The UAE is a fast-expanding economy with trade and investment growing at a rapid pace. Today, UAE is synonymous with trade, travel, tourism, logistics, investment, finance, technology, research, and much more. But, it wasn’t before a couple of decades that the UAE was like any other Gulf economy solely dependent on oil extraction as a source of income stream. So how did UAE transform itself from an exploited oil well to a modern metropolis of the global world order? Although there were multi-pronged strategic initiatives taken at critical moments throughout its relatively short history of being a Republic nation, a key ingredient to UAE’s success story is the formidable role played by Free Zones.
Background of the UAE’s tax-free zones
Tax- Free Zones, as one would make sense of it, was not a revolutionary idea that evolved out of UAE, rather it was a tried and tested formula developed outside the state but masterfully adapted to the nation’s advantage in the most appropriate way possible.
This blog article will trace the history of Free Zones UAE, analyze the impact of Free Zone Establishments on the UAE economy, the effect of UAE’s introduction of Corporate Tax (CT Law) in the Free Zone Entities, understand the concepts of Qualifying activities and Qualifying Income and assess the future trends in the Free Zone UAE Taxation.
Free Zone UAE : Understanding Entities
History of Free Zones in the UAE
The United Arab Emirates (UAE) has a long history of free zones, dating back to the early 1980s. The first free zone UAE, Jebel Ali Free Zone (JAFZA), was established in 1985 to attract foreign investment and diversify the UAE’s economy. JAFZA was a huge success, and it quickly became one of the largest free zones in the world.
The success of JAFZA led to the establishment of other free zones in the UAE. In the early 2000s, the UAE government launched a number of new free zones, including Dubai Airport Freezone (DAFZA), Dubai Internet City (DIC), and Dubai Media City (DMC). These free zones were designed to attract specific industries, such as logistics, technology, and media. Today, there are over 40 free zones in the UAE, located in all seven emirates. These free zones offer a wide range of benefits to businesses, including:
- 100% foreign ownership
- No import duties
- Easy access to global markets
- Excellent infrastructure
The free zones in the UAE have been a major driver of economic growth in the country. They have attracted billions of dollars in foreign investment and created hundreds of thousands of jobs. The free zones have also helped to make the UAE a global hub for trade, commerce, and logistics.
Definitions
Free Zone
As per the CT law, a Free Zone has been defined as “A designated and defined geographic area with in the State that is specified in a decision issued by the Cabinet at the suggestion of the Minister.”
Who is a Free Zone Person
A juridical person incorporated, established, or otherwise registered in a Free Zone, including a branch of a Non-Resident Person registered in a Free Zone. However, the following category of persons are excluded from the definition of a Free Zone Person: A Natural Person conducting business in any Free Zone (including Sole establishments or Civil Companies). Additionally, any entity incorporated outside of a Free Zone is also excluded from the definition of a free zone person.
General overview of the UAE corporate tax system
Although Free Zones came with the promise of a Taxation-free environment, the introduction of the Corporate Tax regime in UAE caused a surprise among many.
While the Corporate Tax also promises a virtual taxation-free environment (0% Taxation) for Free Zone UAE Entities, the tax exemption has been restricted or limited to businesses that undertake certain “specified” activities and fulfill certain pre-emptive criteria. Those entities that satisfy the conditions are defined as a “Qualifying Free Zone Entity”, which is a marked deviation from the previous non-restrictive policy adopted by the state towards activities conducted by Free Zone entities in the respective free zones.
Who is considered a Qualifying Free Zone UAE Entity?
A Free Zone person who meets the following conditions is considered a Qualifying Free Zone Entity (QFZE):
- Maintains adequate substance in the state
- Derives Qualifying Income
- Not elected to be subject to normal C.T.
- Complies with Transfer Pricing Provisions
- Prepares & maintains Audited Financial Statements
- Does not exceed the De-minimis Revenue Threshold
- Meets any other condition prescribed by the Minister
- Failure to fulfill the above conditions will result in disqualification of the entity from the status of a Qualifying Free Zone UAE Entity.
What is considered as maintaining adequate substance in the state?
The QFZE shall operate with an adequate level of assets, employees & operating expenses that correspond to its scale of business operations.
Activities may be outsourced to a related party or a third party based in the Free Zone UAE, provided adequate supervision is maintained.
Current corporate tax rates
The taxation policy surrounding a Qualifying Free Zone Entity can be summarised as follows:
Qualifying Income will be subject to 0% taxation and
Non- Qualifying Income will be subject to 9% taxation.
Qualifying Income in the UAE
What is included under Qualifying Income?
Qualifying income comprises the following categories of income:
- Income derived from Transactions with Other Free Zone Persons where the other free zone person is the beneficial recipient (Except income derived from excluded activities).
- Income derived from transactions with a Non-Free Zone person (on Qualifying activities that are not excluded activities)
- Any other income provided that the QFZE satisfies the de-minimis requirement
Who is a Beneficial Recipient?
A beneficial recipient is a person who has the right to use the good or service and does not have a contractual/ legal obligation to pass on the good or service to another person.
What are Qualifying Activities?
Qualifying activities include any activity specified in the Ministerial Decision and conducted by a Qualifying Free Zone Person from which Qualifying Income is derived. These include:
- Manufacturing or processing of goods or material
- Trading of Qualifying Commodities
- Holding of shares and other securities for investment purposes
- Ownership, management and operation of ships
- Reinsurance services
- Fund management services
- Wealth and investment management services
- Headquarter services to Related Parties
- Financing and leasing of Aircrafts
- Distribution of goods or material in or from the Designated zone
- Logistics services
- Any other activities ancillary to the above.
