To Qualify or not to Qualify: Analysis and Tax Advisory on the UAE Free Zone Regime, Interaction with Pillar Two, and Beyond

To Qualify or not to Qualify: Analysis and Tax Advisory on the UAE Free Zone Regime, Interaction with Pillar Two, and Beyond


On 31 January 2022, the Ministry of Finance (“MoF”) announced that the United Arab Emirates (“UAE”) will introduce a federal Corporate Income Tax (“CIT”) on business profits that will be effective for financial years starting on or after 01 June 2023. This was followed by the release of a Public Consultation Document (“PCD”) in April of 2022 before the publication of the CIT legislation on 9 December 2022.

One of the key elements addressed in the PCD and CIT legislation is with respect to the UAE’s Free Zone Regime. The UAE Free Zone Regime is a system of economic zones established in the UAE that offer favourable conditions for doing business. The Free Zones offer a range of benefits, including 100% foreign ownership, certain tax incentives (including 0% CIT) and simplified administrative procedures.

Subject to certain conditions (summarised in further detail below), “Qualifying Income” of a Qualifying Free Zone Person (“QFZP”) will remain subject to a 0% tax rate under the CIT law for the remainder of the tax incentive period, as provided for in the applicable legislation of the Free Zone in which the QFZP is registered.

As we approach the introduction of the UAE’s CIT regime, many of the burning questions for businesses operating in the UAE revolve around the UAE Free Zone Regime. In particular, the central theme of many people’s inquiries concerns the definition of “Qualifying Income”, which remains subject to a Cabinet Decision.

Given that Non-Qualifying Income shall be subject to CIT at the standard rate of 9%, it is critically important for businesses to understand this definition to appropriately forecast their future tax liability, distributable reserves and manage shareholders’ expectations regarding post-tax profitability etc.

In addition, there are many other practical considerations which taxpayers will be keen to understand going forward. Below we give a short summary of where we stand as well as our thoughts on a number of the key queries and recommendations for businesses in relation to their Free Zone operations.    

Where We Stand

According to Article 18 of UAE CT legislation, an entity operating in a Free Zone is considered a QFZP where it meets all of the following conditions:

Where all these conditions are met, a QFZP shall be subject to zero percent CIT on its Qualifying Income while being subject to tax at 9% on its non-Qualifying Income. Another condition, although not expressly provided in CIT legislation but based on Ministerial Decision No. 73 issued on 6 April 2023, is that a QFZP cannot elect for the Small Business Relief under Article 21 of UAE CT legislation, such that the two regimes are fundamentally alternative.

As discussed above, however, the most critical aspect is that a definition of Qualifying Income is not provided in the CIT legislation but remains subject to a Cabinet Decision yet to be published.

Our Thoughts

In the wait for the Cabinet Decision, one can only advance some hypotheses regarding the scope of application of CIT to QFZP. Below we have outlined some initial thoughts and considerations in relation to each of the abovementioned conditions:

Adequate Substance: We expect this condition will be linked to the Economic Substance Regulations (“ESR”) and the specific criteria used therein. This is primarily due to the Federal Tax Authority’s (“FTA”) familiarity with this approach. Moreover, many Free Zone Persons are already subject to ESR reporting requirements, so it should not cause a major additional administrative burden for the tax administration or the taxpayers. Finally, the lexicon used in the ESR reporting requirements (i.e., “Relevant Activity” and “Core Income Generating Activity”) may suggest a possible analogy between the two pieces of legislation.

Free Zone Persons that do not currently file ESR reports should familiarise themselves with the content and structure in order to best prepare for the future substance requirements.

While we expect that the substance requirement will be linked to the ESR, at the same time, one of the comments that was made by the MoF in its UAE CT Awareness Sessions was that they have so far not decided on whether the ESR regime itself will continue after the CT regime is implemented. More details on this aspect will be issued by the MoF.

Qualifying Income: As outlined above, the definition of Qualifying Income remains the most controversial issue for most businesses operating in the UAE or looking at this geographical area to expand their activities. .Although it is not definitive, the expectation is that the scope of Qualifying Income under the UAE CIT legislation will be broadly in line with the PCD.

