Unfolding Free Zone Corporate Tax Guide provisions

Free Zones are an integral part of the UAE economy and play a critical role in driving economic growth and transformation both in the UAE and internationally. In order to recognize the continued importance of Free Zones in UAE, the Federal Decree Law No. 47 of 2022 on “Taxation of Corporations and Businesses (‘CT Law’) enables Free Zone Persons (‘FZP’) to benefit from 0% corporate tax rate upon fulfilment of all the conditions (as prescribed below) i.e. if the FZP becomes a Qualifying Free Zone Person (‘QFZP’):

1. Maintains adequate substance in the Free Zone;
2. Derives Qualifying Income;
3. Satisfies the de minimis requirement;
4. Has not elected to be subject to Corporate tax;
5. Complies with Transfer Pricing regulations;
6. Maintaining Audited Financial Statements.

Non- Compliance to meet any of the aforementioned conditions shall lead to disqualification of a FZP to be a QFZP from the beginning of the relevant Tax Period in which such non-compliance occurred and for the subsequent four consecutive Tax Periods. This is also applicable, if the FZP elects to be subject to Corporate Tax.

Thereafter, Cabinet Decision No. 100 of 2023 and Ministerial Decision No. 265 of 2023 (collectively referred to as ‘Implementing Decisions’) were issued providing the requisite regulatory framework for implementation of Free Zone provisions.

Recently, with an intention to provide further clarifications regarding the taxability of FZP and addressing some of the important aspects necessary for free zone businesses, Federal Tax Authority, has issued a Comprehensive Corporate Tax Guide on FZPs.

We have summarised below the few important areas discussed in the aforesaid Free Zone guide:

1. What is FZP?

A FZP is defined as a juridical person incorporated, established, or otherwise registered in a Free Zone including a branch of a Non-Resident Person or a UAE juridical person that is registered in a Free Zone (for e.g.: A Branch of a Mainland Company incorporated in a Free Zone).

2. Conditions to become a QFZP

To be a QFZP, the Free Zone Person must meet all of the conditions as provided in the Corporate Tax Law and the Implementing Decisions

If a Free Zone Person does not meet all of the conditions, it will no longer be a QFZP and its income will be subject to the standard Corporate Tax rules and rates. A FZP will be deemed to be a QFZP unless one of the conditions to be a QFZP is not met, or if the QFZP makes an election to be subject to tax.

3. Tax Rates of QFZP:

A QFZP will be subject to Corporate Tax at the following rates:

1. 0% on Qualifying Income;
2. 9% on its Taxable Income that is not Qualifying Income

4. Taxable Income that is not Qualifying Income

To determine the amount of Taxable Income that is not Qualifying Income, which will be subject to the 9% Corporate Tax rate, a QFZP will need to:

1. Separate the Revenue in its Financial Statements into Revenue pertaining to the Qualifying Income component and to the Taxable Income component;
2. Allocate the expenses in its Financial Statements against those components in a reasonable manner, consistent with the arm’s length principle; and
3. Apply general rules for determining Taxable Income that is not Qualifying Income.

5. Adequate Substance

A FZP must maintain adequate substance in a Free Zone. Adequate substance needs to be seen in relation to adequate assets, full-time employees, and incurrence of an adequate amount of operating expenses in the Free Zone to perform core income generating activities.

A FZP must ensure to undertake its core income-generating activities relating to transactions and activities benefiting from the 0% Corporate Tax rate on Qualifying Income in a Free Zone (for distribution activities, this needs to be a Designated Zone). The core income-generating activities are the essential and value-adding activities that a Free Zone Person performs to generate Revenue from its Free Zone Business.

Further, it is important to note that adequate substance in a Free Zone (or in a Designated Zone for the Qualifying Activity of distribution) needs to be maintained throughout the Tax Period.

Determining adequate substance will depend on the nature and size of the business that the respective FZP is conducting.

