Venture Capital Funds and Corporate Taxation: Finding the Winning Formula

Introduction

In recent years, the United Arab Emirates (“UAE”) has emerged as a recognized hub for technology and innovation. One of the pivotal drivers of this transformation has been the increase in venture capital (“VC”) activity in the UAE. VC is a form of private equity funding used as a viable alternative to traditional bank financing for new businesses.

VC investments are crucial in nurturing start-ups to scale their operations and promote innovation in key technologies. Although VC funds may well stimulate innovation and growth in the economy, the core mandate of these investment vehicles (like all others) is ultimately to produce satisfactory returns for its underlying investors.

The recent introduction of corporate income tax (“CIT”) in the UAE may significantly impact persons involved in VC funds, both investors looking to deploy capital strategically and maximize returns and entrepreneurs seeking funding for the ‘next big thing’. Due to the international structure of modern investment strategies, it is also important that VC fund stakeholders are sufficiently aware of the international tax implications associated with their investments.

In this article, we discuss some of the nuances VC fund investors must consider going forward as part of the new UAE CIT and international tax landscape.

UAE CIT Law Overview

Broadly, the UAE Federal Corporate Tax Law (“UAE CIT Law”)[1] identifies two types of partnerships, namely:

Incorporated Partnerships: these include limited liability partnerships (“LLP”), partnerships limited by shares, and other types of partnerships where none of the partners have unlimited liability, and
Unincorporated Partnerships: these essentially involve a contractual relationship between two or more persons. The main feature of an unincorporated partnership is that the partners have unlimited liability for the debts and obligations of the unincorporated partnership and its business. Examples include general partnerships (“GP”) and joint ventures (“JV”). We have previously commented on applying this regime for law and professional services firms[2].

A VC fund is typically structured as a partnership, with a general partner responsible for managing the fund’s investments and limited partners providing the capital (the so-called classic GP-LP structure). Limited partners tend to be passive investors who have limited liability, while the general partner is actively involved in managing the fund. Below, we have included a diagram of the common VC fund structure.

Unincorporated Partnership and Fiscal Transparency

As discussed above, one of the primary considerations in characterizing a partnership for UAE CIT purposes is the concept of limited or unlimited liability. In this regard, an incorporated partnership where all partners have a limited liability is relatively straightforward from a UAE CIT perspective. Given the limited liability status of the partnership, it is considered to have a separate legal personality and taxable status, similar to a limited liability company or other juridical person. It is ultimately treated as a juridical person and taxed accordingly under the UAE CIT Law.

More complex is the UAE CIT treatment of unincorporated partnerships (which may involve an incorporated entity where partners have unlimited liability). A partner in an unincorporated partnership is regarded as conducting the partnership’s business as if it were his own, and he is jointly or severally liable for the obligations resulting from being in such arrangement.[3] For this reason, this type of partnership lacks independent legal personality[4] and is considered “transparent” for UAE CIT purposes.

According to Article 16 of the UAE CIT Law, any income derived by a tax-transparent vehicle shall be treated as earned by the underlying investor(s). In this regard, depending on the tax profile (natural persons vs. juridical persons) and tax residence status of the underlying investors, they may be subject to UAE CIT on the income derived from a tax-transparent entity. For example, a corporate investor in a UAE tax-transparent vehicle is subject to UAE CIT on the income to which that corporate investor is entitled. Conversely, a UAE tax resident natural person not conducting a business activity would not be subject to UAE CIT on their portion of the profit earned from the tax transparent entity, in so far as the activities of the unincorporated partnership do not bring a natural person within the scope of UAE CIT[5].

Each partner of an unincorporated partnership would need to assess whether they are within the scope of UAE CIT and, if so, register, prepare, and file annual UAE CIT returns accordingly, based on their portion of the income generated from the partnership. This causes important administrative obligations.

Another significant drawback of a transparent vehicle such as an unincorporated partnership is that they generally cannot claim any benefits under a double tax treaty (“DTT”) in so far as those vehicles do not meet the “liable to tax” criterion under Articles 1(2) and 4 of the OECD Model Tax Convention (“MTC”)^[6].

As outlined above, VC structures typically have partners with both limited and unlimited liability. This potentially creates a so-called “partially tax-transparent entity” for UAE CIT purposes since the partnership is only considered transparent with respect to the income attributable to the partners with unlimited liability.