What are excluded Activities?
This includes activities specified by the minister and conducted by a QFZE from which non-qualifying income is derived. This includes:
- Any transactions with natural persons (except ownership, management and operation of ships, fund/ wealth and investment management services, and financing & leasing of Aircraft)
- Banking activities
- Insurance activities without prejudice to Reinsurance services and headquarter services to related parties.
- Finance and leasing activities without prejudice to Ownership, management and operation of ships, Treasury and financing services to related parties and Financing and leasing of aircrafts.
- Ownership/exploitation of immovable property (other than Commercial property located within a Free Zone and where transactions are made with other Free Zone persons).
- Any activities ancillary to the above
How does the source of Income of a QFZE impact its taxation?
The income of a QFZE can be segregated into four major components. Based on these streams, the taxation rules applicable can be classified as follows:
Income from other Free Zone persons
- Income from qualifying activities (excluding income from excluded activities, where the other free zone person is the beneficial recipient of the relevant services or goods) is considered as qualifying income and subject to 0% taxation.
- Income from excluded activities will be subject to the De-minimis test.
Income from Non-Free Zone Persons
- Income from qualifying activities that do not fall under the category of excluded activities will be considered qualifying income and will be subject to 0% taxation.
- Income from the non-qualifying activity is subject to the De-minimis Test.
Income from Immovable property
- Income from a commercial property where the counterparty in the transaction is a free zone person will be considered as qualifying income and therefore will be subject to 0% taxation.
- All other income derived from a QFZE’s immovable property will be considered taxable income and taxed at 9%. However, this income will not be considered as non-qualifying income for the De-minims test.
Income from Domestic or Foreign Permanent Establishments of the QFZE
- Domestic or Foreign Permanent Establishments of a QFZE will be considered as a separate and independent Person that is a Related Party of the Qualifying Free Zone Person. The income derived from such establishments will be considered taxable income and therefore will be subject to 9% taxation.
- The income derived from these establishments would not be considered as non-qualifying income for the De-minimis Test.
What is considered Commercial Property?
Commercial property is an immovable property solely used for business purposes and not for residential or accommodation purposes.
What is the De-Minimis Test?
The De-Minimis limit prescribes the maximum permissible limit of Non-Qualifying Revenue that can be derived by a Free Zone Entity while continuing to enjoy the status of a QFZE.
- The De-Minimis threshold is the lower of:
- AED 5 million and
- 5% of Annual Revenue
- If the income derived falls within the threshold, the income so derived will be considered as a Qualifying income and subject to 0% taxation.
- Breach of the De-Minims threshold will result in disqualification of the FZE from the status of a QFZE, which will extend up to 4 subsequent years (5 years in total) during which the firm would be subject to tax at the normal CT rate of 9%.
What is included in the Non-Qualifying Revenue for the De-Minims Test?
This includes:
- Revenue from excluded activities and
- Revenue from Non-Qualifying Activities where transactions are made with a non-free zone person
What is excluded from the Non-Qualifying Revenue and Total Revenue calculation for the De-Minimis Test?
- Revenue from a Non- Free zone person with respect to a commercial property located within a Free Zone
- Revenue from any person with respect to a non-commercial property located within a Free zone
- Revenue attributed to Domestic/Foreign P.E of the QFZE.
Corporate Tax Exemptions and Conditions for QFZEs
No Income Threshold for Qualifying Income
Although Corporate Tax offers consideration to the hardships faced by ordinary taxpayers by restricting its applicability to individuals and businesses deriving income above a certain threshold (AED 375,000), the CT for Qualifying Free Zone Entities (QFZEs) does not prescribe such an income threshold. This is because a QFZE deriving qualifying income already benefits from 0% taxation. However, any QFZE that derives non-qualifying income will be subject to a flat 9% tax on that income without the relief of any income thresholds.
Unavailability of Certain Tax Reliefs
Another key consideration is the unavailability of certain reliefs normally applicable to ordinary taxpayers. Therefore, a QFZE will not be able to avail itself of the benefits of Small Business Relief, Restructuring Relief, or be part of a Qualifying Group or a Tax Group.
Suitability of QFZE Status for Smaller Businesses
If you are a business owner operating in a Free Zone with an annual turnover of less than AED 3 million (which also includes income from non-qualifying or excluded activities) and expect to derive revenue below the general threshold limit in the foreseeable future, QFZE status may not be the best option for you.
Irrevocable Nature of Opting for Normal Taxation
However, once you decide to be subject to normal taxation, you cannot revert to QFZE status. The CT specifically prohibits a QFZE from returning to its former state once it has made an irrevocable decision to be subject to normal CT rates.
Impact of Free Zone Entities on the UAE Corporate Tax System
The free zones in the UAE have had a major impact on the UAE’s economy. They have helped to diversify the economy, attract foreign investment, and create jobs. The free zones have also helped to make the UAE a global hub for trade, commerce, and logistics.
According to the UAE government, the free zones have contributed over AED 200 billion to the country’s GDP, and have contributed to the creation of over 1 million jobs. The free zones have also helped to attract billions of dollars in foreign investment.
Future Trends: Corporate Taxation and Free Zone Entities in the UAE
The free zones in the UAE are expected to become more specialized in the future. The UAE government is planning to create new free zones that focus on specific industries, such as healthcare, education, and renewable energy.
Conclusion
Free zone UAE is a major success story. They have helped to diversify the country’s economy, attract foreign investment, and create jobs. The free zones are expected to continue to grow in the future, and they will play a key role in the UAE’s economic development. The UAE government is committed to making the country a global hub for trade and commerce. The free zones will play a key role in achieving this goal.