UAE free zone-based manufacturing gets 0% corporate tax, but keep an eye on these details
These businesses will still need to split up profits from manufacturing and their sales
The UAE Ministry of Finance launched a digital consultation to seek views on elements of the corporate tax framework for the free zone companies.
The focus is on the classification and scope of qualifying activities - and those deemed as excluded. Responses are sought through an online form by August 2. The consultation process is a business-friendly step in approach and guidance. All stakeholders should take the benefit to share feedback and contribute to the process.
The consultation paper provides valuable insights into the proposed tax implications on the free zone companies.
Manufacturing activities
Manufacturing of goods or materials in a free zone is a qualifying activity, allowing for 0 per cent tax-rated. The consultation paper explains that manufacturing activities can be broadly categorised as follows:
- Manufacturing one’s own products, and
- Manufacturing products for and on behalf of another person, i.e., contract or toll manufacturing
The corporate tax implications on both categories are expected to be different.
In the case of contract manufacturing, a free zone-based entity acts for and on behalf of another person. It would mean procuring raw materials, etc. Toll manufacturing is different from contract manufacturing in as much as it requires the customer to provide the necessary raw materials.
The fee for the manufacturing service as well as for the supply/usage of raw material (in case of contract manufacturing) is expected to be treated as qualifying income for a 0 per cent tax rate.
However, in the case of manufacturing one’s own product, the total profit needs to be split into ‘manufacturing profits’ and ‘sales profit’.
The latter is the profit attributable to the distribution (sale) of the manufactured products. The sales profit would be treated as qualifying income for a 0 per cent tax rate only if it meets the conditions of ‘qualifying distribution activity’, i.e. the distribution activity is in or from a designated zone. The manufacturing profit will be eligible for 0 per cent as qualifying income irrespective of the location of the manufacturing company.
Challenges for manufacturers
Manufacturing companies operating in free zones that are not ‘designated zones’ should evaluate the tax implications and contribute to the consultation process.
The splitting of profits between manufacturing and sales profits may add an additional requirement of benchmarking to avoid excess profit attribution towards manufacturing activity to avail of the 0 per cent tax rate.
As the sales profit is proposed to be taxed, it needs to be examined whether or not the sales revenue - i.e., revenue attributable to the distribution/sales activity - also needs to be determined to check the de-minimis threshold. (Which is 5 per cent of total revenue.) If yes, companies having a sales and marketing budget of more than 5 per cent of the revenue could expect to have their corresponding sales revenue also exceed 5 per cent of total revenue.
As the manufacturer is expected to split the profits into various categories, tax implications relating to ancillary activities such as income from manufacturing waste, process losses, and cost allocation would also need to be evaluated.
Processing activities
Processing of goods in a free zone is also a qualifying activity for a 0 per cent tax rate. This covers the preparation, treatment, transformation or conversion of goods or materials into another form of material or goods for further commercial or industrial use or sale.
The requirement that the processing activity should result in another form of material could be a defining requirement to evaluate tax implications.
The jurisprudence of other countries, especially India, demonstrates that the issue of whether an activity results in another form of goods is not free from doubts. In multiple cases, the apex court of India has examined if processing activities such as bleaching of fabrics, cutting jumbo rolls into smaller ones, simple assembling of the components of a fountain pen, printing of labels, scaling down bulk packaging into smaller retail packs, results in the emergence of a new form of a product.
The extent of jurisprudence on this issue could become relevant for the free zone companies undertaking processing activities. Whether a particular processing activity is covered under the scope of qualifying activity would determine the tax implications on such free zone companies.
Witnessing the implementation of a tax regime in a country is a once-in -a-lifetime opportunity for businesses - and consultants. Once they understand the gravity of the dynamics of the tax policy process, the importance of the ongoing consultation by the Ministry of Finance can be appreciated.
All stakeholders should endeavour to contribute to the process as the regime is ultimately meant for them.