VC Funds and Taxable Person Election

To avoid some of the abovementioned administrative complexities associated with being a ‘transparent’ or ‘partially transparent’ investment vehicle, a VC fund may opt to be treated as a fully taxable person under the UAE CIT Law.[7] One of the benefits of this approach would be that the taxable person would be able to make a substantial claim to the application of rights under a DTT, given that it would be liable to tax. Additionally, this would reduce the compliance burden on individual partners, particularly where they are within the scope of the UAE CIT regime.

While, at first view, this option may seem inefficient from a tax perspective, as it would ensure the full partnership is within the scope of UAE CIT, several potential exemptions are available to a VC fund, as discussed below.

Qualifying Investment Fund

In the first instance, a VC fund may submit an application before the UAE Federal Tax Authority (“FTA”) to be considered exempt from UAE CIT as a Qualifying Investment Fund (“QIF”) where all of the following conditions are met:[8]

The investment fund or the investment fund’s manager is subject to the regulatory oversight of a competent authority in the State, or a foreign competent authority recognized for the purposes of this Article.
Interests in the investment fund are traded on a Recognized Stock Exchange, or are marketed and made available sufficiently widely to investors.
The main or principal purpose of the investment fund is not to avoid CIT.
Any other conditions as may be prescribed in a decision issued by Cabinet at the suggestion of the Minister.

As regards the fourth condition above, we note that a Cabinet Decision was issued[9] (no. 81 of 2023) containing other requirements to be considered a QIF, namely:

The main business or business activities conducted by the investment fund are investment business activities, and any other business or business activities conducted by the investment fund are ancillary or incidental.
A single investor and its related parties do not own the following:
– More than 30% of the ownership interests in the investment fund, where the investment fund has less than ten investors.
– More than 50% of the ownership interests in the investment fund, where the investment fund has ten or more investors.
The investment fund is managed or advised by an Investment Manager that has a minimum of three investment professionals.
The investors shall not have control over the day-to-day management of the investment fund.

This exemption is likely to apply to many VC fund structures. However, some criteria (particularly the related party/ownership structure requirements from the Cabinet Decision) may be a potential tension point for certain funds.

Qualifying Free Zone Person

For those VC funds that may not meet the criteria for a QIF but are established in any of the UAE economic free zones (“FZs”), there is also the possibility to qualify for the 0% beneficial rate available to Qualifying Free Zone Persons (“QFZP”).

Given the continuing discussion regarding the QFZP regime and the prospect of upcoming modifications due to the public consultation on the UAE FZ CIT regime closed last August, we will only briefly summarize the key requirements below. Notably, a FZ person is considered a QFZP for UAE CIT purposes where it meets the following conditions[10]:

It derives Qualifying Income.
Its Non-Qualifying Income does not exceed the prescribed de-minimis requirements.
It is compliant with the arm’s length principle and transfer pricing (“TP”) documentation requirements.
It maintains adequate substance in the UAE.
It does not elect to be subject to CIT (at 9%).
It prepares and maintains audited financial statements.

Important in the context of VC funds is that the income generated from these vehicles will likely meet the definition of income derived from a “Qualifying Activity”[11] (i.e., it would be considered “Qualifying Income”). This is because the “Qualifying Activities” list includes, amongst others, the holding of shares and other securities.[12]

However, another important consideration and potentially critical point for a VC fund is that a QFZP must be a juridical person under the UAE CIT law.[13] Hence, the qualification for the QFZP regime depends on how the VC fund is structured, including assessing whether it has a separate legal personality for tax purposes.

International Tax Considerations

The UAE has more than 140 DTTs with partner jurisdictions[14]. This makes the UAE an appealing destination for VC funds to establish operations and engage in international investment opportunities. As such, it is also very important to consider the implications of the domestic tax treatment of a VC fund from an international tax perspective, particularly whether the VC fund can access benefits under a DTT.

A person can only claim treaty benefits under a DTT when he resides in one of the two Contracting States. One of the key criteria under Article 4 of the OECD MTC for tax residence is that the person is “liable to tax” in the Contracting State. We mentioned previously that a tax-transparent partnership is typically not eligible to claim treaty relief due to non-fulfillment of the “liable to tax” criteria.

For partially or fully tax-transparent entities, it is possible that the underlying investors may be considered tax residents in the UAE (provided they meet the relevant conditions in the DTT) and, therefore, be entitled to treaty benefits. However, tax treaty residence eligibility is subject to complex assessments for the VC fund and its investors.

