Free Zones UAE Corporate Income Tax

Free Zones and UAE Corporate Income Tax – a complicated harmony

Free Zones and UAE Corporate Income Tax – a complicated harmony

In the text of the public consultation, published by the UAE Ministry of Finance, it discusses its proposed regime for Free Zone Companies.

While the Corporate Income Tax concepts are thus far fairly straightforward, they are much less so for Free Zones.

Contrary to perhaps more simple exemptions for Free Zone companies in the Philippines or India, the UAE is implementing a fairly complex regime, trying to balance a number of interests.

Free Zones have been one of the success stories of the UAE, but incorporating there comes with limitations too, as e.g. the prohibition to trade with the mainland. In mainland, foreign businesses needed a local sponsor or shareholder.

In recent times, those lines have blurred, with more legal possibilities for foreign businesses to fully own a mainland businesses. In addition, free zones businesses were sometimes awarded a “dual license”, allowing them to operate in the mainland, and sometimes were even awarded importer codes.

The principle under the Corporate Income Tax Law which will be implemented with effect from June 2023, is that the UAE will honour the tax incentives currently being offered to Free Zone businesses that maintain adequate substance and comply with all regulatory requirements.

Presumably the reference to substance is a reference to the Economic Substance Regulations introduced in 2019 by way of Cabinet Decision No. 57 of 2020. It would be helpful if it is clarified whether for example a free zone business with a mainland branch can count its mainland substance towards the substance required for ESR purposes.

In addition, it is assumed that when a Free Zone business loses its tax exemption, the substance requirements are no longer applicable.

The CT exemption only continues to apply if the business solely transacts with other Free zone businesses (in the same free zone or another) or with third countries. This offers substantial possibilities, as JAFZA alone, according to its own claims, in 2019 contributed 23.8% to Dubai’s GDP (1).

There are some interesting considerations as regarding what constitutes transacting with the mainland. If a Free Zone business does so, without having incorporated a branch subject to CT, then the income of the Free Zone business is fully subject to CT. In other words, there is no more blanket exemption available.

What constitutes transacting with the mainland is interesting to note, as:

  • Free zone businesses in a Designated Zone for VAT purposes are not considered transacting with the mainland, if the buyer is the importer of record.
  • Conversely, assumed, though not made explicit, services rendered to the mainland are considered, and therefore such FZ businesses involved in these services will loose their tax exemption.

As regarding goods, there are a number of situations to be considered:

  • Free Zone businesses do not control the status of the Free Zone as a Designated Zone. Such a status needs to be applied for by the Free Zone Authority, and is subject to approval. Moreover, Free Zones can loose or gain Designated Zone status with retroactive effect. This has an adverse impact on legal certainty in regard to the application of the tax exemption.
  • There is a stark contrast with traders in a free zone (e.g. commodity traders), who may buy in mainland to sell in mainland, or to bring those goods into a free zone. Those seem to be excluded from the tax exemption, whereas they are conducting the same trade, just in the opposite direction.
  • Retail sales in the Designated Zone look to be at an advantage. For VAT purposes, they are subject to VAT, but when conducted by a Free Zone business with mainland and free zone branches, the mainland branches’ income is subject to CT, and the free zone branches in a designated zone are not.

Certain transactions are further allowed to be conducted with the mainland, such as situations where a free zone business earns passive income, i.e. interest, royalties, dividends and capital gains from mainland companies. This is good news for holding companies in free zones.

Transactions from a Free zone to a group company in mainland are also allowed without losing the benefit of the 0% CT. However, payments made to a Free zone business will not constitute a deductible expense for CT purposes.

So far, we have not identified an anti-abuse rule preventing a free zone company to make the charge to a business abroad, for that business to subsequently charge the mainland business, this nonetheless creating a deductible expense.

Group Treasury Centres or HQs often established in Free Zones may considered the non-deductibility on a group level a disadvantage. This may tempt groups to reconsider their structure, and put their regional headquarter in a different country with a low level of taxation (e.g. Bahrain or a gree zone abroad), and where payments would nonetheless be deductible. Additionally, the non deductibility looks limited to UAE Free Zones.

A business who relocates their Group Treasury Centre for example to a KSA Free zone, or a HQ, may continue to benefit from tax exempt income on the one hand, and deductibility on the other hand.

From a policy perspective, the UAE may consider an anti-abuse rule considering this situation, which may for example consist of defining a Free Zone in a broad enough manner in order for it to encompass foreign free zones as well, as no or only nominal tax jurisdictions in which activities may be relocated.

It is fair to say that due to the complexities, compliance will need to be closely monitored.

(1), consulted on 4 May 2022.