UAE corporate tax: Free zone businesses need to check ‘disqualified income’

Since the launch of the UAE Corporate Tax Decree on 9 December 2022, business owners and tax advisors have been attracted by the two tax rates applicable to free zone registered entities. The law states that qualifying free zone entities will be taxed at 0% on their qualifying income – and 9% on taxable income on non-qualifying income.

The scope of “qualifying income” will be specified in an upcoming Cabinet decision.

The concept of two tax rates included in the Act is widely regarded as a welcome departure from the Public Consultation Document (PCD) issued earlier by the Ministry of Finance (MoF). This is because free zone entities can continue their normal business operations without losing tax exemption benefits. They can simply tax any income that does not qualify for the 0% rate without restructuring their business activities, especially those carried out within the UAE mainland/free zone.

The question is whether such celebrations are premature? On closer reading, the Act appears to be in line with the PCD’s provisions on free zone taxation. While you may have only read about “qualified” income and “disqualified” income, we’ve introduced you to a new concept of “disqualified” income.

Qualified Income – 0% tax

The PCD proposes a 0% tax rate on income earned:

• From transactions with companies outside the UAE;

• From trade with businesses located in the same or any other free zone;

• from certain regulated financial services for foreign markets; and

• Sale of goods from an entity located in a VAT designated area to a mainland UAE business, provided the latter remains the importer of record.

A 0% tax rate is also proposed on transactions between free zone entities and their group companies based in the UAE mainland, as well as on “passive” income earned from the mainland. This passive income may include interest and royalties, as well as dividends and capital gains from holding shares in UAE mainland companies.

Such income listed in the PCD may be classified as “qualifying income” under the Act.

The PCD provides differential tax treatment for free zone entities with branches in the UAE mainland. A free zone entity with a branch in the mainland will be taxed at 9% on its mainland sourced income.

Income from Mainland China may include income earned from customers in Mainland China. It may also include income generated from activities carried out in the continent, assets located, capital invested, rights to use or services rendered.

As a specific case, certain mainland source income may be taxed at 0% if it is “passive” in nature. For example, royalties for the use of intellectual property by a mainland client, or dividends received from capital invested in a mainland company, may be mainland-sourced income but still qualify as “passive” income taxed at 0%.

This is in line with the 9% tax rate proposed in the Act for income that is not “qualified income”. We call this “disqualified” income.

The PCD includes an important policy objective of preventing free zone businesses from gaining an unfair competitive advantage over those established on the mainland. The PCD states that if a free zone entity earns any mainland-sourced income (other than the qualifying and non-qualifying income mentioned above), the 0% tax rate on all its income will be abolished.

For example, if a free zone entity provides installation services in the mainland, or if a free zone enterprise provides services to overseas customers as well as mainland/free zone customers, will they lose their full tax exemption status?

Unlike the PCD, the Act does not contain any express provisions regarding such disqualification. However, the Corporations Tax Act does state that a free zone entity must meet conditions set by the Ministry of Finance to be eligible for tax exemption.

Taking into account the policy objective of preventing unfair tax preferences, it is not excluded that a free zone entity may be disqualified if its business activities include certain continental activities or other prescribed activities.

It is important for businesses to ask the right questions to understand the scope of the tax and its impact. Free zone entities may believe they can continue normal business operations by taxing “non-qualifying” income.

However, they must reflect on “non-qualifying” income. While a Cabinet decision is awaited on the exact scope of exemptions offered for free zones, the concept of “disqualification” revenue could be a hitherto unknown weakness for free zone businesses.