The difficulty in accessing treaty benefits for tax-transparent entities is one of the key reasons a VC fund may elect to be a taxable person under the UAE CIT Law. However, there is also an argument that a QIF or QFZP would not meet the “liable to tax criteria”. The OECD Commentary on the MTC effectively leaves the interpretation of whether an entity satisfies the “liable to tax” criterion at the discretion of the source jurisdiction.

From our experience, ZATCA in the Kingdom of Saudi Arabia (“KSA”) has historically sometimes rejected claims by UAE FZ entities under the KSA-UAE DTT because they are not liable to tax in the UAE and, therefore, do not meet the residency criteria. Where the VC fund is not considered resident in the UAE, it could result in foreign withholding tax being applied on the payments received at gross, with no domestic credit available, as the VC fund is exempt from UAE CIT or is subject to tax at 0%.

Nevertheless, it is important to consider each DTT and transaction or arrangement on a standalone basis, as in some jurisdictions, a person is considered liable to comprehensive taxation even if the Contracting State does not actually levy any income tax.[15] As such, there may be scenarios where a VC fund can elect to be considered a taxable person and qualify as either a QIF or QFZP such that there is no domestic UAE CIT while maintaining access to treaty benefits.

Conclusions

This article has outlined some potential intricacies that VC funds must consider when determining their “winning formula” under UAE CIT Law. This decision requires a critical evaluation by VC funds of the different options available (transparent vs. opaque, QIF, QFZP, etc.). VC funds must also evaluate the extent of their international portfolio, as well as the tax profile and residency of underlying investors, if they want to continue maximizing investor returns in the changing world of taxation in the UAE.

Summary Table

[END NOTES]

[1] Federal Decree Law No. 47 of 2022 on the Taxation of Corporations and Businesses (“UAE CIT Law”).

[2] T. Vanhee, “Impact of UAE Corporate Tax on Law Firms and Professional Services Firms“, https://aurifer.tax/uae-corporate-tax-which-impact-on-law-and-professional-services-firms/, accessed on 2 October 2023.

[3] Article 16(9), UAE CIT Law; Clause 8.2, Corporate Tax General Guide issued on 11 September 2023.

[4] Clause 8.2, Corporate Tax General Guide issued on 11 September 2023.

[5] This is determined by Article 11(6), UAE CIT Law, for which the UAE Federal Cabinet issued Cabinet Decision No. (49) of 2023 On Specifying the Categories of Businesses or Business Activities Conducted by a Resident or Non-Resident Natural Person that are Subject to Corporate Tax. This Cabinet Decision determines that for resident and non-resident natural persons, wages, personal investment income, and real estate investment income are not subject to UAE CIT. For more details on the application of UAE CIT to natural persons, please refer to our previous articles: T. VANHEE, “Tax Implications for Resident and Foreign Investors in the UAE Real Estate”, https://aurifer.tax/tax-implications-for-resident-and-foreign-investors-in-the-uae-real-estate/, accessed on 2 October 2023; T. VANHEE., “CIT in the UAE: The PE Clause for Individuals”, https://aurifer.tax/cit-in-the-uae-the-pe-clause-for-individuals/, accessed on 2 October 2023.

[6] See Paragraph 8.3., OECD Commentary to the OECD Model Tax Convention (“MTC”) on Article 4, which states the following: “Where a State disregards a partnership for tax purposes and treats it as fiscally transparent, taxing the partners on their share of the partnership income, the partnership itself is not liable to tax and may not, therefore, be considered to be a resident of that State”. This reflects the idea of when a person is covered and is entitled to the benefit of a double tax convention (“DTT”) as specified in Article 1(2) of the OECD MTC (as updated in 2017) as regards wholly or partly transparent entities. Some treaties will, however, specifically note that a partnership is a resident. See Article 4(1)(b) of the DTT between the United States and Luxembourg or Article 4(1) of the DTT between Belgium and Luxembourg

[7] Article 16(8), UAE CIT Law.

[8] Article 10(1), UAE CIT Law.

[9] Cabinet Decision No. 81 of 2023 On Conditions for Qualifying Investment Funds for the Purposes of Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses.

[10] For more details on the QFZP regime, see L. Purcell, “To Qualify or not to Qualify: Analysis and Tax Advisory on the UAE Free Zone Regime, Interaction with Pillar Two, and Beyond”, https://aurifer.tax/to-qualify-or-not-to-qualify-that-is-the-question-the-uae-free-zone-regime-interaction-with-pillar-two-and-beyond/, accessed on 2 October 2023. See also UAE Corporate Tax on Qualifying Free Zone Persons, https://youtu.be/HmjnOAUFm7g, accessed on 2 October 2023.