In this regard, it is worth noting that while the PCD did not include the terms Qualifying or non-Qualifying Income, it did outline certain types of income earned by Free Zone entities that will be subject to zero percent UAE CIT. We have summarized these below:

  1. Income earned from transactions with businesses located outside of the UAE or income from trading with businesses in the same or another Free Zone.
  2. Passive income earned from UAE-mainland. Such income includes interest, royalties, dividends, and capital gains from owning shares in UAE-mainland companies.
  3. Income earned from transactions with a UAE-mainland group company. However, to maintain tax neutrality, the UAE-mainland group company will not be able to deduct the corresponding expense.
  4. Income earned from the sale of goods from Designated Zones to buyers in the UAE mainland where the buyer is the importer of record. We have written a piece explaining the nuances of the interplay between the VAT Regime and the Free Zone regime earlier on our website.


Currently, it is assumed that the above income streams would constitute Qualifying Income. However, this ultimately remains subject to the anticipated Cabinet Decision. Being a critical issue for many businesses, we expect specifications in this regard to be disclosed imminently.

Although the PCD remains our best point of reference for Qualifying Income, we note some critical divergences between the PCD and the CIT legislation. For example, reference to both Qualifying and non-Qualifying Income in the CIT legislation suggests partial qualification is available, whereas the PCD implied an “all or nothing” approach whereby any amount of other UAE-mainland sourced income would disqualify a Free Zone Person from the 0% rate in respect of all their income.


While this is a welcome change for businesses with a mix of mainland and foreign-sourced income, it does present some additional practical questions in terms of the calculation of CIT payable on the Non-Qualifying Income of a QFZP. For example:

 ·       Would the AED 375,000 income threshold before applying the 9% CIT rate be charged to the non-Qualifying Income of a QFZP, or would Qualifying Income also be taken into account for the calculation of the AED 375,000 income threshold?

·       What is the appropriate method for allocating cost between Qualifying and non-Qualifying Income to determine the final tax liability?


In relation to the first question, it would be prudent at this stage to assume that the income threshold would not apply to non-Qualifying Income of a QFZP. This is supported by the fact that the tax rates applicable for QFZPs are defined in a separate section of Article 3 of the CIT legislation. However, this should become clearer upon issuance of the Cabinet Decision.


With respect to the second question, this should be determined through a combination of appropriate management accounting, transfer pricing policies (for intercompany transactions) as well as preparation of adequate documentation to support the allocation in the event of future audits. In this regard, we expect this to be an area that the FTA will scrutinize due to the potential for manipulation and ultimate reduction of tax payable.


Election for 9%: Under the CIT legislation, QZFPs have the option to ‘elect’ to be subject to tax at the 9% standard rate. Many readers may question why anyone would elect out of such a beneficial regime, if available to them. In this regard, notwithstanding the obvious benefit of the 0% rate there are some restrictions associated with being a QFZP.


For instance, a QFZP cannot become a member of a tax group, it cannot transfer losses to related parties or offset losses from related parties where those related parties are subject to the standard 9% rate.  Furthermore, some of the benefits associated with the Free Zone Regime may be largely diminished for multi-national groups that are within scope of Pillar Two. This is discussed in further detail below.


In spite of the above, we expect the Free Zone regime to remain attractive to the large majority of taxpayers. However, our recommendation would be for businesses to perform a holistic assessment of their UAE operations to determine whether the election may be convenient for them once the Cabinet Decision is made public. This should include an assessment of the group’s entire presence in the UAE as well as a cost-benefit or financial modelling exercise to understand whether there is sufficient value in availing of the Free Zone regime.


Transfer Pricing: As part of introducing CIT legislation, the UAE shall also adopt formal Transfer Pricing (TP) regulations for the first time. TP is predicated on the arm’s length principle, which states that the commercial and financial arrangements between related parties are conducted in a manner that is consistent with arrangements between independent enterprises.


In the event that foreign-sourced related party income meets the definition of Qualifying Income, there will be additional scrutiny on payments made to QFZPs going forward from the counter-party jurisdiction. The requirement for transactions to meet the arm’s length principle aligns with the UAE’s commitment to transparency and alignment with international best practices. Additionally, it is important to note domestic transactions are also in scope of TP. As such, Free Zone entities that only transact domestically would still be required to meet this obligation.


