What is common to rocket science and tax laws? Both are intriguing and require intense research, with even a minor error resulting in a quantum change in the trajectory. Either reach for the skies or come crashing down.
The UAE’s corporate tax public consultation for free zones (PCD) has provided several insights and the possible direction of the tax regime these hubs would come under. The interpretation of the tax rules among the finance and tax fraternity reveals critical gaps in the understanding gaps, and which could be detrimental in the long run.
Processing vs. distribution
Income from distribution of goods is eligible for the preferential 0 per cent tax rate (subject to conditions) only if the distribution is in or from a designated zone. However, income from processing of goods is eligible for 0 per cent tax rate if the business is based in any free zone.
The latter includes the preparation, treatment, transformation or conversion of goods into another form for further commercial use or sale. International jurisprudence is rife with principles to decide what activities could amount to processing of goods.
Will roasting of coffee beans and sales amount to processing or distribution? Does packing of readymade jackets and trousers into individual suit sets change the form of the goods? Does a scrap dealer dismantling old goods into components, or simply crushing them into multiple pieces, undertake processing or distribution?
Does packing of goods change its form and thereby result in a processing? Are companies that program debit/credit cards (with chips) before selling processing those goods?
The expression ‘preparation’ has caused varied interpretations as to how this alone could change the goods into another form. For free zone businesses contemplating to classify their distribution activities as processing, the wider tax ramifications should be evaluated first before finalising their tax position.
Processing vs. manufacturing
Income from qualifying activities – eligible for preferential 0 per cent tax rate – inter-alia includes income from manufacturing of goods and from processing of goods. The PCD proposes to categorise such activities into:
- Manufacturing of own goods, and;
- Manufacturing for and on behalf of another person.
In the former, the income of the manufacturer has to be split into manufacturing and sales profits. We have previously discussed how manufacturers in free zones - other than those in designated zones - could find themselves into tax conundrums.
The manufacturing profit will be at 0 per cent tax rate for all free zone based manufacturers. However, sales profits - equated to ‘distribution activity’ – will qualify for 0 per cent tax rate only if the manufacturer is in a designated zone. Practical challenges in such splitting of profits adds to the complexity.
The processing of goods could also be done:
- Of own goods and;
- For and on behalf of another person.
Free zone businesses should wait for the clarity if the concept of ‘sales profit’ could be extended to income from processing of own goods and the potential tax impact on their operations.
'Headquarters services' to related parties
Income from headquarters services to related parties is also eligible for 0 per cent tax rate.
The public consultation proposes that headquarters services include the administering, overseeing and managing of business activities of related parties, including provision of senior and general management, captive insurance services, administrative services, business planning and development, risk management, coordination of group activities, procurement and in general incurring expenditures on behalf of related parties and providing other support services to related parties.
Varied interpretations have resulted in companies planning to shift their senior management and head offices into free zones even if it is outside the designated zone. By attributing a portion of the overall corporate profits to such headquarters services, businesses are eyeing to save significant tax outflows.
However, a careful reading of the public consultation may divulge a different interpretation. Headquarters services could require that all the activities listed above should be provided as a single package.
Any one or more activities provided individually would not qualify for 0 per cent tax rate. Additionally, shifting the place of management without any commercial or fiscal justifications could also expose companies to anti-abuse provisions.
A clarification and/or guidance by the tax authorities would be of immense help.
If the Economic Substance Regulations (ESR) could be used as a guidance, additional requirements would apply. Through the provision of headquarters services, a free zone company should take on the responsibility for the overall success of the group or is responsible for an important aspect of the overall group’s performance.
Businesses should also wait for the additional guidance/legislation on the free zone taxation resulting from the pubic consultation process. Ask the right questions to keep your business on the correct trajectory.