[11] Ministerial Decision No. 139 of 2023 Regarding Qualifying Activities and Excluded Activities for the Purposes of Federal Decree Law No. 47 of 2022 on the Taxation of Corporations and Businesses.

[12] Article 2(1)(c), Ministerial Decision No. 139 of 2023. It should be noted, however, that both management services and wealth and investment management services must be subject to the regulatory oversight of the competent authority in the State.

[13] Article 11(3)(a), UAE CIT Law.

[14] UAE Ministry of Finance (MoF), “Avoidance of Double Taxation Agreements” https://mof.gov.ae/wp-content/uploads/2023/08/Avoidance-of-Double-Taxation-Agreements1.pdf, accessed on 2 October 2023.

[15] Paragraph 8.6, OECD Commentary to the OECD MTC on Article 4.

Aurifer’s submission for Pillar one – Amount B

Pillar One – Amount B Submission

In the first instance, we would like to express our admiration towards the ongoing technical work undertaken by the OECD and the Inclusive Framework on the BEPS initiatives to address the difficulties which arise regarding the taxation of the digital economy. The tax challenges of the digital economy are extensive and difficult to address.

Our firm is incorporated in KSA and UAE, with a representation in Brussels. We have a strong focus on tax policy matters in the Gulf Cooperation Council (“GCC”).

Although it is an oversimplification, in a general sense, the GCC has been slow in the adoption of the principles of international taxation which has perhaps led it to being an under-represented region relative to its growing economic influence. Historically therefore, GCC countries have not participated much in international forums in the same way as other countries may have.

Much of the GCC has also only known only strong economic development towards the second half of the 20^th century, and therefore have only started to assert themselves more recently on an international level.

This submission aims to contribute constructively to the discourse, drawing from our experience and insights in the GCC region, and to collectively shape a future where international tax frameworks harmonize with the evolving dynamics of the global economy. In the subsequent sections, we provide our observations and recommendations in relation to the proposed scoping and pricing mechanism for Pillar One – Amount B. At the outset, we would like to express our endorsement for any initiative which seeks to improve legal certainty for tax payers and tax authority alike.

1. GCC Perspective

The GCC region is composed of six sovereign nations, each of which have their own individual tax legislation. However, the commonality in the GCC is that each of the countries remain in a relatively early stage in the development of their domestic tax systems and policies. This is certainly the case for transfer pricing. In this regard, the Kingdom of Saudi Arabia (“KSA”) was the first to introduce formal transfer pricing rules in February 2019 and currently only KSA, Qatar and the UAE have introduced full transfer pricing rules.

As such, the concept of transfer pricing remains relatively novel amongst the majority of taxpayers in the region. Indeed, the tax authorities in the region also have relatively limited experience with transfer pricing compared to other parts of the world.

Although perhaps not in an economic sense it appears clear that the GCC region would be considered a low-capacity jurisdiction in terms of experience and capacity. While the region continues to evolve and modernize rapidly, it will take several years to build up capacity, knowledge, knowhow, and expertise.

On this basis, the introduction of a simplified regime to promote tax certainty in the future would be most welcomed in the region. In this context, we have provided our comments on the current proposal below.

2. Scope

In the GCC, the distribution of goods (i.e. commercial agencies) is often only a privilege of companies held by GCC nationals. As such, distributors for products manufactured outside of the GCC are often unrelated parties and on that basis the pricing is generally inherently arm’s length.

Notwithstanding the above, there remains sufficient intergroup distribution activities to warrant the introduction of Amount B in the region. In relation to the transactions in scope, we broadly agree with the current proposal.

The exclusion of the distribution of services and commodities is in our view appropriate given the difference in functional and risk profile associated with these transactions. The UAE may have benefited from including distribution of services given it has a higher concentration of businesses performing these activities. Notwithstanding this, we agree in principle with these exclusions. The allowance of a de minimis threshold for retail sales is also helpful for some distributors in the region which are often part of large conglomerates undertaking a very wide range of activities.

However, given the difference in functional profile and remuneration structures of sales agent and commissionaire models as compared to buy-sell distribution activities, it may also be worth considering the exclusion of such transactions from the scope of Amount B. Alternatively, allowing for more flexibility in the pricing mechanism for such transactions may be sufficient.

