S&P Global Ratings believes the United Arab Emirates (UAE)'s introduction of a 9% corporate tax on business profits above UAE dirham (AED) 375,000 ($102,110) from June 1, 2023, is part of a gradual tax reform across the Gulf Cooperation Council (GCC). The tax will help diversify the UAE government's revenue away from the oil sector. We also believe that the broadening of the government's revenue base should support smaller emirates' economies. However, the full impact is unclear because it is not yet known how the tax will be distributed. In our view, the tax is likely to put some pressure on banks, corporates, and insurers, but this will be manageable and not significantly affect their creditworthiness.

If the federal government keeps the tax receipts and uses them for UAE-wide capital investment, this would indirectly support economic activity in the individual emirates and enhance their economic growth potential. Alternatively, corporate tax could be distributed in the same way as value-added tax (VAT) revenue. Some 70% of VAT receipts collected in the individual emirates go to their respective governments, with the balance sent to the federal government. If the corporate tax is distributed in the same way, it would support the emirates' fiscal positions, especially Sharjah (BBB-/Stable/A-3) and Ras Al Khaimah (A-/Stable/A-2). These emirates have two of the lowest revenue bases of our globally rated sovereigns, at about 8% of GDP.

In 2018, we estimated that a 15% corporate tax rate could generate the equivalent of about 3% of GDP in revenue at the UAE federal government level (see "GCC Economic And Social Structures Will Likely Curb Tax Reforms," published Jan. 25, 2018, on RatingsDirect). The new tax rate will be 9%, suggesting that annual revenue could be about 1.8% of GDP. However, a reduction in dividends from government-related entities to the individual emirates could partly offset the increase in revenue from the tax. Individual emirates could also adjust the fees and levies they already apply to resident corporates to reduce their tax burden, which would again reduce the overall revenue increase.

The Introduction Of Corporate Tax Further Aligns The UAE With International Standards

In the context of the GCC, the UAE has been proactive in implementing fiscal reforms to diversify government revenue streams and bring its business environment more in-line with global norms. Saudi Arabia (A-/Stable/A-2) and the UAE were the first GCC countries to introduce VAT in 2018. Tax reforms in the UAE are progressing in line with changes to social policy and the business environment, such as no longer requiring the participation of local partners in every business and allowing foreigners to own up to 100% of local companies.

The introduction of corporate tax will further align the UAE with international efforts to combat tax avoidance. The tax will be applied to all business and commercial activities except the hydrocarbon sector, which will remain subject to emirate level taxation.

It also prepares the ground for compliance with the global minimum tax rate of 15%, which the UAE has agreed to as per the 2021 Organization for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) project. We understand that large multinational companies with consolidated global revenue above €750 million ($857 million, AED3,149 million) will be subject to tax at a rate other than 9%. The rate for those companies that meet the criteria with reference to Pillar Two of the OECD BEPS project will most likely be closer to the 15% global minimum.

All GCC countries except Bahrain already levy a corporate tax on foreign nonhydrocarbon companies: Qatar 10%; Saudi Arabia 20%; and Kuwait 15%. However, until the UAE's recent announcement, no GCC country apart from Oman had applied corporate tax to domestic nonhydrocarbon companies. Oman levies a rate of 15% on both foreign and domestic companies and is already in compliance with the BEPS agreement. GCC countries have no personal income tax regime, although Oman has plans to introduce it for higher earners at a relatively low rate in 2023. Given this direction, it is likely that personal income tax will become more widely applicable across the GCC in the coming years.

Corporate Tax Could Improve The Transparency Of Free Zone Trade

The UAE has a large number of free zones, where companies benefit from 100% foreign ownership–-even before recent changes allowed this across the UAE more broadly--100% repatriation of capital and profits, and exemption from customs duty. The new corporate tax will only apply to the business that companies within free zones conduct with the UAE mainland. However, free zone companies will be required to file tax statements on all their business. This increased transparency could help reduce concerns raised by anti-money-laundering watchdog, the Financial Action Task Force, around business activities within free zones.

The Effect On Corporates' Cash Flows Will Be Manageable

Levying a corporate tax will inevitably affect corporates' cash flow positions and have earnings implications, but we think it is likely that companies will increase prices and manage their financial policies to absorb the impact. As such, for most corporates, we do not necessarily foresee a pronounced change in leverage. A key metric in our corporate analysis is debt to EBITDA. Since we use earnings before tax in our calculations, it is unlikely that there will be a direct effect on this data point. That said, the new tax will be a burden for small corporates or those in price-sensitive sectors. Dubai (not rated) and to a lesser extent Abu Dhabi (AA/Stable/A-1+) account for the lion's share of corporate activity in the UAE. This is where most tax will be collected and where there will be the most pressure on corporates to cut costs, perhaps by reducing their headcount.

We do not expect significant numbers of corporates to relocate outside the UAE due to the new tax. All GCC countries (except Kuwait) are members of the OECD/G20 inclusive framework on BEPS. There are 141 member countries, including others with currently low corporate tax rates. We expect a leveling of the playing field for corporates operating globally in terms of the corporate tax rate they will be required to pay. The UAE is to some extent stealing a march on its regional peers in terms of preparing the corporate sector for the new global operating environment, while applying the tax at a competitive rate within its own borders.

Banks Will Continue To Enjoy Strong Profitability

We do not expect the introduction of corporate tax will have a significant impact on banks' creditworthiness. Banks in the UAE enjoy strong profitability, with an annualized return on assets of 1.2% on Sept. 30, 2021. They also have strong efficiency, with a cost-to-income ratio of 36.4% on the same date. In our view, banks will use whatever tax-reduction mechanisms the government introduces to optimize their tax bills. However, at this stage we don't know whether the introduction of corporate tax will prompt any cost-cutting initiatives.

Insurers Also Won't Be Materially Affected

The corporate tax will not have a material bearing on the creditworthiness of UAE-based insurers, in our view. Listed insurers in the UAE typically have adequate capitalization and the sector has shown strong profitability in recent years, with a return on equity of about 10%-12%. Therefore, we do not believe that the introduction of corporate tax will weaken our ratings on UAE insurers. However, we believe that insurers will need to adjust their information technology systems and operations to comply with the new tax requirements. In our opinion, this will lead to one-off expenses and put additional pressure on the earnings and capital of some smaller and weaker players.

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