic substance of a transaction is paramount.
This article explores the tension between legal form and economic substance in the classification of late payment charges, and evaluates the additional, under-addressed dimension of timing of recognition, which is a critical issue under IFRS. Together, these considerations form a comprehensive framework for assessing how such charges should be treated for both tax and accounting purposes.
Legal form vs. economic substance in tax classification
The FTA’s position initially suggests a form-based test: if a contractual clause specifies the charge as a penalty or fine, it is not classified as interest. However, if the charge is not so labeled, it is considered to be compensation for the delayed use of funds and thus treated as interest.
Yet this formalistic threshold is almost immediately refined through an illustrative example. The FTA contrasts two types of charges:
- A monthly percentage-based fee on overdue amounts, such as 1% per month, which is treated as interest; and
- A fixed lump-sum amount, such as AED 10,000 regardless of how late the payment is made, which is treated as a penalty.
This example reveals that the FTA's classification ultimately rests not on nomenclature, but on the characteristics of the charge. A payment that compensates for the time value of money, especially if it is proportional to the amount owed and accrues over time, functions economically as interest, and should be treated as such. In contrast, a one-time, non-time-based charge may reflect a deterrent or punitive element, and would justifiably fall outside the definition of interest.
This approach is consistent with the long-standing principle in tax and accounting law that substance prevails over form. It aligns UAE tax guidance with broader FTA’s guidance and international practice, including the treatment under IFRS.
Accounting treatment: classification and recognition
The financial reporting treatment of late payment charges draws on two central principles under IFRS: one relating to classification, and another to recognition.
Classification
IFRS consistently emphasizes that classification depends on the economic characteristics of a transaction. This principle is expressed across various standards, including IFRS 15 “Revenue from Contracts with Customers”.
Under this Standard, if a seller imposes a charge for delay in payment, the nature of that charge must be carefully analyzed to determine whether it represents a price adjustment, a form of variable consideration, or a significant financing component that results in the recognition of interest income. This treatment is grounded in IFRS 15, paragraphs 60–65, which require entities to assess whether the timing of payments provides a benefit of financing to either party. Specifically, paragraph 60 states: ‘In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer… A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract’.
Where the charge compensates for the buyer’s delayed use of funds, this time-value component may require separate presentation as interest income, distinct from the underlying revenue from goods or services.
Recognition: enforceability and probability
While the FTA’s guidance addresses classification, it is silent on the timing of recognition, that is, when such interest or penalty becomes reportable as income or expense. Here, IFRS introduces a critical layer of analysis: recognition depends not only on classification, but also on enforceability and the likelihood of realization.
An important interpretive nuance arises where a contractual clause grants the entity the discretion to impose a charge, such as a fee for late payment or other compensation, but does not obligate the entity to enforce it. Even when a customer contractually agrees to such a charge in the context of goods or services, IFRS 15 requires that enforceability be considered not in isolation, but in conjunction with the entity’s intention and historical practice of enforcement.
IFRS 15:51 lists examples of common types of variable consideration: ‘discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items’. IFRS 15:56 states that ‘an entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 53 only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved’. Hence, the mere existence of a clause in a contract does not confer the right to immediate recognition. A creditor cannot recognize interest income, and a debtor cannot accrue interest expense, unless the charge is legally enforceable and there is high probability of collection or payment.
Moreover, IFRS 15.9(e) sets a threshold for contractual enforceability by stating that ‘an entity shall account for a contract with a customer that is within the scope of this Standard only when …it is probable that the entity will collect the consideration to which it will be entitled... In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession’. Thus, if the entity has routinely waived the right or failed to exercise it in comparable cases, the promised consideration may lack the probability criterion. In such cases, revenue recognition must be deferred, even if the clause itself appears contractually sound.
Where the nature of the charge falls within the scope of IFRS 9 “Financial Instruments” such as interest or late payment fees, the principle of contractual determinability becomes decisive. While IFRS 9 B5.4.1 and B5.4.6 do not expressly reference discretion, the effective interest method presumes that cash flows are contractually fixed and enforceable. In our view, where payment depends on the entity’s decision to claim a charge, such income falls outside the scope of determinable interest under effective interest rate and should be excluded from recognition until the right becomes enforceable.
Furthermore, if the entity’s right to claim a charge depends on an internal decision (e.g., whether to initiate legal proceedings or demand compensation), the scenario may fall under the framework of IAS 37 “Provisions, Contingent Liabilities and Contingent Assets”. Under IAS 37.31 contingent assets may not be recognized. IAS 37.33 sets forth that ‘contingent assets are not recognised in financial statements since this may result in the recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate’.
In this context, contractual discretion introduces an element of contingency that precludes early recognition, regardless of the underlying classification of the charge as interest, revenue, or compensation.
This means that classification as interest is a necessary, but not sufficient, condition for recognition. Even properly labeled and economically structured interest charges may need to be deferred if they are disputed, subject to negotiation, or contingent on a court ruling.
Practical implications for tax and financial reporting
The convergence of FTA tax guidance and IFRS accounting principles gives rise to several practical takeaways:
- Substance determines classification. The proper treatment of late payment charges, whether under UAE Corporate Tax Law or IFRS, cannot rely solely on the contractual language used. A clause titled “penalty” may still be interest if it replicates the features of a financing arrangement. Hence, whether a charge is labeled as a “penalty” or “interest” is secondary to its functional characteristics. If it accrues over time and is proportional to the outstanding balance, it will likely be treated as interest for both tax and accounting purposes.
- Contractual clarity still matters. The burden falls on drafters to ensure that contractual terms reflect not just the intended legal form, but also the underlying economic rationale for the charge. Ambiguity may result in inconsistent or incorrect treatment.
- Recognition depends on enforceability. Charges, regardless of classification, can only be recognized when the right to receive (or the obligation to pay) becomes legally binding and probable. Recognition must be deferred in the case of uncertain enforceability, unresolved disputes, or potential reversals. Even a clearly defined interest charge cannot be recognized in financial statements unless its realization is enforceable and highly probable.
- Where businesses treat a charge as interest for tax deduction purposes but defer it for accounting purposes, reconciliation must be carefully documented to avoid regulatory challenges.
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.
