UAE Ministry of Finance provides clarity on definition of ‘Qualifying Income’

Background

The United Arab Emirates (UAE) have introduced Corporate Income Tax (CIT) for financial years starting on or after 1 June 2023. In recent weeks, the UAE Ministry of Finance has released a series of Cabinet and Ministerial Decisions, providing us with a clearer understanding of the intricacies of the new CIT regime.

On 1 June 2023, the Ministry of Finance published a Cabinet and Ministerial Decision¹ which provide more details regarding the CIT regime applicable to Qualifying Free Zone Persons. These decisions were highly anticipated, as they provide further insights and clarity regarding the scope of the beneficial 0% tax regime for Free Zone entities.

In this alert, we have summarized the main takeaways from both decisions.

Qualifying Free Zone Person

The 0% tax regime is only available for Qualifying Free Zone Persons.

A Qualifying Free Zone Person (QFZP) is a Free Zone Person that meets all of the following conditions:

• the QFZP maintains adequate substance in the UAE (see below);
• the QFZP derives Qualifying Income;
• the Free Zone Person has not elected to be subject to CIT as a regular taxpayer;
• the QFZP complies with the arm’s length principle and transfer pricing documentation requirements;
• the QFZP meets the de minimis threshold (see below); and
• the QFZP prepares and maintains audited financial statements.²

Qualifying income

To determine which income streams are eligible for the 0% tax rate, QFZPs will need to analyze the nature and origin of their sources of income and categorize such income for CIT purposes.

The following income categories are considered Qualifying Income:

• Category 1: Income derived from transactions with other Free Zone Persons, except for income derived from ‘Excluded Activities’. Income will only be considered as derived from another Free Zone Person if that Free Zone Person is the Beneficial Recipient of the relevant goods or services.³
• Category 2: Income derived from transactions with Non-Free Zone Persons,⁴ but only in respect of ‘Qualifying Activities’ that are not ‘Excluded Activities’.
• Category 3: Other income provided that the QFZP satisfies the de minimis requirements.⁵
• Category 4: income derived from any Person where such income is incidental to the income under category 1 or 2.

Qualifying income is in principle eligible for the 0% tax rate.

Qualifying Activities

The following activities are considered Qualifying Activities under Ministerial Decision No. (139) of 2023:

1. manufacturing of goods or materials;
2. processing of goods or materials;
3. holding of shares and other securities;
4. ownership, management and operation of ships;
5. reinsurance services that are subject to regulatory oversight of the competent authority in the UAE;
6. fund management services that are subject to regulatory oversight of the competent authority in the UAE;
7. wealth and investment management services that are subject to regulatory oversight of the competent authority in the UAE;
8. headquarter services to related parties;
9. treasury and financing services to related parties;
10. financing and leasing of aircraft, including engines and rotable components;
11. distribution of goods or materials in or from a Designated Zone to a customer that resells such goods or materials, or parts thereof or processes or alters such goods or materials or parts; thereof for the purposes of sale or resale;
12. logistics services, and
13. any activities that are ancillary to the activities listed above.

Excluded Activities

The following activities are considered Excluded Activities under Ministerial Decision No. (139) of 2023:

1. any transaction with a natural person (i.e., individual) except for transactions that fall under Qualifying Activities (iv), (vi), (vii) and (x) listed above;
2. banking activities, insurance activities and finance and leasing activities that are subject to regulatory oversight in the UAE unless they are specifically permitted as a Qualifying Activity;
3. ownership or exploitation of immovable property, other than commercial property that is located in a Free Zone where the transaction is with other Free Zone Persons;
4. ownership or exploitation of intellectual property assets; and
5. any activities that are ancillary to the activities listed above.

Income from Excluded Activities will in principle always qualify as taxable income, subject to tax at 9%.⁶ In this respect, it is worth noting that QFZPs cannot benefit from the 0% tax bracket for income up to AED375,000.⁷

Permanent establishment

Income attributable to a domestic or foreign permanent establishment is not considered Qualifying Income for a QFZP.

To determine whether the QFZP has a domestic PE, an assessment should be made whether the QFZP has a PE in the geographical area outside the Free Zone (i.e., whether the QFZP has a PE in UAE mainland).

Immovable property

To determine whether income derived from immovable property is considered Qualifying Income, QFZPs will need to consider the following aspects:

• the location of the property: inside or outside the Free Zone;
• the designation of the property: commercial or non-commercial;
• the origin of the sources of income: whether the income is derived from a Free Zone Person or Non-Free Zone Person.

Only income derived from a Free Zone Person that is attributable to a commercial property located within the Free Zone will be considered Qualifying Income eligible for the 0% tax rate.

The following income is considered as derived from an Excluded Activity:

• income derived from a Non-Free Zone Person that is attributable to a Commercial Property located within the Free Zone;
• income that is attributable to a Non-Commercial Property located within the Free Zone (irrespective of the origin of the income);
• income that is attributable to an immovable property (commercial or non-commercial) outside of the Free Zone (irrespective of the origin of the income).

Interestingly, hotels, motels, bed and breakfast establishments and serviced apartments are not considered commercial property for the determination of Qualifying Income. Any income attributable to such properties will therefore qualify as taxable income which is subject to tax at 9%.

De minimis rule

A QFZP is only allowed to derive income which is not eligible for the 0% tax rate within certain limits. In the regulations, this is referred to as the de minimis rule. The de minimis rule imposes a limit in terms of the amount of non-qualifying Revenue a QFZP can derive, without losing its status as a QFZP.

