• Home
• /
• UAE
• /
• Business

Corporate tax in UAE free zones: All you need to know

Khaleej Times talks to experts to clear investors' doubts

In a landmark decision on June 1, the UAE introduced corporate tax businesses operating in the country. The move is a significant step in the UAE’s efforts to diversify the government’s sources of income, as it seeks to move away from a hydrocarbon-based economy.

Free zones are a key component of the UAE economy’s diversification efforts, and the zones have been serparately mentioned under specific provisions of the law. Khaleej Times talks to Dr Nabeel Ahmed, partner at DVS Management Consultancy and Siddharth Kohli, founder and CEO of Indigenesis Consulting, to get a clear idea of what the free zones need to do to comply with the UAE’s corporate tax rules. Excerpts from the interview:

What are the specific rules and regulations regarding the taxability of companies operating in free zones under the UAE’s corporate tax law?

Nabeel Ahmed: The legislation that would govern the taxability of corporations and business in all of UAE, is Federal Decree-Law No. 47 of 2022 on the taxation of corporations and businesses (‘CT Law’). Chapter 5 - Article 18 of the law specifically deals with qualifying free zone person (QFZP), wherein the taxability of QFZP would be at zero per cent tax rate, if all the conditions mentioned therein are met with. Cabinet decision No 55 of 2023 on determining qualifying income for the qualifying free zone person for the purposes of CT law and the ministerial decision no. 139 of 2023 regarding qualifying activities and excluded activities the purposes of the CT Law give a thorough understanding of the taxability of free zone companies.

Siddharth Kohli: Companies operating in free zones can benefit from zero per cent tax on income from carrying out ‘qualifying activities’. They would be termed Qualifying Free Zone Person (‘QFZP’) provided they maintain adequate substance in the free zone, have not specifically elected to be taxed, follow transfer pricing regulations and satisfy the de-minis requirement (explained below). All free zone companies are required to take corporate tax registration and file corporate tax returns.

Explain the concepts of qualifying income, qualifying activity, and excluded activities in relation to free zone entities?

Nabeel Ahmed: The Cabinet decision on what constitutes qualifying income was the most awaited decision after the CT law came into effect. Qualifying income as provided under ministerial decision no. 139 Of 2023 is defined as income from transactions with other free zone persons and non-free zone person, (be it domestic or foreign) and does not include excluded activities.

Qualifying activities are mentioned in cabinet decision no 55 of 2023, which gives a list of 13 activities conducted by QFZP as qualifying activities. The qualifying activities are : manufacturing and processing of goods or materials, holding of shares and other securities, ownership, management and operation of ships, reinsurance and fund management services, wealth and investment management services, headquarter services to related parties, treasury and financing services to related parties, financing and leasing of aircraft, distribution of goods or materials in or from a designated zone to a customer that resells such goods or material, logistics services and lastly any activities that are ancillary to the activities listed.

Excluded activities would include any transactions with natural persons, banking activities, insurance activities, finance and leasing activities ownership or exploitation of immovable property, other than commercial property located in a free zone where the transaction in respect of such commercial property is conducted with other free zone persons, ownership, or exploitation of intellectual property assets.

Siddharth Kohli: Simply put, a free zone company would not pay any tax on income derived from carrying out qualifying activities. QI been now defined to include:

(i) Income derived from transactions with other free zone persons, except income derived from “excluded activities”; (ii) Income derived from transactions with a non-free zone person, but only in respect of “qualifying activities”; and (iii) any other income provided that the QFZP satisfies the de minimis requirements (explained below). Qualifying activities include manufacturing, ownership & management of ships, fund management services etc.

The complete and specific list of qualifying activities and excluded activities can be referred from the ministerial decision no. 139 Of 2023 regarding qualifying activities and excluded activities and cabinet decision no. 55 Of 2023 on qualifying income.

What is the minimum requirement for transactions with mainland entities that could impact the tax-exempt status of free zone companies, and what are the potential consequences?

Nabeel Ahmed: The tax exempt status of the QFZP would be affected in case of income attributable to domestic permanent establishment (‘DPE’), or a foreign permanent establishment (‘FPE’). This therefore means that the income attributable to a mainland branch will remain taxable at 9 per cent. This, however, will not disqualify the QFZP from benefitting from a zero per cent CT rate on qualifying income or be factored into the de minimis test. A QFZP, can benefit from the zero per cent corporate tax rate when the taxable income is generated from the Free Zone area and is a qualifying income. The QFZP would be required maintain separate accounts one for the QFZP and another for the mainland documenting the transactions.