The CIT legislation also includes a requirement for taxpayers to prepare adequate TP documentation to support the arm’s length nature of their related party transactions. The UAE’s TP documentation requirements include three components. These components are summarised in the table below:

Businesses should be pro-active in determining an appropriate operating model and transfer pricing policy for their Free Zone operations, including a policy for their transfer pricing documentation. 


Other Conditions: Currently, we are not aware of any other conditions that will be announced by the MoF. We expect that this section was included to allow the MoF and FTA some flexibility to make an assessment on whether the current criteria are fit for purpose following the introduction of CIT in the UAE. For example, additional conditions may regard the need to counter abusive arrangements, such as the artificial separation of companies or activity lines to obtain illegitimate tax benefits.

As such, businesses should remain vigilant and attentive to future announcements to ensure they remain fully compliant and can continue using the tax incentives available under the Free Zone Regime.


Pillar Two


The BEPS Pillar Two proposal aims to introduce a global minimum tax rate of fifteen percent on multinationals with annual consolidated revenue above EUR 750m (AED 3.15b). The proposal is designed to ensure that multinational companies pay a fair share of tax wherever they operate, and to prevent them from artificially shifting profits to low-tax jurisdictions.


There are prescribed rules issued by the OECD to calculate a group’s Effective Tax Rate (“ETR”) on a jurisdictional basis to determine the appropriate level of top-up tax required.


Additionally, there are prescribed charging mechanisms to collect any top-up tax payable. These include:

  • Qualified Domestic Minimum Top-Up Tax (“QDMTT”) which may be optionally applied domestically at the local entity level (for example, the minimum tax as enacted by Qatar at 15% on excess profits);
  • Income Inclusion Rule (“IIR”) where the tax is payable by the parent entities of a low-tax jurisdiction; and
  • Under-Taxed Payments Rule (“UTPR”), which acts as a back-stop mechanism where the other two options are not available or applied.


Although the UAE has not announced much in relation to its intentions regarding Pillar Two, many countries and jurisdictions have confirmed they will implement the rules by January 2024 (EU, Switzerland, the UK, South Korea etc.). However, notable nations that have not made any announcements in relation to Pillar Two include the US, India, and Saudi Arabia. We have captured in one of our earlier pieces on the steps available for GCC countries as the world gradually moves towards Pillar Two.  

Notwithstanding this, given the wide range of charging mechanisms noted above combined with the ever-growing number of jurisdictions that have announced they will implement, it is clear that the impact of Pillar Two will permeate through to the UAE regardless.

For qualifying multinationals with a QFZP, the benefit of the zero percent rate will likely be reduced through the ETR calculation and subsequent top-up tax payable. However, there may be some reprieve for entities with significant substance in the UAE due to certain measures the OECD has included as part of the Pillar Two model rules which promote substance, such as the Substance Based Income Exclusion and the Routine Profits Test Safe Harbour.


Multinationals should stay alert for future updates from the MoF and the FTA on the UAE’s intentions with Pillar Two and the possible impact on their Free Zone arrangements.


As outlined above, there remains a lot of uncertainty in relation to the UAE Free Zone Regime and how it will interact with the wider introduction of CIT in the UAE. However, it is clear that the Free Zone Regime shall remain a staple of the UAE economy and in most instances will provide a significant tax benefit to entities which qualify as a QFZP. As such, taxpayers should continue to remain attentive and prepare for the journey ahead.   


Int'l Tax & Transfer Pricing

2022 – Inflation and the Impact of Transfer Pricing for your Business

2022 – Inflation and the Impact of Transfer Pricing for your Business


In addition to the festivities so often associated with this time of year, December is also a time to reflect on the preceding 12 months and consider what the New Year may bring.

When we reflect on 2022, one of the defining features has been the marked increase in inflation across the globe. We have seen inflation impact all major economies in 2022, with key markets such as Europe, the United Kingdom and the United States recording their highest inflation rates in decades. Some of the key drivers have been the disruption in global supply chains of both food and energy due to the ongoing conflict in Europe, as well as the over stimulation of developed economies as a result of quantitative easing and other stimulus measures employed by governments to counteract the impact of the pandemic on global markets.

