Corporate tax in the United Arab Emirates: companies based in free zones must carry out a forensic investigation of income streams

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The history of free zones in the UAE dates back to the 1980s. Since then, they have been the backbone of the economy, with tax incentives for people in free zones (FZPs), as well as simplified regulations, world-class infrastructure and strong government commitment, the catalysts for their development and growth.

With the introduction of Corporate Tax (CT) in the UAE, the question is whether Free Zones will lose their shine or continue to shine as before. While the UAE TC’s Public Consultation Document (PCD) calls for respecting existing tax incentives for free zones, it is not that simple.

FZPs will need to maintain proper substance, comply with regulatory requirements and have their financial statements audited to qualify for a zero percent TC rate. Let’s discuss various scenarios that emerge for the future.

  • When companies set up FZPs to host the shared services function (such as finance, purchasing, HR, IT, treasury) for the group. With the introduction of a corporation tax regime coupled with national transfer pricing, now is the time to review and isolate your FZP income from the 9% corporation tax.
  • An FZP that derives commercial income from its transactions with other FZPs will continue to benefit from the 0% TC rate. FZPs receiving service revenue will have to wait for the final TC law, as the PCD does not specify whether or not the benefit will be extended to service revenue.
  • An FZP receiving passive income (interest, dividends, royalties and capital gains) from the mainland will continue to benefit from the 0% rate of CT. Rental income is currently not mentioned in the category of passive income. A FZP with a non-essential activity of renting real estate will have to assess whether the rental income can be qualified as passive income or not.
  • An FZP receiving income from a continental group company will also continue to benefit from the 0% rate of corporate tax. However, the payments would not be tax deductible for the mainland group entity. Such scenarios can result in significant tax costs at the group level, requiring a fresh look at the existing supply chain and business model.
  • Income from the sale of goods by an FZP located in a designated area for VAT purposes to a mainland business as importer of record will not affect the 0% TC rate. Additionally, if an FZP has a branch in the mainland UAE, it will be taxed 9% on income originating from the mainland and 0% on other income. A FZP receiving income from continental sources other than those mentioned above will lose the benefit of the 0% CT rate on all of its income.

Tax implications on FZPs in case of transactions with the mainland will be one of the critical aspects of the UAE TC regime. FZP undertaking transactions with the mainland will need to be careful about the legality of said transactions as failure to comply with regulatory requirements will result in denial of the benefit of the 0% TC rate for all revenue streams.

The method of allocating income to a mainland branch of an FZP may be subjective in the absence of detailed guidance in this regard. It also has to be seen whether compliance with regulations on economic substance would be sufficient. Some clarification in the final law in this regard could be useful.

The government has shown its commitment to maintaining the attractiveness of free zones by extending tax incentives to businesses. Companies operating in free zones will need to review their existing supply chain and operating structure and reshape them if necessary to ensure compliance with the conditions of applying for the benefit of the 0% CT rate.

It would be interesting to see if the advantage of the 0% TC rate will be extended to MNEs (multinational enterprises) above the second pillar threshold and operating in free zones.

Now may be the perfect time to review business operations and maximize profits under the 0% tax rate and prepare for the 9% corporate tax.

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