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Foreign trade, investment act as backbone of non-oil economy

The Participation Exemption regime in the UAE aligns with the global practices and is forward looking

The UAE, a global hub for trading receives huge amount of capital from overseas. The foreign trade and investment acts as a backbone for UAE’s non-oil economy.

Thus, it becomes imperative to incentivise and safeguard such foreign investment. One such move in corporate tax is ‘Participation Exemption’, whereby any income in the form of divided, gains on transfer or any notional gains on investment made by a resident person shall be exempt from tax. Article 22 and 23 of the Corporate Tax Law and Ministerial Decision 116 of 2023 govern the Participation Exemption Regime in UAE. The FTA has also issued a detailed tax guide on the subject.

The objective behind this exemption is to eliminate double taxation of income, encouraging foreign investments and establishing a holding company regime. The law also has checks and balances, to plug the misuse of exemption for both the Resident Person (say ‘investor’) and the foreign Investee (say ‘Participating Interest’ or Participation).

First – 'Holding Period test', the Participating Interest must be held for a minimum period of 12 months or there should be intention to hold the interest for such period. If this condition is breached after the exemption to income has been claimed, then such income which was exempt in the earlier period shall be taxed in the year of non-fulfilment of the condition.

Second – 'Subject to tax test', the Participating Interest should be subject to tax in its country of residence at rate not less than nine per cent (being the rate of tax applicable to UAE Resident countries). This condition shall be deemed to be fulfilled, if the primary objective of the Participation is to hold investments that meets the conditions for Participation Exemption and the income of Participation substantially (50 per cent or more) consists of income from such investments and other prescribed anti-abuse conditions are fulfilled. This condition is also deemed to be fulfilled in case the participation is not subject to tax of 9% due to lower tax rates for certain bracket of income, targeted temporary tax incentives, other taxes on income and reduction / reliefs. Conversely, if the tax in foreign residence jurisdiction of the participation is applicable on selected activities, tax is refunded on distribution or tax is levied only on distribution, the subject to tax condition shall not be considered as fulfilled.

Thirdly – 'Ownership Test', the investor has at least five per cent share in profits and liquidation proceeds of the Participation. However, if the acquisition cost of the Participation is Dh4 million or more, this condition is deemed to be fulfilled even if the stake in participation is less than five per cent.

Lastly, —'Asset test', 50 per cent or more the assets of the participation on consolidated basis should not be ownership interest or entitlements, which if held by the investor would not be eligible for Participation Exemption.

The complexities only increase if one marries the provision of Participation Exemption with Tax Group. Say Mr. A owns all the shares of X LLC and Y LLC (both residents in UAE). Further X LLC and Y LLC hold 3% each in Z Inc. (resident in USA). Now, X LLC and Y LLC would be subject to tax on dividend from Z Inc since the Ownership test is not met. However, if Mr. A transfer all shares of X LLC to Y LLC, they would be eligible to form a tax group. Now, since the group hold 6% of the shares of Z Inc, the Ownership test is met, and the tax group is eligible to claim participation exemption. For math enthusiast here tax under X + Y > (XY).

The concept of Participation Exemption is not new to the tax world. Majority of the advanced economy has such regime in their domestic law in one form or the other. Countries like Australia, Lithuania, Luxembourg, Portugal follow 10 per cent criteria for Ownership Test (Singapore follows 20 per cent minimum holding criteria). Whereas countries like Netherlands, Spain, France, Ireland follow five per cent test. Interestingly, some countries only allow exemption for a portion of foreign dividend say 97% or 95% of the total dividend or capital gains. On the other hand, the Participation Exemption regime of few countries only exempt Divided (e.g., USA, Poland, Japan).

The Participation exemption regime in UAE aligns with the global practices and is forward looking. One thing the taxpayers in UAE needs to be careful is the expenditure on earning such exempt income has to be disallowed. Identifying such expenses could be a challenge. On the face of it, the rules seem to be simple, however, there are multiple boxes to be ticked to avail benefit of this regime. Thus, a careful analysis of the facts and compliance with the law, Ministerial decision read with the tax guide is imperative to avoid litigation.