Theunis Claassen
Hadef & Partners, Dubai
t.claassen@hadefpartners.com

Sonia Dukes
Hadef & Partners, Dubai
s.dukes@hadefpartners.com

On 31 January 2022, the Ministry of Finance announced that the United Arab Emirates (UAE) would introduce a federal corporate tax for the first time. On 9 December 2022, Federal Decree Law No 47 of 2022 (the CT Law) was published; this provides for the commencement of corporate tax (CT) in the UAE for financial years starting on or after 1 June 2023.

Following the release of the CT Law, several Cabinet and Ministerial Decisions were also released. These provide supplementary guidance on the application of the CT Law. One of the most anticipated decisions to come out of the recent legislative process has been the decision regarding what constitutes the qualifying income of a free zone (FZ) person.

In this article we briefly look at the definition of a FZ person, how they are taxed and why qualifying income is important.

Background

In terms of the CT Law, CT is imposed on the taxable income of a taxable person at a standard rate of nine per cent, whereby the first AED 375,000 is subject to a zero per cent rate. Where the taxable person constitutes a qualifying free zone person (QFZP), its qualifying income is subject to a reduced CT rate of zero per cent. Any non-qualifying income will remain subject to CT at nine per cent, noting other exemptions or reliefs as may be applicable.

Free zone person

A FZ person is defined as a juridical person incorporated, established or otherwise registered in a FZ, including a branch of a non-resident person registered in a FZ.

A FZ in turn is a designated and defined geographic area within the UAE that is specified as a FZ through a Cabinet Decision. At present, no such Cabinet Decision has been published; however, we understand from the Ministry’s official website that businesses can contact their relevant FZ authority in order to confirm whether that FZ is eligible for the zero per cent CT relief.

Qualifying free zone person

For a FZ person to qualify as a QFZP, it must:

• maintain adequate substance in the UAE (this requires that the entity undertake its core income-generating activities in the FZ and, having regard to the level of activities carried out by it, maintain adequate assets, an adequate number of qualified employees and incur an adequate amount of operating expenditure in the FZ. Outsourcing within a FZ is permitted, provided there is adequate supervision of the outsourced activity);
• derive qualifying income (see discussion below);
• not elect to be subject to CT (FZ persons can opt to apply the normal CT rates to their taxable income);
• comply with the arm’s length and transfer pricing documentation requirements set out in the CT Law;
• not derive non-qualifying revenue in excess of the de minimis threshold (see discussion below);
• prepare audited financial statements in accordance with the International Financial Reporting Standards (IFRS); and
• meet any other conditions as may be prescribed by the Minister.

Qualifying income

‘Qualifying income’ includes three categories of income according to Cabinet Decision No 55 of 2023 (CD55), namely:

• income derived from transactions with a non-FZ person, but only in respect of qualifying activities that are not excluded activities;
• income derived from transactions with other FZ persons, provided these are not excluded activities (income will be considered as derived from transactions with a FZ person where that FZ person is the beneficial recipient of the relevant goods or services); and
• any other income, provided the QFZP satisfies the de minimis requirement.

An exception to these three categories is where such income is attributable to a domestic (UAE mainland) or foreign permanent establishment (PE) of the QFZP, or to the ownership or exploitation of certain immovable property located in a FZ. In these circumstances, the income will be deemed to be taxable income subject to the standard nine per cent rate. Although such income will be deemed to be taxable income, it will be disregarded for the purposes of applying the de minimis threshold discussed below.

Qualifying activities

According to Ministerial Decision No 139 of 2023 (MD139), qualifying activities include:

1. manufacturing of goods or materials;
2. processing of goods or materials;
3. holding of shares and other securities;
4. ownership, management and operation of ships;
5. reinsurance services that are subject to the regulatory oversight of the competent authority in the state;
6. fund management services that are subject to the regulatory oversight of the competent authority in the state;
7. wealth and investment management services that are subject to the regulatory oversight of the competent authority in the state;
8. headquarter services to related parties;
9. treasury and financing services to related parties;
10. financing and leasing of aircraft, including engines and rotable components;
11. distribution of goods or materials in or from a designated zone to a customer that resells such goods or materials, or parts thereof, or processes or alters such goods or materials or parts thereof for the purposes of sale or resale;
12. logistics services; and
13. any activities that are ancillary to the activities listed above.

Any income derived from transactions with persons located in the UAE mainland or in a foreign country would only be eligible for the zero per cent rate where the activities can be categorised under one of these categories. Income derived from sources other than these qualifying activities would be excluded from FZ relief and would be considered non-qualifying revenue for purposes of applying the de minimis test as described below. Income derived from transactions with other FZ persons does not have to relate to qualifying activities to be eligible for the zero per cent rate.

