Founded in the 1980s, UAE free zones have a long history. As a result of tax incentives, easy regulations, world-class infrastructure, and a strong government commitment, they have become the backbone of the economy.
Since UAE introduced Corporate Tax (CT), the question is whether or not the free zones will lose their sheen. However, honoring existing tax incentives to free zones is not as straightforward as it seems in the UAE CT Public Consultation Document (PCD).
In order to benefit from a zero CT rate, FZPs must maintain sufficient substance, comply with regulatory requirements, and have their financial statements audited. Here are some future scenarios we can discuss.
Where businesses have set up FZPs for housing the shared services function (such as Finance, Procurement, HR, IT, and Treasury) for the group. As a result of the introduction of corporate tax legislation along with domestic transfer pricing, now is the perfect time to look at and insulate your FZP’s income from corporate taxation of 9 %.
A FZP earning trading income from dealing with other FZPs will continue to benefit from the 0 % rate. FZPs earning service income will have to wait for the final CT law as it is not clear from the PCD whether the benefit will be extended to service income or not.
A FZP earning passive income (interest, dividend, royalties and capital gains) from the mainland will continue to benefit from the 0 per cent CT rate. Rental income is currently not mentioned under the category of passive income. A FZP with a non-core activity of renting an immovable property will have to evaluate whether rental income can be categorized as a passive income or not.
A FZP earning income from a mainland group company will also continue to benefit from the 0 per cent CT rate. However, the payments would not be tax-deductible to the mainland group entity. Such scenarios may lead to significant group-level tax costs, necessitating a fresh look at the existing supply chain and business model.
Income from the sale of goods by a FZP located in a designated zone for VAT purposes to a mainland business being an importer of record will not impact the 0 per cent CT rate. Further, if a FZP has a branch in mainland UAE, it will be taxed at 9 per cent on the mainland sourced income and at 0 per cent on other income. A FZP earning any mainland sourced income other than mentioned above will lose the benefit of 0 per cent CT rate with respect to all its income.
Tax implications on FZPs in case of transactions with the mainland will be one of the critical aspects in the UAE CT regime. FZP undertaking transactions with the mainland will have to be cautious with respect to the permissibility of the said transactions as non-compliance with the regulatory requirements shall lead to denial of benefit of 0 per cent CT rate for all income streams.
The method of allocation of income to a mainland branch of a FZP can be subjective in the absence of detailed guidance in this regard. It also needs to be seen whether compliance with economic substance regulations would be sufficient. Some clarifications in the final law in this regard may help.
The Government has shown its commitment to keeping free zones attractive by extending the corporate tax incentives. Businesses operating in free zones will have to review their existing supply chain and operating structure and remodel the same wherever needed to make sure compliance with conditions for claiming the benefit of 0 per cent CT rate.
It would be interesting to see whether the 0 per cent CT rate benefit will be extended to MNEs (multinational enterprises) breaching the Pillar Two threshold and operating in free zones.
Perhaps, this is the ideal time to review business operations and maximize profits under the 0 per cent tax rate and prepare for the 9 per cent corporate tax.