With the Corporate Income Tax (CIT) regime planned to be introduced in the United Arab Emirates (UAE) next year (2023), many businesses are examining the impact of the reforms on their existing business structures. 

Free Zones have played a large part in the economic development of the UAE, attracting foreign businesses with relaxed requirements and tax benefits. The tax regime applicable to Free Zone businesses has evolved greatly in the last years, with the introduction of VAT in 2018 and CIT planned to be introduced in 2023 respectively.

What is the applicable regime? We provide you with a recap in this article.

Highlights of the proposed UAE CIT system

The CIT system will be implemented with effect from June 2023. The headline rate will be 9% for taxable income earned in an year exceeding AED 375,000 (slightly above $100,000). This is globally a very competitive rate, and even within the Gulf states, it is the lowest among states that have a CIT regime. 

The Public Consultation Document issued by the Ministry of Finance states that the CIT regime will apply to the following persons

• UAE companies and other legal persons incorporated in the UAE.
• Foreign legal entities that have a Permanent Establishment (PE) in the UAE. 
• Individuals (natural persons) engaged in a business or a commercial activity in the UAE. 

The calculation of taxable income would be aligned with the international accounting standards. Like most tax systems, the taxpayer would be able to deduct most expenses that are incurred in the process of generating revenue, subject to expense deduction limitations. Likewise, losses can also be generally carried forward from one year to the next and setoff against future profits. 

UAE resident companies will generally be subject to CIT on their worldwide income, including capital gains. There are certain exceptions to this rule. 

To retain and further develop the UAE’s status as an international financial and regional hub, the UAE has proposed many reliefs intending to reduce the effective tax rate or simplify matters administratively for businesses.

Amongst others, it has envisaged adopting a so-called ‘participation exemption’ which is relatively common. Here, a UAE Corporate shareholder would generally be exempt from CIT on dividends received and capital gains earned from the sale of shares of a subsidiary company, subject to fulfillment of both of the following two conditions:

• The UAE Corporate shareholder owns at least 5% of the shares in the subsidiary company.
• The (foreign) subsidiary is subject to CIT at least 9%. 

Finally, we come to grouping options available under the proposed regime. Such grouping may reduce the effective tax rate of a group containing several businesses. The objectives of providing the grouping facility are:

• To allow one group member’s loss to be setoff against another group member’s profits.  
• To treat the whole tax group as a single taxable person, with the parent company responsible for the administration and payment of CIT on behalf of the tax group. 
• To ignore the transactions between the members of the tax group. 

A UAE resident group of companies can elect to form a tax group if the parent company holds at least 95% of the share capital and voting rights of the subsidiaries. 

Where the parent company does not meet the 95% criteria and instead holds 75% of the ownership of the subsidiaries, it can still seek to transfer losses from a loss-making group company to a profit-making group company, as long as both the following conditions are met:

• The company transferring losses is neither exempt nor benefits from the 0% Free Zone regime. 
• The total tax loss offset ought not to exceed 75% of the taxable income of the company receiving the tax losses for the relevant period. 

In addition to the above-mentioned facilities, the proposed UAE CT regime will also allow for an exemption or deferral of CT in respect of the transfer of assets or liabilities between members of a group, to avoid triggering an unnecessary tax charge when businesses reorganize themselves. The CT regime would also allow some corporate reorganization transactions (e.g., mergers) to be undertaken on a tax-neutral basis.  

What about the Free Zone tax exemption and Corporate Income Tax?

Companies and branches that are registered in a Free Zone (Free Zone Persons) are within the scope of the CIT regime and subject to filing requirements. 

The UAE Government has committed, however, that the tax exemptions will continue to apply to Free Zone Persons provided they (i) maintain adequate substance, (ii) comply with all other regulatory requirements, and (iii) income is earned from transactions with businesses located outside the UAE, or from trading businesses located in the (same or any other) Free Zone.

The complications start when Free Zone businesses interact with businesses located in Mainland UAE (Mainland Persons). Let’s consider a few scenarios here:

• A Free Zone business (that does not have a branch in the Mainland) transacting with a Mainland business: 

– If the income is passive (like interest, royalties, dividends, and capital gains from owning shares in Mainland Persons) – 0% CIT.

• A Free Zone business (that has a branch in the mainland): 

– Taxed on the Mainland Sourced income. 

– Not taxed on its other income. 

• A Free Zone business transacting with a (group company) Mainland business: 

– 0% CIT, but 

– Payments made by the Mainland business to its group company in Free Zone will not be deductible. 

