The UAE's Corporate Income Tax regime's impact on M&A transactions

The Corporate Income Tax (CIT) regime has come into effect in the United Arab Emirates (UAE) for financial years commencing on or after 1 June 2023. The standard CIT rate is set at 9%, whereas various exemptions are available for specific types of entities and Qualifying Free Zone Persons may benefit from a 0% tax rate, provided specific conditions are met. Whilst Value Added Tax (VAT) and Economic Substance Regulations were already areas of focus for M&A transactions involving UAE target companies, the introduction of CIT means the scope of tax due diligence and tax structuring and planning will widen significantly. We are already witnessing tax considerations drive key strategic decisions on M&A transactions and we further anticipate an increase in the robustness and complexity of tax indemnification provisions to be negotiated into the M&A transaction documentation, usually the share purchase agreement (SPA).

 

Due Diligence

When performing a tax due diligence (DD), a purchaser would like to determine the risk level and magnitude of any historical tax exposure. From a CIT perspective, it seems such exposure should in most cases be limited to UAE target companies’ tax periods starting from 1 January 2024, where their financial year is equal to the calendar year. Instead, target companies with a financial year commencing between 1 June and 31 December 2023 will become CIT payers as per such earlier date, meaning the potential tax exposure stretches back to that date. In addition, the CIT Law became effective on 25 October 2022 (it was published in the Official Gazette of 10 October of that year) and provides that the Law’s General Anti-Abuse Rule (GAAR) already applies as from 25 October 2022. The GAAR allows the Federal Tax Authority (FTA) to deny a UAE target company any tax advantages achieved by a transaction or arrangement, where the main purpose was to obtain a tax advantage. This means that any target company transactions or arrangements that have taken place from 25 October 2022 can be subject to the GAAR and can give rise to tax assessments after the acquisition.   

From the perspective of historic tax exposure, the standard statute of limitation for VAT is five years and fifteen years in case of tax evasion (VAT was introduced in the UAE in 2018). As per a legislative change which came into effect on 1 March 2023, the FTA may now conduct a tax audit or issue an assessment beyond the five-year window, provided the FTA has (i) notified the taxpayer of an audit before the expiration of the standard five-year period and (ii) the audit is completed within four years of the date of the notification. This means that theoretically, the statute of limitation can now be extended to nine years. Therefore, purchasers are advised to ensure the time limits to bring any tax claim under the SPA are aligned with such extended statute of limitation period.

Any tax exposures identified during DD should be appropriately addressed in the tax indemnities in the SPA or a separate purchase price adjustment.

 

Share deal vs. asset deal

From a tax perspective, we distinguish M&A transactions into the following two categories: (i) a share deal, and (ii) an asset deal. The two categories come with different considerations from a tax and corporate perspective.

Usually for reasons of simplicity and business continuity we see the vast majority of UAE transactions undertaken as share deals. This approach avoids the requirement with an asset deal to individually transfer each asset and liability, which is usually time consuming and carries increased implementation risk. We don’t anticipate that the incoming CIT changes will alter this preference for share deals.

Share deal

If a purchaser acquires the shares in a UAE target company, any existing and contingent tax liabilities of the target will remain with the target and will therefore be for the account of the purchaser once under its ownership. This means that performing appropriate DD is crucial to determine the level and magnitude of any tax liabilities.    

From a CIT perspective, UAE taxpayers will be able to offset tax losses against taxable income of subsequent tax periods up to a limit of 75% of the taxable income of the relevant tax period. Unused tax losses can be carried forward indefinitely until the losses have been fully utilized. To prevent abusive trading in tax loss companies, the CIT regime includes restrictions of using a UAE target company’s tax loss. Tax losses may only be carried forward provided (i) the same shareholder(s) continuously owned at least 50% of the shares in the company from the beginning of the period in which the tax loss was incurred to end of the period in which the tax losses are offset against taxable profits, or (ii) the company continued conducting the same or similar business activity following an ownership change of more than 50%. Because tax losses come with the value of potentially reducing taxable profits in the future, purchasers of loss-making UAE target companies should consider the usability of such losses in a share deal.  

Both from a CIT and VAT perspective, it is possible to form a tax (consolidated) group, which means that only one single tax return would need to be submitted for such group, and transactions between group members would be ignored for tax purposes. For both CIT and VAT purposes, the default position is that the parent company and each subsidiary shall be jointly and severally liable for the tax payable by the tax group for those tax periods when they form(ed) part of such a group. This means that when member companies of a tax group are sold to a purchaser outside the group, the group’s historic tax liabilities may under certain circumstances remain attached to such de-grouped companies under their new ownership. It is therefore critical to carefully consider such group tax liabilities when purchasers acquire UAE target companies that form part of a CIT and/or VAT group and appropriately deal with the de-grouping and related potential liabilities in the tax provisions of the SPA.

Asset deal

Contrary to a share deal, a UAE target company’s tax liabilities will not be transferred to a purchaser in an asset deal (i.e., the liabilities should remain with the legal entity that is selling the assets). This means the tax DD normally has a more limited scope than for a share deal. Under the new CIT regime, any capital gains realized with the transfer of assets may be subject to tax, unless a specific relief is available.  

