UAE Corporate Tax: Free zone businesses need to check out 'disqualifying income'

Ever since the UAE Corporate Tax decree was issued on December 9, 2022, business owners and tax consultants have been captivated by the two tax rates applicable on free zone registered entities. The law provides that the qualifying free zone entities will be taxed at 0 per cent on their qualifying income - and at 9 per cent on taxable income that is not a qualifying income.

The scope of the ‘qualifying income’ will be specified in an upcoming cabinet decision.

Are we celebrating too early?

The concept of two tax rates contained in the decree is widely hailed as a welcome departure from the public consultation document (PCD) issued earlier by the Ministry of Finance (MoF). This is because free zone entities may continue their normal business operations without losing tax exemption benefits. That they may simply pay tax on any income that does not qualify for the 0 per cent rate without restructuring their business activities, especially those carried out in the mainland UAE/within a free zone.

A question arises if such celebrations are premature? On careful reading, the decree appears to be in line with the PCD on free zone taxation. While you may have learnt only about the ‘qualifying’ income and ‘non-qualifying’ income, we introduce you to a new concept of ‘disqualifying’ income.

Qualifying income - 0% tax

The PCD proposed a 0 per cent tax rates on incomes earned:

• From transactions with businesses located outside of the UAE;

• From trading with businesses located in the same or any other free zone;

• From certain regulated financial services directed at foreign markets; and

• From the sale of goods by entities located in VAT designated zones to UAE mainland businesses, if the latter remains the importer-on-record.

The 0 per cent tax rate was also proposed for transactions between free zone entities and their group companies located in mainland UAE and for the ‘passive’ income earned from the mainland. Such passive income could include interest and royalties, and dividends and capital gains from owning shares in mainland UAE companies.

Such incomes listed in the PCD could be categorised as ‘qualifying income’ as per the decree.

Non-qualifying income - 9% tax

The PCD provided a differential tax treatment for free zone entities that have a branch in the mainland UAE. A free zone entity having a mainland branch will be taxed at 9 per cent on its mainland sourced income.

The mainland sourced income could include income earned from mainland customers. It could also include income from activities performed, assets located, capital invested, rights used, or services performed in the mainland.

Contextually, certain mainland-sourced income could be taxed at 0 per cent if it ‘passive’ in nature. For example, royalties for the IPR rights used by a mainland customer, or dividend earned from capital invested in a mainland company may be a mainland-sourced income but would still qualify for 0 per cent rate as ‘passive’ income.

This aligns with the 9 per cent tax rate proposed in the decree for income that is not a ‘qualifying income’. Let’s call it ‘non-qualifying’ income.

Disqualifying Income – free zones’ vulnerability?

The PCD contained an important policy objective, i.e., prevent free zone businesses from gaining an unfair competitive advantage compared to businesses established on the mainland. The PCD stated that if a free zone entity earns any mainland-sourced income (other than qualifying and non-qualifying incomes mentioned above), the entity will be disqualified from 0 per cent tax rate in respect of all its income.

For example, if a free zone entity provides installation services in the mainland, or if a free zone business provides services to overseas clients and also to mainland/FZ clients, would they forfeit their entire tax exemption?

Unlike the PCD, the decree does not contain any express provision for such a disqualification. However, the Corporate Tax decree does provide that free zone entities will have to meet conditions prescribed by the Minister of Finance to qualify for the tax exemption.

Considering the policy objective to prevent unfair tax advantage, it should not be ruled out that free zone entities could be disqualified if their business operations include certain mainland activities or other prescribed activities.

It is important for businesses to ask the right questions to understand the scope of taxation and its implications. Free zone entities may believe they could continue their normal business operations by paying tax on ‘non-qualifying’ income.

However, they must reflect about the ‘disqualifying’ income. While the cabinet decision is awaited to provide the exact scope of free zone exemptions, the concept of ‘disqualifying’ income could become a vulnerability for the free zone businesses hitherto unknown to them.