The Federal Tax Authority (FTA) released a guide on 1 May 2024 that provides valuable insight and in-depth explanations regarding the application of the corporate tax (CT) law to UAE free zone persons (FZPs). The guide is not a legally binding document but is intended to be read in conjunction with the CT law and Cabinet and Ministerial decisions.
The background to this guide is that the CT law allows the income from certain ‘qualifying activities’ to be taxed at a zero rate. The law relating to this relief is complex and certain matters could be open to interpretation. The guide clarifies the FTA’s interpretation on a number of key points.
As stated in the guide, free zones are an integral part of the UAE economy and play a critical role in driving economic growth and transformation. Free zones offer businesses various benefits, such as relaxed foreign ownership restrictions, streamlined administrative procedures, modern and sophisticated infrastructure, developed business communities, and the availability of additional legal entity forms and commercial activities. To recognise the continued importance of free zones, the UAE CCT rules enable free zone companies and branches that fulfil certain conditions to benefit from a 0% CT rate on certain qualifying activities.
Very broadly, to qualify for free zone relief, an FZP must:
The guide offers additional information on various qualifying activities as follows:
Documentation must be maintained to demonstrate the arm’s length nature of the relevant transactions, and a master file, local file and disclosure form for the FZP must be prepared if the relevant transfer pricing compliance thresholds are exceeded.
The background to this guide is that the CT law allows the income from certain ‘qualifying activities’ to be taxed at a zero rate. The law relating to this relief is complex and certain matters could be open to interpretation. The guide clarifies the FTA’s interpretation on a number of key points.
As stated in the guide, free zones are an integral part of the UAE economy and play a critical role in driving economic growth and transformation. Free zones offer businesses various benefits, such as relaxed foreign ownership restrictions, streamlined administrative procedures, modern and sophisticated infrastructure, developed business communities, and the availability of additional legal entity forms and commercial activities. To recognise the continued importance of free zones, the UAE CCT rules enable free zone companies and branches that fulfil certain conditions to benefit from a 0% CT rate on certain qualifying activities.
Very broadly, to qualify for free zone relief, an FZP must:
- Maintain adequate substance in a free zone;
- Generate qualifying income;
- Not have elected to be subject to the standard CT rules and rates;
- Comply with the arm’s length principle;
- Maintain transfer pricing documentation;
- Maintain audited financial statements;
- Pass a de minimis test. This test is met if the FZP’s non-qualifying income does not exceed the lower of AED 5 million or 5% of its total revenue; and
- Fulfil any other conditions set by the minister.
Adequate substance
On the subject of adequate substance, the guide confirms the following points:- The FZP must carry out core income-generating activities for the qualifying activity in a free zone (or designated zone (DZ) if the qualifying activity is the distribution of goods from a free zone) during the tax period. Non-core activities can be conducted outside a free zone provided they do not directly drive sales or are routine in nature. Activities can be outsourced but an FZP needs to establish methods to monitor, evaluate, guide and give instructions on the service provider in terms of quality, quantity and timeliness. This should be documented in agreements and supported by the parties' actions.
- The FZP must have adequate substance in the free zone or DZ throughout the period. This is determined by reference to having adequate assets and qualified full-time employees in the free zone or DZ and incurring an adequate amount of operating expenses. This must be assessed on a case-by-case basis and determining what constitutes adequate substance will depend on the nature and size of the business. Double counting of employees is not allowed.
Qualifying activities
The definition of qualifying activities encompasses activities that are ancillary to the primary qualifying activity. An activity is considered ancillary if it is essential for the execution of the main activity or if it provides a small contribution to the main activity and is closely connected to it without being regarded as a distinct activity.The guide offers additional information on various qualifying activities as follows:
- Manufacturing of goods or materials: Goods mean tangible (not intangible) items. Software embedded in hardware would generally be considered goods. Manufacturing covers both fully-fledged manufacturing and contract or toll manufacturing (irrespective of the contractor’s location). Manufacturing excludes repair services as this is a service involving the restoration or repair of existing products to their original or functional condition, as opposed to the creation of a new product (manufacturing) or the significant alteration of a product's form or characteristics (processing).
- Processing of goods or materials: Processing is normally the intermediary stage in the production process, although exceptions exist where it may serve as the final step. It is important to note that processing extends beyond manufacturing and can occur when an object undergoes a transformation without creating a new product. The term ‘processing’ conveys the idea of consistent or ongoing actions carried out on a tangible item.
- Trading of qualifying commodities: This covers ‘raw form’ commodities and raw commodities that have undergone minimal processing, such as cleaning, sorting, grading and minor refining to meet quality and uniformity standards for commodity exchanges.
