UAE Corporate Tax: Free zone-based businesses need to do a forensic on income streams

The history of UAE free zones dates back to the 1980s. Since then, they have been the backbone of the economy, with tax incentives to free zone persons (FZP), along with ease of regulations, world-class infrastructure, and strong government commitment, the catalysts for their development and growth.

With the introduction of Corporate Tax (CT) in the UAE, the question is whether the free zones will lose their sheen or continue to shine as before. While the UAE CT Public Consultation Document (PCD) provides for honoring the existing tax incentives to free zones, it is not that straightforward.

FZPs will have to maintain adequate substance, comply with regulatory requirements and get financial statements audited to benefit from a zero percent CT rate. Let’s discuss various scenarios which emerge for the future.

  • Where businesses have set up FZPs for housing the shared services function (such as Finance, Procurement, HR, IT, Treasury) for the group. With the introduction of a corporate tax regime coupled with domestic transfer pricing, now is the time to examine and insulate your FZP’s income from corporate taxation of 9 percent.
  • A FZP earning trading income from dealing with other FZPs will continue to benefit from the 0 percent CT rate. FZPs earning service income will have to wait for the final CT law as it is not clear from the PCD whether the benefit will be extended to service income or not.
  • A FZP earning passive income (interest, dividend, royalties and capital gains) from the mainland will continue to benefit from the 0 percent CT rate. Rental income is currently not mentioned under the category of passive income. A FZP with a non-core activity of renting an immovable property will have to evaluate whether rental income can be categorized as a passive income or not.
  • A FZP earning income from a mainland group company will also continue to benefit from the 0 percent CT rate. However, the payments would not be tax-deductible to the mainland group entity. Such scenarios may lead to significant group-level tax costs, necessitating a fresh look at the existing supply chain and business model.
  • Income from the sale of goods by a FZP located in a designated zone for VAT purposes to a mainland business being an importer of record will not affect the 0 percent CT rate. Further, if a FZP has a branch in the UAE mainland, it will be taxed at 9 percent on the mainland sourced income and at 0 percent on other income. A FZP earning any mainland sourced income other than mentioned above will lose the benefit of 0 percent CT rate with respect to all its income.

Tax implications on FZPs in case of transactions with the mainland will be one of the critical aspects in the UAE CT regime. FZP undertaking transactions with the mainland will have to be cautious with respect to the permissibility of the said transactions as non-compliance with the regulatory requirements shall lead to denial of benefit of 0 per cent CT rate for all income streams.

The method of allocation of income to a mainland branch of a FZP can be subjective in the absence of detailed guidance in this regard. It also needs to be seen whether compliance with economic substance regulations would be sufficient. Some clarifications in the final law in this regard may help.

The Government has shown its commitment to keeping free zones attractive by extending the corporate tax incentives. Businesses operating in free zones will have to review their existing supply chain and operating structure and remodel the same wherever necessary to ensure compliance with conditions for claiming the benefit of 0 percent CT rate.

It would be interesting to see whether the 0 percent CT rate benefit will be extended to MNEs (multinational enterprises) breaching the Pillar Two threshold and operating in free zones.

Perhaps, this is the ideal time to review business operations and maximize profits under the 0 percent tax rate and prepare for the 9 percent corporate tax.

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