Case Study: interest-bearing deposits and a 0% Corporate Tax rate

The facts

A holding company is registered in the UAE free zone. It earns dividends and capital gains. Every once in a while, the Company deposits money in interest bearing accounts in UAE and foreign banks.

The holding of shares qualifies for a 0% Corporate Tax rate, while interest on deposit in an independent bank does not. In some financial periods, interest added to some occasional non-qualifying income received may increase to 5% of the total revenues or 5,000,000 AED.  

 

The question

Is there any option to apply the 0% Corporate Tax rate to interest paid to deposit account holders?

 

The analysis

In brief, the treatment of interest depends on:

  • Whether the bank is registered in a free zone, and
  • Where the money deposited came from.

 

Deposits in banks registered in a free zone

Qualifying Income includes income derived from transactions with other Free Zone Persons.Art. 3(1)(a) of Cabinet Decision No. 55/2023

Article 1 of the Corporate Tax Law determines that a Free Zone Person is ‘a juridical person incorporated, established or otherwise registered in a Free Zone, including a branch of a NonResident Person registered in a Free Zone’.

In ADGM, for instance, you should check the FSRA Public Register to check whether a bank is registered in Abu-Dhabi. You may find the First Abu Dhabi Bank in this list, for example.

Again as an example, there’s a branch of China Construction Bank Corporation in the Public Register of DIFC. 

Emirates NBD PJSC is in the DIFC Public Register with the legal status of a “Non-DIFC Company” and “Firm type” – “Recognized Member”. 

As per the DIFC’s clarifications, ‘while PLCs, LTDs, LLPs, LPs, NPIOs and Foundations are “incorporated” entities, having separate and independent legal status from their incorporator(s), the Recognised Companies, and Recognised Companies, Recognised Foundations and Recognised NPIOs are “registered” entities and, as such, are a mere extension (and, for purposes of legal authority and liability, is an inseparable part) of the foreign-incorporated company/partnership through whose head office it is registered in DIFC’. Status of ‘registered person’ in DIFC for recognized member is also given by Art 3(1) of the Schedule 1 to Operating Law DIFC Law No. 7 of 2018.

Unless other clarifications or regulation show up, such Recognized members registered in the Public Register of DIFC fit the definition of a Free Zone Person cited above.

On balance, interest on deposits placed in a bank included in the Public Register (or its substitute) in a free zone is qualifying income.

 

Deposits in banks not registered in a free zone

Article 3(4) of Cabinet Decision No. 55 envisages that ‘qualifying Income shall include income derived from any Person where such income is incidental to the income under paragraph (a) or (b) of Clause (1) of this Article’, i.e. to the income which is included in the list of qualifying income issued by the MoF.

There are no relevant examples of interest received by a holding company being treated as incidental to the holding operation. However, you may find them in the ESR regulations of other low-tax jurisdictions.

Para 4.1. of the Guidance on aspects in relation to the ESR as issued by Guernsey, Isle of Man and Jersey sets out that ‘if a company meets the criteria to be regarded as a (pure equity) holding company, the placing of dividend monies received on deposit or using them to acquire and passively hold other securities such as gilts [fixed-interest loan securities issued by the UK government – AN], will not constitute a “commercial activity” and therefore the company will still be regarded as a (pure equity) holding company’.

A similar approach is presented in the example from the Guidelines for the Bahamas Commercial Entities (Substance Requirements) Act issued on 8 September 2023. Section 13.7 elucidates that: ‘Entity C is a commercial entity which holds private equity and pays dividends into a bank account which is interest bearing. Entity C is still conducting holding business even though it is in receipt of incidental interest income from a bank account into which the dividends and capital gains are deposited. In these circumstances, the maintenance of a bank account does not prevent the commercial entity from meeting the definition as intended by the Act’.

In the Guidance Notes on General ESR principles, issued on 24 December 2019,  the MoF of Bermuda explains the same: ‘If an entity meets the criteria to be regarded as a pure equity holding entity, the placing of dividend monies received on deposit or using them to acquire and passively hold other securities such as gilts will not constitute a “commercial activity” and the entity will still be regarded as a pure equity holding entity and subject to applicable substance requirements’.

