UAE Corporate Tax: The Pros and Cons of Free Zone Businesses

The UAE Ministry of Finance has announced that corporate tax awareness sessions will be held in Sharjah and Dubai on June 21 and 22. Among businesses and stakeholders, free zone companies that generate income from trading activities will be keen to learn about their future under corporate tax laws.

Last week, we raised the issue of potential tax implications for dropshipping transactions. This issue deserves a detailed discussion.

Eligible income – taxed at 0% – includes income derived from the distribution of goods within or from designated areas to non-free zone persons. The activity of distributing the goods must be carried out within or from the designated area.

It needs to be clarified whether the condition “at or from DZ” should be tested against the location of the distributor or the location of the goods. In the latter case, not only income from direct shipping may be subject to a 0% tax, it may also result in a violation of the minimum conditions if such income exceeds AED 5 million (or 5% of the gross income).

This will apply regardless of the location inside or outside the specified area.

In the case of the former, a company incorporated in a free zone that is not a designated area will face a special difficulty. Qualifying Free Zone Persons (QFZP) – eligible for the 0% tax rate – may be located in a free zone (whether designated or not).

However, qualifying distribution activities must be within or from within the designated area. Companies incorporated in such free zones (non-designated zones) may not be able to consider trade income from direct international shipments as qualifying income.

If dropshipping is not deemed eligible for qualifying income, the next best assessed alternative is to store the goods in a designated area. One could argue that the distribution activity is carried out in a designated area and should qualify as qualifying income.

However, even if the distributor is not in the designated area, if the goods are actually stored in the designated area, can the distribution income apply for a 0% tax rate?

To qualify as a qualifying free zone person, the entity must, inter alia, conduct its Core Income Generating Activities (CIGA) within the free zone and maintain sufficient substance. CIGA may outsource to affiliates or third parties within the free zone. A point has been made on social media that warehousing (in designated areas) could be outsourced by free zone companies in non-designated areas.

But can the qualifying activity itself be outsourced? People need to know if there is a difference between CIGA and qualifying activities. For example, can a free zone company outsource manufacturing activities and still qualify for the 0% tax rate?

Distribution Activities – Classified as Eligible Activities – Source of procurement of goods not specified. It is unclear whether goods sold in or from designated areas (including exports) can be sourced from mainland suppliers.

There is also a need to review whether mainland suppliers can include related parties. Clarifying these points may affect the restructuring of business operations and potential anti-abuse implications.

It must be remembered that income earned by a Free Zone Company may be subject to taxation if it is attributable to a domestic permanent establishment, i.e. mainland. This will include a place where the management and commercial decisions necessary to conduct the business are essentially made.

For trading companies operating in the Mainland and Free Zones/Designated Zones, the management location will be an important point of compliance. To maintain eligibility for the 0% tax rate, they should ensure that the trading income is not attributed to the domestic permanent establishment.

As has been said many times, taxation will be a paradigm shift for businesses in the UAE. It’s important for business owners to ask the right questions to fully understand the tax impact on their operations.