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Corporate Tax in UAE Free Zones – Clarification of qualifying income and material requirements for eligible free zone persons

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introduce

On 1 June 2023, the provisions of Federal Decree No. 47 of 2022 – Taxation of Companies and Businesses (also known as the “UAE CT Law”) came into effect and became an integral part of the UAE tax landscape. Consequently, the UAE imposes a corporate tax of 9% on most taxpayers.

On the first day of June 2023, the Cabinet and Minister of Finance released one of the most anticipated decisions to the public on the corporate tax regime for companies located in the UAE Free Zones[1].

The UAE CT Law introduced a class of taxpayers who can pay corporate tax at a reduced rate of 0% – Qualified Free Zone Persons (QFZP).

Due to the preferential treatment created above, entities must meet certain conditions in order to benefit from the 0% tax rate in the UAE:

  • Incorporate, establish or otherwise register in a free zone (including a branch of a non-resident registered in a free zone);
  • Maintain sufficient material in the UAE;
  • Procurement of “eligible income” as described in Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023;
  • Comply with the transfer pricing provisions of the UAE CT Law;
  • Application to become a regular CT taxpayer in the UAE is not in the form of an election.

Qualifying Income – What is it?

One of the biggest question marks for free zone operating businesses that are considering applying for the QFZP is what will be considered qualifying income and whether mainland-sourced income will affect QFZP status.

According to CD No. 55 of 2023, qualifying income can be derived from:

  • Transactions with other Free Zone Persons (also those Free Zone Persons who do not have QFZP attributes) who do not fall within the scope of the Excluded Activities.
  • Transactions with Mainland companies (or non-residents) that are qualifying activities but not excluded activities.
  • Any other income that satisfies at the lowest limit Require.

Eligible and excluded activities – what are those?

In MD No. 139 of 2023, the Minister of Finance has set out the list of activities considered as qualifying activities and excluded activities.

  1. Qualifying Activities:
    • Manufacture and processing of goods and materials.
    • Hold shares and other securities.
    • Ownership, management and operation of ships.
    • Activities subject to regulatory supervision by the competent UAE authorities:
      • Reinsurance Services.
      • Fund management services.
      • Wealth and investment management services.
    • Services provided to related parties:
      • Headquarters service.
      • Funding and financing services.
    • Aircraft financing and leasing (including engines and rotatable components).
    • Logistics Services.
    • Distribute goods/materials within or from designated areas[2] further distribution.
    • Supporting services for the above activities.
  2. excluded activities
    • Any transaction with a natural person, except transactions involving:
      • Ownership, management and operation of ships.
      • Fund management services.
      • Wealth and investment management services.
      • Aircraft financing and leasing (including engines and rotatable components).
    • Activities subject to regulatory supervision by the competent UAE authorities:
      • banking activity.
      • insurance activities.
      • Financing and leasing activities, other than activities related to related party funding and financing and aircraft financing and leasing.
    • Ownership or utilization of immovable property, excluding property within a free zone that is used exclusively for commercial rather than residential purposes.
    • Supporting services for the above activities.

Minimum requirements – how does it affect the business?

A QFZP may also receive income from sources that do not qualify as income as long as at the lowest limit fulfil requirements.

According to MD No. 139 of 2023, the amount that does not fall within the scope of qualifying income shall not exceed 5% of the total income of the QFZP during the tax period AED 5,000,000, whichever is lower. The decision also provides information on how the aforementioned limits are calculated.

Complying with the above restrictions and maintaining audited financial statements has been listed as one of the conditions for enjoying the QFZP.

The consequences of not meeting any of the conditions are severe, as a business that violates any of the conditions of the QFZP will cease to be a QFZP starting in the tax period in which the violation occurred and for the subsequent four years.

In fact, if the QFZP exceeds the amount obtained from the above ineligible sources at the lowest limit All taxable income arising during that period and the four subsequent incomes will then be subject to corporate tax at the rate of 9%. This could have a major impact on such businesses.

Conditions for keeping substances in free zones as QFZP

The latest decision also clarifies how businesses should understand the conditions of maintaining substance in the UAE.

According to CD No. 55 of 2023, a business needs to carry out its core income-generating activities in a free zone, fulfilling this condition will consider whether the business:

  • Own enough assets in the free zone.
  • Have a sufficient number of qualified employees in the free zone.
  • Generate sufficient operating expenses in the free zone.

Sufficiency will be measured against the level of activity undertaken by businesses applying for QFZP status.

The decision also mentions that outsourcing is allowed, however, only if related parties located in the free zone or entities with sufficient supervision of the outsourcing activities by the QFZP.

What’s next for businesses operating in free zones?

These decisions provide much-needed guidance and understanding of what taxpayers need to meet to obtain QFZP status. Some conditions, especially around substance, can still create some blurred lines, so we recommend seeking professional advice to assess whether a business meets all the criteria of the QFZP.

As with any business-related decision, businesses should conduct an in-depth pros and cons analysis to determine whether application for QFZP status is beneficial to the organization.

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