Due in part to the Gulf Cooperation Council’s (GCC) status as one of the world’s primary energy exporters, the impact of inflation has been relatively less severe than in other parts of the world. However, the GCC nations have not been immune to the rise in inflation. As of October 2022, the International Monetary Fund (IMF) reported the United Arab Emirates’ (UAE) average Consumer Price Inflation (CPI) rate was 5.2%, up from 0.2% in 2021. Similarly, Qatar’s CPI rate has increased considerably from 2.3% to 4.5% in the same timeframe.

Impact of Inflation

In a business context, the impact of inflation has been significant for both Small and Medium Enterprises (SME) and multinationals globally. Increased supply chain costs have put negative pressure on business margins and the rise in interest rates, employed as an effort to curb inflation, have impacted companies’ ability to obtain debt financing and subsequently affected cash flow and liquidity. 

Transfer pricing is predicated on the Arm’s Length Principle (ALP), which states that the commercial and financial arrangements between related parties are conducted in a manner that is consistent with arrangements between independent enterprises. In this regard, the abovementioned economic circumstances have had a profound affect on pricing arrangements between independent enterprises globally.

As such, it is important for multinationals to consider the impact of inflation on their existing transfer pricing arrangements and operating model, to determine whether an adjustment is required on a go-forward basis. For businesses operating in the UAE, where the introduction of formal transfer pricing rules is imminent, it will also be important to appropriately factor these changes in economic circumstances into any prospective transfer pricing policy/operating model.  

Given the pervasive impact transfer pricing can have on a multinational’s tax arrangements (taxable profit, Value Added Tax (VAT), customs duties etc.), it is important to be proactive in addressing these considerations for your business and appropriately factoring it into the 2023 planning cycle.  

Mechanical Impact

As outlined above, inflation can have a significant financial impact on businesses. The relative impact of inflation on the mechanical operation of a group’s transfer pricing policy is dependent on the nature of the intercompany arrangements, as well as the transfer pricing methodology applied. 

For example, a Limited Risk Distribution (LRD) entity that is remunerated with a fixed operating margin (operating profit/revenue) may require a manual transfer pricing adjustment at year-end to account for inflation, to ensure that the LRD’s margin remains aligned with the transfer pricing policy.

In contrast, where an entity performs contract manufacturing and is remunerated with a mark-up on its cost, any increase in the underlying cost base as a result of inflation should automatically be reflected in the contract manufacturer’s return, as the basis of remuneration (i.e., cost) correlates with the impact of inflation.

However, although a cost-plus return may not be disrupted from the perspective of the contract manufacturer, the higher cost base will impact the profit margin of the counterparty compared to forecasts. Below, we discuss the impact of inflation on the group and how to effectively manage these negative impacts.

Allocation of Risk, Reward and Downside Impact

Under the arm’s length principle, the attribution of business profit amongst group entities should be aligned with each entity’s relative contribution to the functions, assets, and risks of the business.

In this regard, group entities that perform high-value functions and/or assume, control, and have the financial capacity to bear the key market and other operational risks are rewarded with an entrepreneurial return. An entrepreneurial return is typically the residual system profit after rewarding related parties that perform routine activities with a fixed return (“routine returns”).

Under both examples discussed above, we considered how transfer pricing policies adapt to the impact of inflation from the perspective of maintaining the remuneration profile of the routine return entities. However, where the system profit is substantially reduced as a result of inflation or wider economic downturn, the question arises whether the existing remuneration policy remains fit for purpose and appropriately rewards each entity for its relative contribution to the group’s activities.

Under first principles, an entrepreneurial entity that retains any upside on the residual system profit should equally bear the downside risk associated with inflation/economic downturn on group profit. However, as often is the case in transfer pricing, nothing is ever so black and white.

For example, there may be commercial, regulatory, or capital requirements that could impact the entrepreneur (and the business as a whole) which would necessitate an adjustment to the group’s pricing policies to reflect market conditions. In these circumstances, an independent enterprise acting at arm’s length would be expected to re-negotiate existing arrangements to protect themselves from such consequences.