A FZP may outsource its core income-generating activities to other Persons located in a Free Zone (or Designated Zone for distribution activities), provided it has adequate supervision of the outsourced activities. The FZP must put mechanisms and means in place to observe, oversee, assess, instruct, and provide guidance over the deliverables of the service provider in terms of quality, quantity, and timeliness in order to fulfill the adequate supervision requirement.

6. Qualifying Income:

The Free Zone Person must derive Qualifying Income from one or more of the following sources:

1. Transactions with Other FZP being Beneficial Recipient of such transactions and the transaction is not an Excluded Activity;
2. Transactions with a Non Free Zone Person (‘NFZP’) relating to Qualifying Activities that are not Excluded Activity;
3. Income derived from the ownership or exploitation of Qualifying Intellectual Property; or
4. Other Income provided FZP meets the de minimis requirement.

7. Understanding the concept of Beneficial Recipient:

Transactions between a QFZP person and another FZP are considered as Qualifying Activities and Income only where the recipient is the beneficial owner of the services/goods.

A FZP is considered to be the Beneficial Recipient of services or goods, if it has right to use and enjoy the services or goods and is not bound by a contractual or legal obligation to supply such services or goods to another person. Where the recipient is acting as a conduit or intermediary (for example, an agent or nominee) for a third party (including a Related Party or group entity), the Beneficial Recipient of that transaction is the third party and not the conduit or intermediary.

The Seller or Service Provider FZP may rely on a written statement or undertaking from the Purchaser or Recipient confirming that the Purchaser or Recipient is a Beneficial Recipient and will use the services or Goods for its Free Zone Business, unless the seller has reason to believe that such representation may be incorrect (for example, where the Goods are to be delivered to a third party directly by the FZP seller).

8. Qualifying Activities:

If a FZP sells services or goods to a NFZP, the QFZP can benefit from the 0% Corporate Tax rate if it derives Qualifying Income from transactions in respect of the Qualifying Activities.

While determining Qualifying Activities, it is important to consider the Ancillary Activities being conducted by the FZP. Activities that are necessary for the performance of the main Qualifying Activity or that make a minor contribution to the main activity and are so closely related to the main activity that these cannot be regarded as a separate activity, shall also be considered as Qualifying Activity by way of their ancillary nature.

Key Qualifying Activities have been discussed below:

1. Manufacturing of goods or materials

Manufacturing of goods as a process includes a wide spectrum of activities ranging between: 1) Product Planning, 2) Production and 3) Quality Control. A wide range of activities beginning from conception of a product to the end stage of production shall be covered within manufacturing such as conception, business plan, capital investment, R&D, input processing, output, quality control, etc. Further, improving or assembling pre-existing components shall also be included with in the purview of Manufacturing activities.

Both full-fledged and contract manufacturing shall be included within the Qualifying Activity criteria.

Activities that naturally and integrally complement the manufacturing activity shall be considered as ancillary in this regard.

1. Post sale activities such as installation, warranty, maintenance, etc. and customer support services and handling customer queries might be considered as Ancillary activities to the Manufacturing Activity. Ancillary activity does not include repairs. Repairs are typically classified as a service.

2. Trading of Qualifying Commodity

Qualifying Commodity refers to metals, minerals, energy and agriculture commodities that are traded on a Recognized Commodities Exchange Market in raw form.

Qualifying Activity of trading in Qualifying Commodity include buying and selling in relation to the Qualifying Commodity. Ancillary activities include warehousing (i.e. storage or housing) and delivery of Qualifying Commodity.

3. Holding of shares and other securities for investment purpose

Holding of shares and other securities for investment purpose shall be a Qualifying Activity. This includes investment planning, buying and selling securities, and portfolio management. Shares and other securities are deemed to be held for investment purposes when held (or there is an intention to hold and the QFZP can demonstrate its intention to hold) for an uninterrupted period of at least 12 months.

Qualifying Activity of holding of shares and other securities for investment purposes include: Investment planning, buying and selling securities and Portfolio management.