From a CIT perspective, an asset deal may qualify for the business restructuring relief scheme. Under this scheme, companies that transfer their entire business or an independent part of it to another company in exchange for shares or other ownership interest in the transferee, can benefit from tax relief on the transaction (i.e., a merger, spin-off, or other corporate restructuring). This relief means the transaction will be treated as being tax neutral, which is achieved by pricing the transfer of assets and liabilities at their net book value at the time of the transfer (i.e., neither a gain nor a loss will be recognized upon the transfer). The business restructuring relief scheme is subject to conditions and there is a clawback period of two years from the date of the initial transfer if (i) the shares in the transferor or the transferee are sold to a third party, or where (ii) there is a subsequent transfer or disposal of the (independent part of the) business. A transfer under the business restructuring relief scheme normally benefits the seller, which does not have to account for any capital gain for tax purposes. The purchaser on the other hand may prefer a business transfer at market prices as it will be able to claim tax deductible depreciations over the lifetime of the acquired assets.

The transfer of assets by a UAE company would normally be treated as a taxable supply for VAT purposes, for which 5% VAT should be charged. However, where the transfer of assets would qualify as a Transfer of Going Concern (TOGC), those supplies would be considered outside the scope of VAT. The TOGC rules apply to asset deals where the transaction entails a transfer of several assets bundled together, which together include the necessary components to constitute an independent (part of a) business. According to the UAE VAT Law, a transaction can be considered a TOGC if there is a transfer of the whole or an independent part of a business from seller to purchaser, for the purposes of continuing that business by the purchaser. Another condition for the TOGC is that the transferee needs to be a taxable person, or is obligated to register, for UAE VAT purposes. In case the TOGC does not apply, a VAT registered purchaser should normally be able to recover the VAT charged on the transfer of assets as input VAT, although recovering the VAT may take some time. Instead, an important benefit of the TOGC application is that a purchaser does not need to pre-finance the VAT on the transaction. It is worth noting that the application of TOGC treatment is mandatory, where all relevant conditions are met.

 

Other considerations

Debt and equity financing

In terms of acquisition funding, an M&A transaction can be financed with equity, debt (leverage) or a combination thereof. From a tax perspective, a UAE purchaser may prefer debt over equity because interest expenses would normally be tax deductible. Whilst the UAE CIT regime generally allows the deduction of interest expenses, it also includes two specific restrictions. Firstly, a UAE company’s net interest expenses shall only be deductible up to 30% of its earnings before interest, taxes, depreciation and amortization for the relevant tax period. Secondly, no interest deduction will be allowed if the loan was obtained, directly or indirectly, from a related party for the acquisition of an ownership interest in a (target) company, which is or becomes a related party following the acquisition (this restriction may also apply in cases of a capital contribution, repurchase of shares and dividend distribution). The latter restriction does not apply if the debtor can demonstrate that the main purpose of obtaining the loan and carrying out the transaction is not to gain a CIT advantage (which would be presumed to be the case if the creditor is subject to CIT or a similar foreign tax at a rate of at least 9%). A purchaser looking to use leverage for a share purchase should closely consider these rules to ensure any related party interest expenses are tax deductible.

Participation exemption

UAE purchasers acquiring a domestic target company should determine whether dividend distributions received, and capital gains realized, post-acquisition may benefit from a tax exemption. The UAE CIT Law includes a broad-based participation exemption regime which exempts (foreign sourced) dividends, capital gains and other types of income derived from a qualifying shareholding (or Participating Interest). The aim of the participation exemption is to avoid double taxation of corporate profits, whereby such profits would otherwise be taxed at the level of the subsidiary and then a second time when the profits are distributed or when the parent sells its shares in the subsidiary. The main conditions to benefit from the participation exemption and for a shareholding to qualify as a Participating Interest are as follows:

• The parent entity must hold a shareholding of 5% or more in the subsidiary;
• The parent entity must hold the shares for at least 12 months;
• The subsidiary must be subject to tax at a minimum rate of 9 per cent; and
• Not more than 50% of the direct and indirect assets of the participation consist of ownership interests or entitlements that would not have qualified for an exemption from CIT under the participation exemption if held directly by the parent entity.

The first condition will also be met where the aggregated acquisition cost of the ownership interests in the subsidiary is at least AED 4,000,000 (i.e., even where this does not represent a shareholding of 5% or more in the subsidiary). An entity shall be treated as satisfying the condition that it must be subject to tax at a rate that is not lower than the UAE CIT rate (i.e., at least 9%) if the principal objective and activity of the participation is to acquire and hold shares or equitable interests that are considered as Participating Interests and the income of the participation during the relevant tax period substantially consists of income from Participating Interests. Finally, dividend income derived from shareholdings in UAE entities are fully exempt, regardless of whether the conditions for the participation exemption are met.

Tax grouping

If a UAE purchaser acquires a UAE target company, it may be beneficial to subsequently include the subsidiary in a tax group for CIT purposes. Under the CIT regime, a UAE parent company can make an application to the FTA to form a tax group with one or more other resident companies, as a result of which such tax group will be treated as a single taxable person provided certain conditions are met, such as a parent company’s minimum 95% ownership in the subsidiary.

One of the main benefits of forming a tax group is that it reduces the overall compliance burden of the group. This is mainly because the parent entity will file a single consolidated tax return on behalf of the group as opposed to each member filing a separate return, and transactions between members of the tax group would be ignored for tax purposes. A disadvantage is the fact that the standard 0% tax bracket for taxable profits not exceeding AED 375,000 only applies to the tax group, instead of on a per-entity basis.