- Holding of shares and other securities for investment purposes: This includes cryptocurrency investments. For shares and other securities to be classified as held for investment purposes, they must be held for an uninterrupted period of at least 12 months or there must be a clear intention to hold them, and the FZP must be able to demonstrate this intention. It may be assumed that a transaction is not made with an individual if the person trades shares and securities on a recognised stock exchange and the 12-month ownership test is satisfied.
- Wealth and investment management services: Wealth and investment management is a comprehensive service that goes beyond fund management. It covers all aspects of a person's finances, including retirement planning, estate planning, tax planning and budgeting. Wealth managers develop personalised plans to help clients achieve their short- and long-term financial objectives.
- Headquarter services to related parties: An FZP is considered to provide headquarters services if it offers specific services to resident or nonresident related parties. A headquarters company can be responsible for the group’s overall success or an important aspect of the group's performance, while also ensuring corporate governance. To be considered as taking responsibility for a group’s success, an FZP may need to provide strategic services, senior management, assume material risks or give substantive advice on managing risks.
- Treasury and financing services to related parties: Treasury and financing services include cash pooling and centralised payment or cash collection activities for, or on behalf of, related parties including domestic permanent establishments (PEs) and self-investment. Interest income will be treated as arising from treasury and financing services to related parties provided the FZP maintains adequate substance in relation to the activity.
- Distribution of goods or materials in or from a DZ: The distribution of goods or materials outside the UAE (i.e., high sea sales or third port trading) by a person based in a DZ will be considered a qualifying activity. The person involved in distributing goods or materials must perform due diligence to ensure that their customer is not the final user to fall within the scope of the qualifying activity. Sales agents or consultants who only help the purchase or sale of goods or materials without directly participating in the actual transaction are not considered to be carrying out the qualifying activity of distribution.
- Logistics services: An FZP conducts most of its logistics operations within a free zone for clients in the UAE or abroad while offering last mile delivery services outside the free zone in the UAE or another country. Despite the delivery services being outside the free zone, they are considered to be part of the qualifying activity of logistics services.
Transfer pricing
The FZP must apply the arm’s length standard and the transfer pricing rules to qualify for the zero rate. In this regard, a profit allocation between a FZP and its domestic/foreign PE should follow a two-step approach:- Conduct a functional analysis of the FZP PE; and
- Determine compensation based on functions, assets and risks.
Documentation must be maintained to demonstrate the arm’s length nature of the relevant transactions, and a master file, local file and disclosure form for the FZP must be prepared if the relevant transfer pricing compliance thresholds are exceeded.
Other considerations
- De minimis requirement: For the computation of the de minimis threshold, the revenue attributable to a PE is determined by applying the arm’s length principle.
- Audited financial statements: A qualifying FZP must have audited financial statements for CT purposes. It does not need separate financial statements for its qualifying income and other income or for any of its branches, but it should have sufficient documentation to demonstrate the qualifying income calculation.
- Registration: An FZP (including a QFZP) must register for CT within the prescribed timelines. However, a nonresident company with a branch in a free zone and that only earns UAE-source income is not obliged to register for CT purposes.
- Designated zones: The distribution of goods is treated as a qualifying activity only if it is conducted in a DZ. For these purposes, the DZs listed for VAT purposes will be considered DZs for CT purposes.
- Verification: The guide states that taxpayers should verify with their free zone authority that they function in a free zone or DZ for customs and tax purposes.
- Domestic/foreign PE: A head office in the UAE or a branch of a foreign company within a free zone would generally be considered a domestic/foreign PE. The guide contains information on the constitution of a PE for the FZP.
- Satisfaction of beneficial recipient of goods or services: An FZP selling goods or services to another FZP may rely on a written statement or undertaking from the latter confirming that it is the intended recipient of the goods or services and will use them for their free zone business unless there is a valid reason to doubt the accuracy of such representation.
- No qualifying income in first taxable period: A FZP that has no qualifying income during a tax period due to not commencing revenue generation will be deemed to satisfy the qualifying income criteria if it does not earn any non-qualifying revenue.
- Re-evaluating eligibility after the first taxable period: If a FZP fails to satisfy the conditions in the first taxable period, it can opt to be a qualifying FZP after the end of the five-year period. Not fulfilling the conditions for Years 2 to 5 does not affect eligibility for re-qualification.
- Loss setoff: Tax losses incurred in relation to taxable income are eligible to set off and carry forward against a qualifying FZP’s taxable income. However, income from non-qualifying intellectual property may only be offset against tax losses from such intellectual property.
Potentially affected taxpayers should review the FTA guide carefully and understand its contents as the benefit of the zero rate will be lost for the current year and the next four years if the conditions are not fulfilled in the first year.
Ashish Athavale
Brian Conn
Mufaddal Safdari
BDO in United Arab Emirates