In terms of the introduction of scoping criteria for “non-baseline” contributions, it is our opinion that the tax authorities in the GCC will benefit from the additional qualitative scoping criterion to assist in the effective implementation of Amount B. As alluded to in the public consultation, the accurate delineation of a transaction for transfer pricing purposes requires a qualitative assessment of the controlled transaction meaning that there should not be significant incremental effort associated with this approach.

Given the current lack of expertise in the region, the inclusion of guidance in how to navigate the qualitative components of the analysis for application of Amount B would be beneficial.

3. Transfer Pricing Methodology

We agree that the transactional net margin method is the most appropriate methodology for buy-sell distribution transactions in scope of Amount B. Similarly, the flexibility to elect to use the internal CUP method is seen as welcome and aligns with the existing OECD Guidelines.

We note there is currently a “cap and collar” corroborative mechanism embedded in the pricing matrix. The inclusion of a corroborative mechanism does not appear aligned with the objective of adopting a simplified approach and in our view may create unnecessary additional compliance for taxpayers. It appears that the intention behind such a mechanism is to safeguard against potential distortions in functional profiles between certain types of entities in scope namely sales agents/commissionaires versus buy-sell distributors.

As mentioned previously, it may be preferred to simply remove sales agents or commissionaires from the scope of Amount B. Alternatively, given the fundamental differences between these entities it may be preferable to allow for the Berry Ratio to be used as the primary method for sales agent and commissionaire type arrangements rather than as corroborative. Although this would involve developing a separate pricing matrices, the use of the Berry Ratio as the appropriate method may better align with the functional and remuneration profiles of such entities.

4. Pricing Matrix

In general, there is a lack of comparable data of companies in the GCC. This information is often close guarded, and there is currently no project to make such data publicly available. The traditional transfer pricing databases have some data, albeit limited.

As such, tax authorities in the region tend to allow for a wider geographic scope to be applied when searching for comparables, beyond just the GCC or MENA region. As such, the data availability mechanism will likely be applicable for GCC countries to the extent that they fall within the scope of “qualifying jurisdictions”.

We note that there is an option for a local data set to be produced by the local tax authority where there is a potentially material data availability gap in the global dataset owing to lack of country coverage. In this regard, we would have reservations about this option as it would impose an additional burden for the local tax administrations in the GCC as well as reduce the taxpayer’s input in what the appropriate range would be for their own circumstances. This may defeat the purpose of the exercise.

As outlined previously, the tax administrations in the GCC are at the early stages of their understanding of transfer pricing and will take some time to build up the relevant expertise. In our experience, the approach taken by tax administrations in developing their own ranges during disputes usually has the sole objective to increase profit levels in the GCC.

Furthermore, in the context of the GCC a lot of businesses are either directly controlled or receive support from sovereign wealth funds which may potentially distort the results of a local data if not appropriately accounted for. Additionally, a lack of transparency in available company data would also limit the taxpayers’ ability to contest or dispute the ranges produced.

As such, we would suggest that a high-level of transparency is available to taxpayers in relation to the selection criteria applied for such internally developed comparables. Alternatively, further guidance on what constitutes a “qualifying” local data set or the level of involvement from the OECD in supporting the local tax administration to develop these sets would be appreciated to allay any taxpayer fears of the tax administrations developing an unrealistic range of results.

5. Tax Certainty

Currently, the majority of transfer pricing disputes in the region are largely concentrated in KSA. In this regard, the tax authority in KSA has recently introduced an Advance Pricing Agreement (“APA”) regime in an effort to reduce such disputes. The UAE has also included an APA regime as part of its new corporate income tax regime.

We note that the current consultation acknowledges that existing bi-lateral or multi-lateral APAs should be respected following the introduction of the simplified and streamlined approach. We support this approach and would also recommend that the option remains for tax authorities to agree APAs on a go-forward basis in relation to transactions in-scope.

Unfortunately, the tax treaty network of the GCC countries is not always as extensive as other developed nations (except for UAE and Qatar). As such, reliance on mutual agreement procedure under the terms of the OECD model tax convention may not be available for transactions with certain counter-party jurisdictions. As such, we would recommend mandatory binding arbitration to Amount B in order to ensure that disputes are resolved in a timely manner.

Venture Capital Funds and Corporate Taxation: Finding the Winning Formula

Aurifer’s submission for Pillar one – Amount B

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