It is important to note that following activities would not be considered as Qualifying Activity:

1. Shareholders deriving income such as royalties or management fees from the Company Active trading of shares and other securities

4. Ownership management and operations of ships

Qualifying Activity shall include

1. Ownership, management and operation of ships used in the international transportation of passengers, goods or livestock,
2. Towing activities,
3. Provision of general assistance to Ships at sea,
4. Dredging activities at sea,
5. Leasing and chartering of Ships on a bareboat basis used in the international transportation of passengers, goods or livestock.

This activity does not include Ships used for local transportation or leisure or recreational purposes, or as floating hotels, restaurants or casinos.

5. Reinsurance Service

Reinsurance service means reinsurance operations that are regulated under Federal Law No. 6 of 2007. Any income earned by virtue of conducting reinsurance services (such as reinsurance premiums, underwriting fees, actuarial services, account management etc.) will be considered as income generated from a Qualifying Activity. This includes underwriting premiums, salvage and subrogation recoveries, claim handling or management and loss adjusting and claims management activities.

Investing activities, actuarial services and risk management activities may be considered as Ancillary activity to this activity.

6. Fund Management Services

Fund management primarily includes managing a specific portfolio of investments on behalf of third-party investors. This could be a mutual fund, a hedge fund, or a pension fund. Fund management services can be said to include Investment planning and strategy, investment diversification, asset allocation, fund management, and performance monitoring.

Activities such as financial advisory, training and education, financial planning and technological support may be considered as ancillary activity to this activity.

7. Wealth and Management Services

Wealth and investment management services includes the activities of providing discretionary and non-discretionary investment management and advisory services, portfolio management and wealth and investment advisory services. Such services will be Qualifying Activities if they are subject to the regulatory oversight of the relevant Competent Authority in the UAE.

Wealth and management services includes portfolio management, financial planning and asset allocation.

Activities such as risk management, market research, investment analysis and family governance may be considered as ancillary activity to this activity.

8. Headquarter services to Related Parties

Headquarter services to Related parties can be said to include activities such as taking relevant management/strategic decisions, incurring operating expenditure on behalf of the Group entities, coordinating group activities, financial management, central procurement services, human resource management, technical support, legal and compliance services, intellectual property management.

Activities such as training and development may be considered as ancillary activity to this activity.

9. Treasury and financing services to Related Parties

Treasury and financing services includes the provision of cash and liquidity management, financing, debt management, and financial risk management and related advisory services to Related Parties, including centralized payment and collection activities for or on behalf of Related Parties.

Treasury and financing services includes activities such as cash management, risk management, investment management and financing.

10. Financing and Leasing of Aircraft

Financing and Leasing of Aircraft includes the financing, leasing and securitization of the Aircraft, Aircraft engines or rotable component. It includes activities such as agreeing funding terms, financing; identifying and acquiring the Aircraft, Aircraft engines or rotable components to be leased; setting the terms and duration of any financing or leasing; monitoring and revising any agreements, lease management.

Activities such as credit analysis, portfolio management, disposal or sale of aircraft or any part thereof and asset management may be considered as ancillary activity to this activity.

11. Distribution of goods or materials in or from a Designated Zone

Distribution typically includes the process of transporting goods from a manufacturer, storing them, and selling them. Distribution of goods or materials in or from a Designated Zone to a person who resells or processes or alters such goods or materials or parts thereof for the purposes of sale or resale, can be a Qualifying Activity provided that such activity is undertaken in or from a Designated Zone.

Who is a Reseller?

If goods are distributed to a customer that the consumer uses or consumes, then the customer shall be end user. In case, the FZP sells goods to a customer being end user then such activity shall not be a Qualifying Activity.

A FZP that is engaged in the activity of distribution of goods or materials must conduct necessary due diligence (such as ‘know your client’ (“KYC”), seeking confirmation by way of an undertaking or a contract, etc.) to ensure that its customer is a reseller and not the end user, in order to fall within the scope of the Qualifying Activity.