• A Free Zone business located in a Designated Zone for VAT purposes earning income from the sale of goods to a Mainland business: 

– 0% CIT, if 

– The Free Zone business is the importer of record of those goods. 

• A Free Zone business earning income by transacting with a Mainland Person (not covered in any of the above four scenarios): 

– Such Free Zone Person will have its 0% CIT privilege disqualified for all of its Income. 

Fair to say, that there are a number of complexities involving Free Zones. 

UAE VAT 

VAT was introduced in the UAE on 1 January 2018 at a standard rate of 5% on the supply of goods and services. 

VAT is a broad-based consumption tax levied on almost all supplies of goods and services in the UAE, including deemed supplies, as well as the importation of goods into the UAE.

Like most VAT systems, VAT in the UAE avoids a cascading effect on tax (tax on tax) by allowing the Input tax to be subtracted from the output tax liability. Generally, Input tax can be recovered (subtracted from output tax) when goods or services are (intended to be) used for making taxable supplies in the UAE or supplies outside the UAE. 

The term ‘goods’ here refers to all types of physical property. Any supply that does not constitute a supply of goods, is a supply of services.   

The provisions relating to place of supply and valuation of supply are mostly in line with international standards. Some benefits are offered to supplies made in certain Free Zones (referred to as Designated Zones) discussed in the next headline. 

UAE VAT and Free Zones 

When the UAE Government introduced the concept of Free Zones, it did not envisage the requirement of a VAT system at that time. Accordingly, to ensure that the UAE continues to remain a competitive trading and investment destination even after the introduction of the VAT law, some relief is available for the sale of goods. For the supply of services, however, there are no exceptions made to the regular VAT system, except for the shipping of goods from a Designated Zone, if supplied by the same supplier of the goods.

Some businesses in some Free Zones benefit from an exception. These Zones are referred to as ‘Designated Zones’. The list of Designated Zones that are effective as of date is provided in Appendix 1. 

Designated Zones are defined as a specific fenced geographic area and has security measures and Customs controls in place to monitor entry and exit of individuals and movement of goods to and from the area. 

Designated Zones are treated as being outside the State for VAT purposes for certain supplies of goods. This means that a supply of goods within a Designated Zone is treated as made outside the UAE, and therefore, outside the scope of VAT in the UAE. 

Even though Designated Zones are considered to be outside the State, a sale from Mainland UAE to the Designated Zone is taxable at the standard rate of 5%.  

The situations involving a Designated Zone where VAT liability generally become due (treated to be imported into the UAE) are either of the following:

• Goods are consumed within the Designated Zone.
• Goods are rendered unaccounted for. 
• Goods are taken out of a Designated Zone and into Mainland UAE (including Free Zones not considered as Designated Zones). 

In short, the VAT implications of transactions with entities in the Designated Zones can be summarized below: 

• Domestic sale from the UAE to a Designated Zone – 5%.
• Domestic sale from Designated Zones to the UAE Mainland – Import taxable at 5%.
• Domestic sales from Designated Zones to Designated Zones – VAT is not applicable.
• Domestic sales within the same Designated Zone – VAT is not applicable (except for retail sales).
• Export from Designated Zones to GCC countries/non-GCC countries – VAT is not applicable (outside the scope of VAT).

APPENDIX 1

List of Designated Zones in the UAE

Abu Dhabi

• Free Trade Zone of Khalifa Port
• Abu Dhabi Airport Free Zone
• Khalifa Industrial Zone
• Al Ain International Airport Free Zone 
• Al Butain International Airport Free Zone

Dubai

• Jebel Ali Free Zone (North-South)
• Dubai Cars and Automotive Zone (DUCAMZ)
• DAFZA Industrial Park Free Zone – Al Qusais
• Dubai Aviation City
• Dubai Airport Free Zone
• International Humanitarian City – Jebel Ali
• Dubai CommerCity

Sharjah

• Hamriyah Free Zone
• Sharjah Airport International Free Zone

Umm Al Quwain

• Umm Al Quwain Free Trade Zone in Ahmed Bin Rashid Port 
• Umm Al Quwain Free Trade Zone on Sheikh Mohammed Bin Zayed Road

Ras Al Khaimah

• Ras Al Khaimah Port Free Zone
• RAK Maritime City Free Zone
• Al Hamra Industrial Zone – Free Zone
• Al Ghail Industrial Zone – Free Zone
• Al Hulaila Industrial Zone – Free Zone

Fujairah

• Fujairah Free Zone
• FOIZ (Fujairah Oil Industry Zone)

Designated Zones – Ajman

• Ajman Free Zone