Why the UAE's gratuity system has corporate tax implications

We are at an interesting juncture in the UAE regarding the employment separation of companies and their employees, either by choice, termination or retirement.

The labour law has long demanded that a financial cushion is provided for departing foreign employees as they transition to new jobs or are retiring.

In November, the government’s Voluntary Alternative End-of-Service Benefits Savings Scheme began. While not mandatory, it requires employers to register with the Ministry of Human Resources and Emiratisation if they choose to join the scheme.

We are also seeing details of the latest version of the UAE pensions sector, which is currently for Emiratis and GCC citizens. It has yet to launch, but is imminent.

These have corporate tax implications, critical elements of which are still unknown.

For avoidance of doubt, I’m not distinguishing pensions between Emirati and foreign workers. I’m questioning whether the corporate tax treatment for both systems will logically coexist while they are in place.

The push is to have a single platform, pension provision for foreign workers being self-funding. The drive is to create a sizeable UAE pensions industry, which has monies to invest; hopefully here. End-of-service is paid when an employee leaves their job and pensions when a person retires.

The calculation methods of the cost to the employer are likely to be different. The end-of-service benefits system is as per the defined calculation based on time served. It’s highly unlikely a pension scheme will exactly follow the same model. What the final delta is between the two is currently unknown.

Let’s take a look at both and review the potential corporate tax treatments.

In a fiscal year, or the 12 months you will be reporting corporate tax, do you deduct the provision for end-of-service benefits accrued for those employees remaining employed for that period against taxable revenue? Or, do you deduct the end-of-service payments made to departing employees in that period?

Under the accrual method of accounting, it would be the amount provided for future payments. Any payments in the current fiscal year to a departing employee would be matched to zero value by releasing a prior year provision against that cost.

Intuitively, the obvious answer would be the current period provision. In considering the potential treatment for pension costs, this decision logically follows.

What I mean is you would not wait until paying on an ongoing pension amount before being allowed to deduct it for tax purposes. It would mean costs relating to a 25-year-old employee would not become deductible until they retire and actual payments are made.

Pension scheme costs that are only deductible against taxable revenue on payment to the retiree do not make sense. Additionally, it would not be unusual for the management of such schemes to be operated by external parties.

What would be the implications of selling your internal scheme to a third party that specialises in managing them? If you had this party manage the pension scheme from its inception, would that make all the costs deductible in the year of expenditure? Or do you separate them and treat the management fee and contributory elements differently?

Let’s move to an adjacent topic: When is an employee not an employee? This should be easy, so let’s start with what an employee is.

An employee has an employment contract, which details how much the person is to be paid, broken down by various traditional categories. That contract, properly executed by both employer and employee, is lodged with the relevant trade licence issuing authority.

Depending on the authority, a labour card is issued to the employee. At a minimum, the UAE standard labour contract rights apply. These are enforceable by an action taken at the Labour Court.

If the above doesn’t apply to an individual, then they are not an employee. They are a third-party supplier of services to the legal entity that is paying them. The regularity of these payments is mostly irrelevant.

Yes, an individual who has formal communication that they are supposed to be an employee has a prima facie case against what they thought was their employer; an entity that has not completed their side of what was thought as agreed.

In this case, the payments made are tax deductible.

But what if the same individual is both the owner of the company and the employee? In the above example, they are not an employee and you cannot bring legal action against yourself for something you believed to be true. And strangely, that is rather common.

A person who believes, and has the paperwork to back it up, that he has been hired and discovers he is not, would have a legal case against that business. The owner would not.

You cannot bring yourself to court. There are (lots of) owners of companies in the UAE who are paying themselves a monthly amount. They believe that this is a salary.

Unless a contract of employment is in place, the same as for any other person, that owner is drawing a dividend. Dividends are not tax deductible, salaries are. I come across any amount of people who mistakenly believe that they will be able to deduct from taxes the, often small, amount they pay themselves each month.

Corporate tax launched in June 2023. We are four months away from the first entities closing their accounts and commencing work on their tax returns.

Yes, they have nine months to complete the exercise. How many times will these hard-working entities need to revisit that work to update for the latest law, updated guidance or corrected understanding?

Due to this, there is a danger that businesses will leave this work until closer to the latest reporting date. Such an approach, while understandable, leaves an organisation open to other pressing distractions.

The time to review how corporate tax impacts different elements of your financial accounts is fading quickly. Today is almost always the time to get something done.

David Daly is a partner at the Gulf Tax Accounting Group in the UAE