UAE corporate tax to help diversify budget revenues

UAE corporate income tax to come into effect in 2023

Having announced the introduction of a UAE Corporate Income Tax (CIT) in 2022, the Ministry of Finance (MoF) recently provided further details on the taxation of corporations and businesses in a Federal Decree.

The key points of the decree confirmed that the headline tax rate will be 9% on profits above Dh375,000, earned by both resident and non-resident individuals and businesses conducting activities under a commercial licence in the UAE. There will however be several exemptions to the tax including qualifying income earned by free zone entities, government and government-controlled entities, qualifying investment, pension and social security funds, qualifying public benefit entities, businesses engaged in extractive industries and businesses engaged in non-extractive natural resource activities. All legitimate business expenses which have been incurred wholly for the purpose of deriving taxable income will be treated as deductible, although there are some categories such as corporate entertainment and interest expenditure which are only partially deductible. Companies will be eligible to pay corporate tax in their first financial year, starting on or after 1 June 2023.

Although the introduction of corporate tax marks a significant move for the UAE, at a headline rate of 9% it remains one of the lowest globally. The average global corporate tax rate is currently in the region of 23%, after having declined steadily from average rates of around 40% in the 1980s. Only a limited number of jurisdictions across the world still maintain a 0% corporate tax rate. The headline rate of 9% is also one of the lowest amongst GCC member states, although the coverage in the UAE is significantly broader than other members.

Income tax across the GCC

Source: Emirates NBD Research

Why introduce CIT now?

One clear reason for the introduction is to diversify government budget revenue away from hydrocarbons, while also allowing the UAE to further rebuild fiscal buffers. Although hydrocarbons are likely to provide an invaluable source of government revenue for many years to come, marked declines in the price of oil in 2020, on the back of the Covid-19 pandemic, highlighted the importance of a more broad-based approach to raising revenue, with the total tax take falling by 33% between 2019 and 2020. More generally a broader base for tax collection provides additional buffers against unexpected macro-economic shocks.

Another likely reason for the introduction of corporate income tax is the adoption of the OECD’s Base Erosion and Profit Shifting (BEPS) Pillar 2 framework by the UAE and over 134 other jurisdictions in 2021. The BEPS Pillar 2 rule applies to large multinationals earning revenues of more than EUR 750mn per year, and is designed to ensure than these companies pay a minimum of 15% effective corporate tax on “excess profits” in every country they operate in. The Pillar 2 rules are designed to reduce the practice of shifting profits to low-tax countries by large multinationals. It is estimated[1] that at present up to 40% of multinationals’ global profits are shifted to tax havens, thereby reducing, or avoiding taxation. While BEPS Pillar 2 isn’t expected to raise significant revenue (OECD estimates put the global revenue from Pillar 2 at USD150bn annually, of which the UAE will only receive a small share) it nonetheless provides an additional revenue stream.

At present MoF has indicated that large multinationals will be subject to CIT under the new tax regime until Pillar 2 rules are formally adopted, which will need to be done by introducing legislation for a “top-up” tax. It is worth noting that as soon as multiple signatories start adopting legislation to introduce Pillar 2, there is likely to be an incentive for the UAE to do the same. This is because the Pillar 2 rules makes an allowance for other nations to apply the top-up tax in lieu when the country in which the ultimate parent entity is headquartered applies an effective tax rate below 15%. Tax due under Pillar 2 is only expected to be payable after 2025. 

The introduction of a broad-based CIT is likely to require similar investments by the federal government into systems such as IT, regulation, and legislation and as such there are likely to be several synergies between the administration of BEPS Pillar 2 and general CIT. 

How much revenue could CIT generate?

There are no publicly available estimates of the potential scale of revenue the Federal Tax Authority might collect from CIT. Although it is difficult to estimate CIT revenue with any certainty, since the government is still finalizing several aspects, we have generated an initial estimate based on a top-down approach using publicly available national accounts data.

As a first step we estimate the nominal value of total non-oil Gross Operating Surplus (GOS). This is done by applying the share of nominal non-oil GDP in total nominal GDP to the published value of total nominal GOS. Note that oil industries are excluded from the calculation because extractive industries are exempt from paying CIT. This measure is used as a proxy for the profit of enterprises, in non-oil sectors, after they have paid their workers.