It is anticipated that the Ministry may release further guidance on the ambit of each of these categories in due course.

Excluded activities

Regardless of whether income is derived from FZ or non-FZ persons, such income would be disqualified from FZ relief where it is derived from excluded activities. According to MD139, this includes:

1. any transactions with natural persons, except transactions in relation to the qualifying activities specified under points (4), (6), (7) and (10) above;
2. banking activities that are subject to the regulatory oversight of the competent authority in the state;
3. insurance activities that are subject to the regulatory oversight of the competent authority in the state, other than the activity specified under point (5) of the qualifying activities listed above;
4. finance and leasing activities that are subject to the regulatory oversight of the competent authority in the state, other than those specified under points (9) and (10) of the qualifying activities listed above;
5. ownership or exploitation of immovable property, other than commercial property located in a FZ where the transaction in respect of such commercial property is conducted with other FZ persons;
6. ownership or exploitation of intellectual property assets; and
7. any activities that are ancillary to the activities listed above.

The FZ relief would therefore typically not cover transactions with natural persons, nor would it apply to most immovable property transactions (aside from commercial property transactions with other FZ persons). In addition, the FZ relief will not apply to any income derived from the licensing or exploitation of IP.

Income expressly included as taxable income

Notwithstanding the rules set out above, income attributable to immovable property located in a FZ would be taxable income, unless it relates to transactions with other FZ persons in respect of commercial property. Commercial property is defined as immovable property (or part thereof) that is used exclusively for a business or business activity and which is not used as a place of residence or accommodation (including hotels, motels, bed and breakfast establishments, serviced apartments and the like).

Furthermore, income attributable to a domestic (UAE mainland) or foreign PE of the QFZP shall be considered taxable income. The income attributable to a domestic or foreign PE of a QFZP for a tax period is to be calculated by the taxpayer as if the PE was a separate and independent person that is a related party of the QFZP. A domestic PE is defined for the purposes of the CT Law as a place of business or other form of presence of a QFZP outside the FZ in mainland UAE. In determining the existence of a PE, guidance can be obtained from the PE definition as contained in Article 14 of the CT Law, and the Organisation for Economic Co-operation and Development’s (OECD) Commentary on Article 5 of the Model Tax Convention.

De minimis requirement

Where a QFZP derives non-qualifying revenue in excess of the de minimis threshold, it would be disqualified as a QFZP. Insofar as the QFZP derives non-qualifying revenue below this threshold, such income will still be taxed at zero per cent notwithstanding that it does not qualify under the categories mentioned above.

The de minimis requirement shall be satisfied where the non-qualifying revenue derived by the QFZP in a tax period does not exceed five per cent of the total revenue of the QFZP in that tax period or AED 5m, whichever is lower.

Non-qualifying revenue is defined as the revenue derived in a tax period from (1) excluded activities and (2) activities that are not qualifying activities where the other party to the transaction is a non-FZ person.

Total revenue in turn is the total revenue derived by a QFZP in a tax period. In calculating the non-qualifying revenue and total revenue of a QFZP, a QFZP must disregard revenue expressly included as taxable income under the previous section.

Disadvantages associated with QFZP status

Although the FZ regime provides a very attractive tax benefit, it does come with certain restrictions. A QFZP will be disqualified from forming part of a tax group or transferring its tax losses. A QFZP will also not be eligible for the CT rollover relief as contained in Article 26 (Transfers within a Qualifying Group) and Article 27 (Business Restructuring Relief).

When operating in a FZ, those that avail of the zero per cent tax holiday ought to be mindful that the QFZP remains subject to the transfer pricing obligations imposed under the CT Law and is required to prepare annual audited financial statements.

Summary

Persons operating in a FZ should not assume that all income will automatically be eligible for the zero per cent tax rate. Being located in a FZ is not enough, as certain criteria must be met to avail of the FZ relief. Parties should assess eligibility carefully, having regard to the following questions:

1. Is the entity located in a FZ that is eligible for the FZ relief?
2. Will transactions be concluded with FZ persons, non-FZ persons or both?
3. If transactions are concluded with non-FZ persons, do these activities constitute qualifying activities?
4. Regardless of who the transactions are concluded with, are these excluded activities?
5. Will the non-qualifying revenue of the entity exceed the de minimis threshold?
6. Is any of the entity’s income expressly included as taxable income?
7. Does the entity comply with all the requirements to qualify as a QFZP?
8. Is the entity aware of all the administrative requirements associated with being a QFZP?
9. Is it perhaps more beneficial for the entity to opt out of FZ relief to benefit from other reliefs such as tax grouping, transfer of tax losses and/or the CT rollover relief provisions?