Discussions on the 0 per cent tax rate for free zone companies has focused on qualifying income (QI), qualifying activities (QAs), excluded activities and de-minimis rules.
These topics are indeed important. However, attention on maintaining ‘adequate substance’ seems to have been lost. Free zone companies should ensure the adequate substance should not become their Achilles’ heel. It could not only wash away the 0 per cent preferential tax rate, but result in penalties and tax arrears.
As per Ministry of Finance (MoF) FAQs, a Qualifying Free Zone Person (QFZP) must have - and be able to demonstrate - adequate substance in a free zone relative to the nature and level of its activities and the qualifying income it earns.
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Maintaining adequate substance involves having adequate staff and assets and incur adequate operating expenditure in the relevant free zone for the purposes of undertaking its core income-generating activities (CIGAs).
As to how much would be ‘adequate’ – and how much would be too less - would not be a mathematical formula but a subjective assessment based on the level of activities and qualifying income.
The core income-generating activities is not a compliance checklist but will need to be independently identified based on each business activity. A study of existing Economic Substance Regulations (ESR) will provide a fair understanding of the concept.
Assessing adequate substance
In addition to the nature and level of activities and qualifying income earned, other relevant facts and circumstances have to be taken into consideration to assess the adequacy. The three important factors are staff levels, assets and operating expenditure.
Unlike the concept of transfer pricing, benchmarking comparable of fellow free zone companies may not directly apply to assess adequate substance. What is adequate for one free zone company would not be automatically adequate for another.
Place of adequate substance
A qualifying free zone person must maintain its economic and operational substance in the free zone where it is established or in any other free zone. In other words, the substance cannot be maintained on the mainland or outside UAE.
It is not mandatory for a qualifying free zone person to undertake all the activities by itself, and could outsource the activities to related or unrelated parties. However, these must also be in a free zone and the qualifying free zone person must exercise control and supervision over the outsourced activities.
It should be able to demonstrate that such control and supervision existed in the relevant financial year during any future audit.
Place of management
It is often mentioned that the corporate tax law and guidance does not prescribe that the place of management of the qualifying free zone person should be in the free zone. Accordingly, it is easily assumed that the management can sit in the mainland as it manages other mainland businesses also.
If the place of management is outside the free zone, it is at a risk of creating a domestic permanent establishment (PE) in the mainland. The qualifying free zone person’s profits – to the extent attributable to such domestic permanent establishment – will be taxable at 9 per cent. The 9 per cent rate could apply even if the adequate substance is otherwise maintained in the free zone.
Business owners should remember that the corporate tax assessment by the Federal Tax Authority (FTA) could be undertaken anytime in the next seven years from the relevant financial year. If a qualifying free zone person is found to be non-compliant for a particular financial year in those 7 years, the tax arrears and penalties will apply.
Further, the preferential 0 per cent tax rate claimed in the 4 years following the relevant financial year will also be automatically denied giving rise to tax arrears and penalties for 4 more years.
Lost in translation
Discussion with businesses, especially free zone companies, makes us realise how important tax issues gets lost in translation and explanation. The ‘adequate substance’ requirement has been simplified to a statement that the free zone company should not be a ‘paper’ company.
The business owners therefore have no reasons to doubt the status of their free zone companies as enough staff, assets and expenditure are devoted to the free zone operations. The subtle point that the adequate substance should be maintained in a free zone is however easily missed out.
UAE businesses must not find themselves non-compliant even by ignorance. Let ‘adequate substance’ - or failure to ask the right questions – not become the Achilles’ heel for the UAE businesses.