In this regard, there are a number of methods that could be employed to effectively spread downside risk amongst related parties while maintaining the arm’s length principle:

  • Selection of a lower point in the arm’s length range. The selection of a point within the interquartile range may be appropriate. An adjustment should be applied in accordance with the terms of the intercompany agreement and supported by robust documentation outlining the rationale for the adjustment, as it is likely to be challenged from the local tax authority of the routine entity.
  • Defer payments until a recovery in economic circumstances. This situation may be more relevant for royalty license arrangements. Rather than a complete forgiveness of a royalty payment, a licensor may allow licensees to defer payment until such time as the economic circumstances have improved. Again, consideration to the terms of the existing intercompany agreement and appropriate support documentation is required. It may be appropriate for the licensor to apply a small portion of interest, as the characterization of the arrangement may take the form of a loan or working capital balance.
  • New transfer pricing policy/benchmarking. Performance of an updated benchmarking or implementation of a new operating model may result in a more equitable distribution of profits/losses between group entities.

The appropriateness of the above options will depend on each business’s specific facts and circumstances, the risks for which each entity is responsible, the impact of inflation on system profit etc. We would advise that these points are considered and addressed pro-actively, as retrospective adjustments may be more likely to be challenged by tax authorities.

Finance Arrangements

As indicated above, one of the key measures adopted by central banks to counteract inflation has been to increase interest rates. These measures have had a seismic effect on capital markets and the liquidity of multinationals and SMEs. 

From a transfer pricing perspective, where the group’s external borrowing costs have increased significantly as a result of these measures, this should be appropriately reflected in prospective intercompany loans. It may be possible to reflect this change in economic circumstances through application of an increased rate of interest or the introduction of additional loan fees and charges (e.g., commitment fees, annual fees etc.) to ensure the lender is appropriately rewarded. In this regard, multinationals should ensure that their interest rate benchmarking analyses are up to date such that the group’s financing arrangements are reflective of the financial markets at the time a loan is entered into.

Inflation and higher interest rates may also affect a borrower’s key financial metrics. In the context of debt financing, this could impact the borrower’s credit rating and/or ability to demonstrate that the quantum of intercompany debt it has on its balance sheet is not excessive relative to ordinary market behavior. This in turn may impact the group’s ability to claim interest deductions on its existing or prospective debt. An assessment of these metrics is an important step to consider when determining the debt/equity mix for companies in 2023.

Separate to intercompany financing, rising interest rates may also affect the valuation of intellectual property and other assets when priced using an income-based approach. The underlying premise of this approach is that the value of an asset can be measured by the net present value of the economic benefit to be received over the life of the asset. The steps followed in applying this approach include estimating the expected cash flows attributable to an asset over its life and converting these cash flows to a net present value using an appropriate discount rate.

In principle, an increase in the cost of debt would lead to an overall increase in the discount rate applied. Ultimately, a higher discount rate would reduce the net present value (i.e., price) of the asset.


Finally, multinationals should be considerate of the impact of inflation and other economic shocks from a documentation and benchmarking perspective.

For example, many jurisdictions allow companies to maintain a TNMM benchmarking for up to three years (with an annual financial refresh), before a full re-performance is required. This is based on the recommendation in the OECD Guidelines on the frequency of documentation updates. However, the key caveat for this allowance is that there is no change to the operating conditions, including economic circumstances, to the controlled transaction. Any of the abovementioned factors discussed may trigger the requirement to re-perform an existing benchmarking analysis.

Additionally, we note that many jurisdictions in the GCC have a strong preference for the use of local comparables (e.g., Saudi Arabia). However, in practice it is common for a benchmarking analysis to incorporate comparables from other jurisdictions, including Africa and Eastern Europe, in an arm’s length range.

The OECD Guidelines indicate that arm’s length prices may vary across different markets even for transactions involving the same property or services. As such, in order to achieve comparability, the markets in which the independent and associated enterprises operate should not have differences that have a material effect on price. In this regard, given the relative impact of inflation and other economic and political circumstances in places such as Eastern Europe compared to the GCC, these practices may no longer be appropriate over the short-term.

However, the OECD Guidelines suggest that it may still be appropriate to rely on such comparables where appropriate adjustments can be made. Where it is not possible to completely eliminate these jurisdictions from a comparable set, appropriate adjustments to reflect the difference in inflation or other economic differences should be reflected in the transfer pricing documentation.

With the forthcoming introduction of transfer pricing in the UAE, transfer pricing continues to gain momentum in the GCC. As such, multinationals should be pro-active in determining an appropriate operating model and transfer pricing policy for the region. As part of this, companies need to make sure they consider the wider global economic circumstances in addition to their specific business strategies and plan accordingly.