What is the arm’s length principle for UAE’s Free Zones?
Concept ensures transactions between related parties are priced fairly and transparently
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Dubai: The UAE’s corporate tax framework has introduced specific requirements for free zone companies seeking to benefit from preferential tax treatment. One of the most critical requirements is compliance with the arm’s length principle - a concept that ensures transactions between related parties are priced fairly and transparently.
A Qualifying Free Zone Person (QFZP) is a Free Zone Person that meets the conditions of Article 18 of the Corporate Tax Law. A QFZP is a Free Zone Person that meets all of the following conditions:
derive Qualifying Income from relevant transactions;
maintain adequate substance in the UAE
satisfy the de minimis requirement
must not have elected to be subject to the standard Corporate Tax rules and rates
must comply with the arm’s length principle
comply with the transfer pricing rules
prepare and maintain audited financial statements
It’s important to note that not all Free Zone companies automatically qualify for zero percent corporate tax, and not all income generated by a QFZP necessarily qualifies for preferential treatment.
Arm’s length principle explained
The arm’s length principle, introduced under Article 34 of the Corporate Tax Law, requires that transactions between related parties be priced as if they occurred between independent companies under similar circumstances. According to the Federal Tax Authority (FTA), this means considering what price two unrelated parties would agree upon in comparable situations.
Adhering to the arm’s length principle is critical for investors in UAE Free Zones seeking to retain their 0% corporate tax status. Transactions with related parties and foreign or domestic branches must reflect fair market value, backed by robust transfer pricing documentation. This isn’t just regulatory box-ticking—it’s a strategic necessity. Missteps here can trigger full taxation and invite deeper audits
The principle ensures that related parties earn appropriate income and record profits or losses that reflect their actual functions, assets, risks, and contributions to the overall business value chain.
Practical application: Allocating expenses
When a QFZP generates both qualifying income (eligible for zero percent tax) and taxable income (that is not qualifying income), it must allocate expenses between these components using the arm’s length principle.
For income connected to Foreign or Domestic Permanent Establishments, the company must treat these establishments as separate, independent entities - known as the “separate entity approach.”
The FTA outlines a practical two-step approach for attributing profits between a Free Zone parent company and its Foreign Permanent Establishment or Domestic Permanent Establishment:
Step 1: Functional analysis
Identify and analyse the functions performed by each entity, treating them as separate organizations. This analysis should consider the assets used and risks assumed by Foreign Permanent Establishment or Domestic Permanent Establishment and the Free Zone parent.
Step 2: Determine compensation
Calculate appropriate compensation for arrangements between the Foreign Permanent Establishment or Domestic Permanent Establishment and the Free Zone parent, ensuring it matches their respective functions, assets, and risks.
Expense allocation guideline
Where expenses are incurred specifically for a determined income component, those expenses should be allocated directly to that category of income.
However, if the QFZP incurs deductible expenses that cannot be directly attributed to the Qualifying Income or Taxable Income component (for example, interest, centralised general and administration expenses), the QFZP will need to allocate those expenses between the Qualifying Income and Taxable Income components on an arm’s length basis using appropriate allocation keys. This allocation should be consistent with the arm’s length principle.
To sum up, the arm’s length principle is not just a compliance requirement but a fundamental aspect of maintaining QFZP status. Free Zone companies should work closely with tax advisors to ensure their pricing policies and expense allocation methods meet the arm’s length standard, as failure to comply could result in losing QFZP status and facing standard corporate tax rates on the income.
Sameer Mishra is a senior journalist based in the UAE
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