The de minimis threshold is set at 5% of the QFZP’s total revenue or AED 5 million, whichever is lower.⁸

To calculate the de minimis threshold, the QFZP must take into account the following revenue categories:

• Revenue from Excluded Activities.
• Revenue from activities that are not Qualifying Activities where the other party to the transaction is a Non-Free Zone Person.⁹

The following revenue is excluded from the de minimis threshold:

• Revenue that is attributable to immovable property located in a Free Zone that is either (i) derived from Non-Free Zone Persons in respect of Commercial Property, or (ii) derived from any person in respect of immovable property that is not a Commercial Property.
• Revenue that is attributable to a QFZP’s Domestic Permanent Establishment or Foreign Permanent Establishment.

If the de minimis threshold is exceeded, the Free Zone Person loses its status as a QFZP. This means that the Free Zone Person will be considered a regular taxpayer whose income will be taxed according to article 3 (1) of the CIT law. This means that all of the Free Zone Person’s income will be considered taxable income. Any income up to AED375,000 should be taxable at 0% and any income exceeding AED375,000 should be taxable at 9%.

Substance

Cabinet Decision No. (55) of 2023 provides more clarity on the requirement for QFZPs to maintain adequate substance in the UAE as per article 18 of the CIT law.

In order to meet the substance requirements, a QFZP must meet the following conditions:

• conduct its core income-generating activities in a Free Zone; and
• having regard to the level of the activities carried out, (i) have adequate assets, (ii) have an adequate number of qualified employees, and (iii) incur an adequate amount of operating expenditure.

These requirements closely resemble the Economic Substance Test (EST) under the Economic Substance Regulations framework that was implemented in the UAE in 2019.¹⁰ A difference with the EST is the lack of the directed and managed test. At least from a substance perspective, it therefore does not seem required for the QFZP’s strategic decisions to be taken in the Free Zone (or by extension, the UAE).

The Cabinet Decision further stipulates that a QFZP is permitted to outsource activities subject to meeting the following conditions:

• the activities are outsourced to related or third parties in the freezone; and
• the QFZP must have adequate supervision of the outsourced activity. This entails the QFZP must monitor and exercise adequate control of the activity being carried out by any outsourcing provider(s).

In light of these conditions, it is clear that the QFZPs will need to maintain substance within the Free Zone and any substance outside of the Free Zone should not be taken into account when assessing whether the Free Zone Person meets the conditions to be considered a QFZP.

Key takeaways

• On certain items, the new regulations appear to deviate from the principles set out in last year’s Public Consultation Document. Overall, the regulations appear to limit the scope of the 0% tax regime for Qualifying Free Zone Persons. Given this significant divergence, businesses should revisit any previous tax advice in light of the latest decisions pertaining to Qualifying Income to ensure their strategies remain valid.
• Qualifying Free Zone Persons will need to thoroughly analyze the nature and origin of their income sources to categorize their income for CIT purposes and determine to which extent they are eligible for the 0% tax rate.
• As regards income from real estate, only income derived from a Free Zone Person attributable to Commercial Property located in the Free Zone is considered Qualifying Income.
• The 𝘥𝘦 𝘮𝘪𝘯𝘪𝘮𝘪𝘴 rule constitutes a significant limiting factor in terms of the amount of non-qualifying revenue that a QFZP will be allowed to receive, without losing its status as a QFZP.
• Exceeding the 𝘥𝘦 𝘮𝘪𝘯𝘪𝘮𝘪𝘴 threshold means the entity loses its QFZP status for the current and following four tax periods.
• A QFZP must maintain adequate substance in the Free Zone and prepare audited financial statements.
• So far, no guidance has been published in terms of how the regulations will be applied in practice, and most notably, from a tax compliance perspective. Given the complexity of the rules, we expect that the compliance burden for QFZPs will be high. Given the reduced scope of the 0% tax regime, some QFZPs may even consider electing to be treated as a regular taxpayer, thereby forfeiting the benefit of the 0% tax rate in favour of reduced compliance obligations.

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¹Cabinet Decision No. (55) of 2023 on Determining Qualifying Income for the Qualifying Free Zone Person for the Purposes of Federal Decree-Law No. (47) of 2022 on the Taxation of Corporations and Businesses and Ministerial Decision No. (139) of 2023 Regarding Qualifying Activities and Excluded Activities for the Purposes of Federal Decree Law No. (47) of 2022 on the Taxation of Corporations and Businesses.
²Article 54, clause 2 of Federal Decree-Law No. (47) of 2022 on the Taxation of Corporations and Businesses (CIT law). See also Ministerial Decision No. (82) of 2023 on Taxable Persons Required to Prepare and Maintain Audited Financial Statements.
³The term “Beneficial Recipient” shall mean a Person who has the right to use and enjoy the service or the Good and does not have a contractual or legal obligation to pass on such service or good to another person and the term “good” shall mean tangible or intangible property that has economic value in dealing including moveable and immovable property.
⁴A Non-Free Zone Person is a person who is not incorporated in the Free Zone. This includes persons in the mainland or outside of the UAE.
⁵ Examples of ‘other income’ may include income from services provided to Non-Free Zone Persons, or income from trading with Non-Free Zone Persons whereby goods or not distributed in or from a Designated Zone for resale.
⁶Article 3 (2) (b) CIT law.
⁷ Article 3 (2) CIT law, see also Explanatory Guide on Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses, commentary on article 3, p. 10.
⁸ For all taxpayers with a total revenue exceeding AED100 million, the upper limit in terms of non-qualifying Revenue is effectively set at AED5 million.
⁹In our view, this corresponds with the ‘Other income’ category (Category 3).
¹⁰The UAE ESR apply to financial years starting on or after 1 January 2019.