Government Entities must distinguish between sovereign and commercial activities for tax purposes

The Corporate Income Tax (CIT) law was published by the United Arab Emirates (UAE) on 9 December 2022. As per the law, Federal and Local Government entities are exempt from paying CIT for their sovereign activities.

The term 'sovereign activity' is not explicitly defined in the law, but it generally refers to activities without commercial character which are conducted by a public authority, particularly where such activities are not in competition with the private sector, even if the activity involves charging fees, contributions, or other charges.

According to the CIT law, if a Government Entity conducts a Business or Business Activity under a licence issued by a Licensing Authority, then such activity will be treated as an independent business, for which the Government Entity must keep financial statements which are separate from the entity’s other activities.

Government Entities are therefore required to differentiate between their 'sovereign, government, or public' activities and 'business or business activities' to determine their tax liabilities. While the former activities are exempt from tax, the latter are commercial in nature and subject to taxation.

The CIT law further seems to imply that if a Government Entity conducts multiple Business Activities under different licences, each activity will be treated as a distinct Business or Business Activity (article 5, clause 3 CIT law). As a result, the Government Entity must calculate the taxable income independently for each activity and maintain separate financial statements in respect of each activity. It is currently expected that each separate Business or Business Activity will also be entitled to utilise the tax-exempt bracket (i.e., taxable income up to AED375,000) or claim small business relief (provided that the relevant conditions are met).

From a Transfer Pricing (TP) perspective, transactions between a Business or Business Activity and the ‘other activities’ of the Government Entity shall be considered Related Party transactions which are subject to the arm’s length principle. In our view, this should prevent certain arrangements that could result in a tax advantage, by artificially shifting profits from the Business or Business Activity to the Government Entity’s sovereign activity, which is exempt from tax, or to other Business Activities which may be loss-making.

A Government Entity may request the Federal Tax Authority to treat all its Businesses and Business Activities as a single Taxable Person subject to meeting the conditions prescribed by the Minister.

The conditions, which are stipulated in Ministerial Decision No. 68 of 2023 (issued 29 March 2023), are as follows:

• Condition 1: All Businesses and Business Activities must be treated as a Single Taxable Person. It is therefore not possible to only treat some activities as a Single Taxable Person.
• Condition 2: only Businesses and Business Activities that are conducted under a Licence issued by a Licensing Authority are eligible to be treated as a Single Taxable Person.
• Condition 3: the application to be treated as a Single Taxable Person must by made by the Representative of the Government Entity.

For the purposes of determining the Taxable Income of the single Taxable Person, the Government Entity shall consolidate the financial results, assets and liabilities of all Businesses and Business Activities attributable to the single Taxable Person for the relevant Tax Period, eliminating transactions between the Businesses and Business Activities of the Government Entity within the same single Taxable Person.

The concept of treating all Businesses and Business Activities of a Government Entity as a Single Taxable Person is broadly similar to how members of the same corporate group can apply to form a Tax Group (subject to meeting certain conditions).

Key takeaway

Under the new CIT regime, sovereign activities will be exempt from tax. Any Business or Business activity conducted by Governments Entities under a Licence will however be subject to tax. Each Business which is carried out under a separate License will be considered an independent Business or Business activity for which the Government Entity must maintain separate financial statements, unless an application is submitted to the Federal Tax Authority to treat all Businesses or Business Activities as a Single Taxable Person.