Hong-Kong has similar regulation on incidental income. The Inland Revenue OrdinanceCap./Instrument No.: 112 version dated 1 January, 2023   classifies ‘income incidental to the acquisition, holding or sale of such equity interests’ as income from pure holding activity.

The Inland Revenue Department illustrates this with example No. 13 as follows:

‘Company-HK carried on an investment business, other than money lending and intra-group financing, in Hong Kong. The company occasionally lent its idle funds to some non-resident associates and received interest from the associates. The terms of the loans were negotiated and agreed outside Hong Kong. The loans were also made available to the associates outside Hong Kong. In addition, Company-HK also placed a deposit with a foreign bank outside Hong Kong and received interest on the deposit.

Company-HK made strategic decisions in relation to its investments in Hong Kong. It established a physical office in Hong Kong, which had a significant staff establishment and incurred a significant amount of operating expenditures in Hong Kong.

Company-HK could meet the economic substance requirement and will continue to be exempt from profits tax in respect of its foreign-sourced interest from the non-resident associates and overseas deposit although the income generating activities with regard to the income were undertaken outside Hong Kong’.

The template of the Economic Substance Return in Cayman Islands contains a box for incidental income with a note ‘For example, incidental interest earned on a bank account’. Cayman Islands Economic Substance Guidance discloses this example on page 67: “CayCo Ltd, a relevant entity, is an intermediary pure equity holding company in a group structure; it holds 100% of the shares in two other companies and receives dividends annually, which are paid into an interest bearing bank account. The bank account is used for the purpose of receiving the dividends and to pay the company’s expenses. This is CayCo Ltd’s only activity. CayCo Ltd is a pure equity holding company; the receipt of incidental interest income on the bank account does not affect CayCo Ltd’s classification as a pure equity holding company’.

Section 73 of the Barbados Economic Substance Guidelines provides the same clarification: ‘If a resident company meets the criteria to be regarded as a single purpose equity holding company, the placing of dividend monies received on deposit or using them to acquire and passively hold other securities such as government bonds, will not constitute a “relevant activity” and therefore the company will still be regarded as a single purpose equity holding company’.

 

The conclusions

In view of the above, I believe that:

  • Income gained from depositing dividends in an interest-bearing bank account may be treated as incidental to holding activity.
  • This may justify the application of a 0% Corporate Tax rate to interest earned even if a bank is not a Free Zone Person.
  • This interest shall not be included in the sum of non-qualifying income limited by the De Minimis threshold.

 

The assessment of risks

The FTA may challenge the incidental character of interest income if the deposits are made by way of separate business. Business is determined in Art. 1 of the Corporate Tax Law as ‘any activity conducted regularly, on an ongoing and independent basis by any Person and in any location, such as industrial, commercial, agricultural, vocational, professional, service or excavation activities or any other activity related to the use of tangible or intangible properties’. The Glossary in the FTA Corporate Tax General Guide No. CTGGCT1 defines “Business Activity” as ‘any transaction or activity, or series of transactions or series of activities, conducted by a Person in the course of its business’.

These rules allow separate treatment to be given for cases where depositing dividends or other amounts generated in the course of holding business have been withdrawn from holding business for the sake of being deposited. Such separate treatment is not applicable where temporarily free cash is deposited before the moment comes to fund operations inherent to holding business.  In the latter case, the depositing transaction is conducted “in the course of” holding business and meets definition of holding “Business Activity” cited above.  

Relevant free zone legislation may also help. For example, para (3) of Schedule 1 to the ADGM Financial Services and Markets Regulations 2015 sets forth that ‘a person carries on an activity by way of business if the person (a) engages in the activity in a manner which in itself constitutes the carrying on of a business; (b) holds himself out as willing and able to engage in that activity; or (c) regularly solicits other persons to engage with him in transactions constituting that activity’.

 

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. 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.

Contacts

Maria Nikonova
Head of PGP Tax Consultancy in the UAE, PhD in Law
m.nikonova@pgplaw.ae

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