The De-Minimis threshold allows the ‘non-qualifying’ revenue which includes income from ‘excluded activities’ and from activities (other than ‘qualified activities’) with a non-free zone person to be taxed at zero per cent provided qualifying revenue derived by the QFZP in a tax period does not exceed 5 per cent of the total revenue of the QFZP in that tax period or Dh5 million, whichever is lower.

Non-compliance of conditions mentioned in the CT and the cabinet decisions would trigger corporate income tax at 9 per cent for a minimum of five years.

Siddharth Kohli: Free zone companies in the UAE, when conducting transactions with the mainland, must ensure that the transactions fall within the list of ‘qualifying activities’ defined by the cabinet and do not fall under the list of excluded activities. Failure to meet these requirement results in the loss of free zone status for the current year and the subsequent four years. Revenues attributable to a domestic permanent establishment or foreign permanent establishment of the Qualifying Free Zone Person and revenues derived from property located in the respective free zone are excluded from de minimis requirement since these incomes are subject to standard UAE corporate tax regime.

What are the other common questions or areas of uncertainty that companies operating in free zones have regarding the corporate tax rules?

Nabeel Ahmed: One of the conditions that requires compliance for free zone person to be eligible as a QFZP is to comply with the Arm’s length principle and transfer pricing (TP) documentation. I wouldn’t say areas of uncertainty but areas of concern for businesses are centred round evaluating the businesses’ current structure and transfer pricing policies to ensure that they don’t lose out on the benefit. Many businesses post coming of CT law have had to conduct an impact assessment on the existing structure of companies in free zones as there are restrictions in availing group tax reliefs and taxation on transactions of the mainland entities.

Siddharth Kohli: The taxability of service income earned by free zone companies from exports can be ambiguous, necessitating clarity from authorities. Thresholds such as the income threshold of Dh375,000, the Dh 5 million limit under de minimis calculation, the Dh12 million threshold for interest capping, and the Dh3 million threshold for qualifying for small business relief may require prorating if incorporation or liquidation occurs within the year. To address these complexities, seeking clarification from the relevant authorities becomes crucial for accurate interpretation and implementation of tax regulations.

How can companies in free zones determine their taxable income and ensure transparency in their accounting practices to mitigate compliance burdens?

Nabeel Ahmed: A QFZP, in order to maintain the zero per cent tax rate, would be required to prepare and maintain audited financial statements. An internal restructuring to ensure tax compliance could be achieved by setting up a new division or expanding the existing accounts division to have appropriate break-up/allocation of expenses incurred for earning qualifying income and other income. A QFZP will also need to review transactions/arrangements with related parties or connected persons as compliance with the arm’s length principle and transfer pricing (TP) documentation is a mandate under the CT law. Adherence to the above steps would ensure that QFZP are well quipped to ensure tax transparency and mitigate compliance burdens.

Siddharth Kohli: Free zone companies in the UAE should update and integrate their accounting systems to facilitate accurate reporting and identification of qualifying and non-qualifying revenue. This requires adapting the systems, allocating resources, conducting thorough testing, and providing comprehensive training to staff. These measures ensure a seamless transition and successful implementation of the necessary changes. There are lot of companies who are actively developing software solutions that will not only ensure compliance but also enhance transparency and accuracy in reporting for UAE free zones.

What strategies or measures should free zone businesses consider implementing to optimise their operations ahead of the upcoming phase of the corporate tax regime?

Nabeel Ahmed: The CT Law is effective as of June 1, 2023, therefore accurate accounting and auditing mechanisms is an indispensable requirement for Free Zone businesses. The announcement of the CT in the beginning of 2022 should have been treated and used as an opportunity to review legal, financial, governance and risk aspects of businesses because these have a causal effect on management decision and financial outcomes. All areas of structuring, contracting, commercial and employment should be reviewed, and updated, considering the new tax law. In addition, transactional flows and financial matters, governance and policy should be revisited to ensure tax readiness.

Siddharth Kohli: Upon the advent of corporate tax, inter-alia, the primary aspect of all activities that a free zone entity undertakes should be to comply with transfer pricing regulations, i.e. benchmark its transactions with related parties at an arm’s length price. Any substantial rejig in the operations would have to be looked at in light of the general anti abuse provisions provided under the corporate tax regime. However the minimum a free zone entity can do is to analyse their income sources, review legal structures, assess transaction structuring, and ensure compliance requirements and necessary documentation with the help of a tax consultant.