From this we subtract an estimate of depreciation (based on published values of the consumption of fixed capital), to generate a potential tax base. Two further adjustments are then made to this potential tax base figure. The first adjustment is made to account for the fact that CIT is 0% on profits under AED375K. To account for this we assume 70% of the potential tax base is subject to CIT while the remaining 30% falls below the threshold. Secondly, we assume that not all companies that should register and pay for tax, will do so. As such we assume a 60% tax effort. This leaves us with a tax base of AED 308bn for 2019 (we use 2019 as it is the most recent non-covid year with full National accounts data available). The 9% CIT is then applied to the tax base to generate potential 2019 CIT revenue worth AED 27.7bn. As a share of total nominal GDP this is 1.8%. To estimate what potential revenue would have been in 2022, we simply multiply our estimate of 2022 GDP by 1.8%. This yields a hypothetical CIT revenue of AED 33.7bn for 2022.  

This estimate may well represent an upper bound of potential CIT revenue, as we have made no further exclusions for companies in free zones, nor have we made any allowances for possible exclusions for state-owned enterprises. This is in part because we have no clarity at present on what is likely to count as “qualifying income” in free zones, nor do we have information on which SOEs will be exempt once CIT comes into effect. There is also uncertainty about how foreign banks are likely to be treated. These banks already pay emirate level tax, and are reportedly lobbying to be exempt from paying both that tax and CIT.    

There is currently no indication on how the CIT revenue will be split between emirates, but it stands to reason that a similar approach to VAT revenue distribution might be followed. In the case of VAT, 30% of the total revenue accrues to the Federal government, with the remainder being disbursed based on the share of companies headquartered in each emirate. If we assume that the distribution of CIT revenue between the emirates is done along the same lines, then Dubai is likely to receive a sizeable share.

It is worth noting that CIT will only be payable 9 months after the end of the company’s tax year. This means that at the earliest, companies are likely to start paying in early 2025. 

There are likely to be both macroeconomic benefits and costs associated with the introduction of CIT

A primary benefit of the introduction of CIT will be the alignment of the UAE with international best-practices and standards for a modern tax system. In addition, access to additional revenue will assist individual emirates in paying down debt in the short run, while supporting sustainable future spending on public services and infrastructure projects over the medium-term.

The new corporate tax should also improve transparency and oversight over the finances of private sector businesses. Firms will need to improve their financial record keeping and reporting and may be audited by the tax authorities.   

Set against these benefits, there are likely to be potential downsides to CIT. As was seen with the introduction of VAT across the GCC from 2018 onwards, there are several out-of-pocket expenses firms are likely to have to incur. These costs may take the form of additional headcounts, man-hours or specialist advice to help firms navigate the tax system, as well as the possible purchase of IT infrastructure.

Expenses associated with tax compliance, together with the outright “cost” of paying a share of profits to the government may have broader knock-on impacts on the macroeconomy. The first of these is that corporations may attempt to shift a portion of the financial burden associated with corporate tax. One way firms might do this is by simply passing a share of the costs onto customers via price increases. This may in-turn put upward pressure on inflation in the near-term. Alternatively, firms could seek to offset these higher costs by virtue of lower wages for employees. An empirical estimation[1] amongst German firms shows the potential scale of this, with workers bearing just over 50% of the tax burden, largely in the form of lower future wage increases.

The economic literature flags some additional potential downside risks to a variety of other macroeconomic outcomes. Looking at 40 years’ worth of US data, a 2014[2] study suggests that increases in CIT result in material reductions in employment. Corporate tax may also deter firms looking to enter foreign markets. A review[3] of the available economic literature finds that there is a significant negative relationship between corporate tax rates and Foreign Direct Investment (FDI), with a 1pp decline in tax rates resulting in a 3.3% rise in FDI. However, it should be noted that none of the papers considered the recent Pillar 2 framework, which goes some way towards levelling the playing field between nations by imposing a minimum global tax for large multinationals - possibly reducing the sensitivity of FDI to tax rates. More generally, there is also evidence to suggest that lower tax rates are associated with higher levels of R&D activity and investment. A 2018 study[4] showed that a reduction in corporate tax rates eased firms’ financial constraints which in turn allowed them to increase both the quantity and quality of innovation.

At an aggregate level there appears to be an impact on GDP. A study conducted in 2019[5] suggests that a one standard deviation rise in aggregate effective tax rates was associated with a reduction in future real GDP growth of 0.6%. Higher corporate tax rates are also linked to the existence of a larger informal economy, with firms seeking to evade paying tax altogether.

The details of the final rules will be crucial

The selection of a headline corporate tax rate, as well as other elements of tax policy such as deductions, credits, and exemptions all play an important role in ensuring that the benefits from higher government revenue aren’t outweighed by downside risks to activity and growth. The exact policy mix will also dictate the amount of revenue likely to be collected. Given the complexities of the pros and cons of corporate tax, there are likely to be further refinements made to the rules in cabinet decisions in the coming weeks.