High sea sales (i.e. Third port shipments) has been clarified to be considered as a Qualifying Activity.

12. Logistics Services

Logistics services includes the storage and transportation of goods or materials on behalf of another Person without taking title to the good or material of that other Person.

Logistics services includes transporting goods, warehousing, inventory management, declaration and documentation, freight forwarding services, order fulfilment, packing.

Activities such as supply chain management, customs brokerage and customer service may be considered as ancillary activities to this activity.

9. Transactions with natural persons – whether considered as Qualifying Activity?

All transactions with natural persons are treated as Excluded Activities (and hence not eligible for 0% corporate tax rate), except transactions in relation to the ownership, management and operation of Ships, fund management services, wealth and investment management services, and financing and leasing of Aircraft.

10. Tax Losses of QFZP

A QFZP cannot carry forward any losses incurred in relation to its Qualifying Income. However, any tax losses incurred on the Taxable income of the QFZP shall be allowed as a deduction against the Taxable Income if any derived in future years.

Any losses incurred prior to the commencement of Corporate Tax shall not be allowed as a deduction.

11. Ineligibility of a QFZP to claim certain reliefs available under Corporate Tax Law:

A QFZP shall not be allowed to claim below mentioned reliefs available under Corporate tax Law:

1. Small Business Relief
2. Qualifying Group Relief
3. Business Restructuring Relief
4. Ability to transfer or receive Tax Loss
5. Ability to be a member of a Tax Group

12. Compliances of QFZP

1. Maintain all records and documentation required for a period of 7 years following the end of the relevant Tax Period;
2. Obtain Corporate Tax Registration;
3. Prepare financial statements as per IFRS / IFRS SME as applicable;
4. Prepare audited financial statements;
5. Maintain sufficient documentation to demonstrate calculation of Qualifying Income;
6. Pay Corporate Tax (if any) and file Tax Return within 9 months from the end of the relevant Tax Period (in the form and manner prescribed by the FTA)

13. Key Takeaways and Conclusion

1. FZP shall be required to check with their respective Free Zone Authority to confirm whether they operate in a Free Zone or Designated Zone for Corporate Tax purposes;
2. Emphasis has been laid in the Guide on maintenance of adequate substance in the Free Zone/ Designated Zone, as the case maybe and ensuring that core income generating activities must necessarily be performed in the Free Zone/ Designated Zone to substantiate the adequate substance test.
3. Enhanced documentation and record requirements have been prescribed in the Guide to be fulfilled by a QFZP such as KYC/ Undertaking from customers to satisfy the beneficial recipient/ reseller test in case of distribution activity;
4. In case of Non-Qualifying Income which is taxable at the rate of 9%, it is important to ensure proper documentation and workings are maintained regarding segregation of revenue and allocation of expenses between qualifying and non-qualifying income.
5. It is important to continuously monitor that the Free Zone conditions are met by the QFZP throughout the tax period;
6. All QFZPs would be required to undertake necessary compliances such as obtaining Tax registration; ensure Arm’s Length Principle for related party and connected persons’ transactions; Transfer Pricing documentation; corporate tax return filing; statutory audit and ensure maintenance of robust documentation for a period of 7 years.

The UAE CT Guide on Free Zones provides for comprehensive guidance on various issues pertaining to taxation of Free Zone, covering detailed explanations on all Qualifying Activities including ancillary activities. Much awaited clarifications have also been included on areas such as third port shipment; exports from UAE; and eligibility of Free Zone benefit for a Free Zone Branch of a UAE Mainland Company. Furthermore, clarity has also been provided on various administrative aspects such as calculation of Qualifying and Non-Qualifying Income which shall be taxable, splitting of expenses and revenue, separate audit requirement for Non-Qualifying Income, etc.

Given the same, it is important to undertake a thorough assessment and revisit the tax positions already adopted to determine the eligibility of 0% corporate tax rate vis-à-vis all revenue streams for the company.