UAE Corporate Tax: Free zone businesses need to keep strict check on 'disqualifying income'

If at any time during a year, a free zone entity fails to meet any of the prescribed conditions for 0 per cent tax rate, it will remain ineligible for the rate for a further 4 years.

Imagine that during an FTA audit (typically after 5-6 years) you are found to be ineligible as a qualifying free zone (QFZP). The tax incentives claimed during the intermittent 4 years will be automatically denied resulting in tax arrears and penalties.

Do I have your absolute attention?

Fleshing out 'disqualifying income' 

Against widely-held popular beliefs, we introduced you to a concept of ‘disqualifying income’ in an April 23 comment piece, whereby the entire income of a ‘Free Zone Person’ becomes ineligible for 0 per cent rate. We also gave a meaning to the 9 per cent rate proposed in the decree law. We feel gratified both those concepts have been brought into the law through the recent decisions.

Qualifying income

‘Qualifying income’ - the most enigmatic word until recently – is taxable at 0 per cent. The expression has two features: scope and the prescribed conditions.

The scope looks easier to understand. Qualifying income comprises of:

Subject to the de-minimis rule, qualifying income does not include:

The conditions are important.

Qualifying income should not be attributable to a domestic or foreign permanent establishment. In general terms, if the place of management of the business is in the mainland/overseas. But if the resultant transactions are shown under a free zone person, the 0 per cent rate could be denied.

This condition is critical - yet tricky - to demonstrate practically. Similarly, the income attributable to mainland branch would also not be eligible for 0 per cent.

While qualifying income includes income from any transactions with other free zone persons, the recipient should be the ‘beneficial recipient’. The right to use and enjoy the goods/services should be with the recipient free zone persons without any contractual or legal obligation to pass it on to another person.

How a free zone person-supplier could ensure the recipient’s status and handle scenarios like back-to-back contracts or undisclosed agents would require pertinent evaluation.

Qualifying activities

The ministerial decision has listed down the ‘qualifying activities’ eligible for 0 per cent tax rate. Notable activities include manufacturing or processing of goods, headquarter services to related parties, treasury and financing to related parties, and holding of shares and other securities.

The 0 per cent rate also applies on income from the distribution of goods in or from a VAT designated zone (DZ) to a customer that either resells such items or processes/alters such items for sale. Given the strict conditions on the intended use of the goods, sale of plant and machinery, consumables, office furniture, office equipment etc. from DZ for end-use needs to be examined as they are not further processed or altered.

Excluded activities

A list of activities have been prescribed which are excluded from 0 per cent tax rate. Barring few specialised transactions, any transactions with natural persons is an ‘excluded activity’. In other words, transactions say, sale of goods to individuals in or from free zone/designated zone will require monitoring. The ownership or exploitation of IP assets is also an ‘excluded activity’, potentially creating a significant tax impact.

De-minimis rule

The de-minimis threshold allows the ‘non-qualifying’ revenue of a free zone person to be taxed at 0 per cent. The ‘non-qualifying’ revenue includes income from ‘excluded activities’ and from activities (other than ‘qualified activities’) with a non-free zone person.

The threshold is the lower of 5 per cent of its total revenue or Dh5 million.

Income attributable to domestic/foreign permanent establishment is not included in the ‘non-qualifying’ revenue. Accordingly, the income attributable to say, a mainland branch will remain taxable at 9 per cent irrespective of the quantum and threshold. Something that we discussed in this column in April.

Disqualifying income

We suggested in April about disqualifying income finding its way as an eligibility condition. One of the conditions in the ministerial decision for 0 per cent eligibility is that the free zone person must ensure that the ‘non-qualifying’ revenue does not exceed the de-minimis threshold.

In other words, it is not that income above de-minimis will be taxable at 9 per cent irrespective of the quantum, the entire revenue of free zone person would become ineligible for 0 per cent rate.

Taxation is a discipline in itself. With the growing importance of taxation in the UAE, business owners should ensure to ask the right questions, receive correct analysis and value comprehensive recommendations.