UAE Federal Tax Authority releases Corporate Income Tax Guide on Free Zone Persons

Introduction

On 26 May 2024, the UAE Federal Tax Authority (FTA) released Corporate Income Tax (CIT) Guide with reference CTGFZP1 on Free Zone Persons, which provides further details on the Free Zone Tax Regime initially set forth under the Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses and its practical applicability to eligible taxpayers.

The document provides comprehensive guidance on the main characteristics of the Free Zone Tax Regime and the requirements which will need to be met by taxpayers to be eligible to benefit from the 0% tax regime, including a detailed explanation of substance requirements, Qualifying Activities, Excluded Activities and other key aspects of the Free Zone Tax Regime.

Whilst the main characteristics of the Free Zone Tax Regime where already anticipated in the CIT Law, along with previously issued Guides and Cabinet/Ministerial Decisions, the Free Zone Persons Guide provides valuable insights, examples, and detailed explanations on how certain aspects of the regime are envisaged to apply in practice.

 

General considerations

As anticipated in article 3 of the UAE CIT Law, certain entities established in Free Zones (that will satisfy all conditions to be treated as “Qualifying Free Zone Persons” (QFZPs)) will be eligible to benefit from a reduced 0% tax rate on certain income (the so-called “Qualifying Income”).

In general terms, the following requirements must be met for an entity to be eligible to benefit from the Free Zone Tax Regime (specified in article 18 of the CIT Law and further developed in subsequent guidance):

1. Condition 1 - Consideration as a Free Zone Person: the regime will only be applicable to taxpayers which fall under the definition of “Free Zone Person”, which is defined as a juridical person, incorporated, established, or otherwise registered in a Free Zone recognized for CIT purposes.
2. Condition 2 - Maintain adequate substance in the UAE: Free Zone Persons are required to conduct their core income-generating activities (CIGA) in a Free Zone (or Designated Zone, as applicable), with sufficient assets, employees and operating expenditure to conduct the activity.
3. Condition 3 - Derive Qualifying Income: only certain categories of income (Qualifying Income) will be eligible to benefit from the 0% tax rate. Qualifying Income for these purposes includes the following:
• Income derived from transactions (which do not qualify as Excluded Activities) with other Free Zone Persons provided they are the beneficial recipients.
• Income derived from Qualifying Activities which are not Excluded Activities, regardless of whether the counterparty is a Free Zone Person or not.
• Income derived from the ownership or exploitation of Qualifying Intellectual Property as defined under the Free Zone Tax Regime.
• Other income provided the de minimis requirements are met.
4. Condition 4 - The Free Zone Person has not elected to be subject to CIT as a regular taxpayer.
5. Condition 5 - Comply with the arm’s length principle and transfer pricing documentation requirements.
6. Condition 6 - Meet the de minimis threshold: the Free Zone Person may only generate income which is not eligible to benefit from the 0% tax rate (non-Qualifying Income) up to (i) 5% of its total revenue or (ii) AED5 million, whichever is lower. For these purposes, non-Qualifying Income includes:

• Income from Excluded Activities.
• Income from activities which are not Qualifying Activities when the counterparty to the transaction is a non-Free Zone Person.
• Income derived from transactions with Free Zone Persons which are not the beneficial recipient of the goods or services.

When a Free Zone Person meets all the above requirements, it will be eligible to benefit from the Free Zone Tax Regime and will be subject to tax at the following rates:

• 0% on Qualifying Income.
• 9% on taxable income which is not Qualifying Income.

The 0% tax rate applies for the remainder of the tax incentive period stated in the regulations of the Free Zone in which the Free Zone Person is established.

A Qualifying Free Zone Person may voluntarily opt to be taxed as a regular taxpayer, which will entail that the entity will lose its status since the beginning of the tax period in which the election is made and the four (4) subsequent periods.

 

Main considerations from the Guide

Whilst the general framework of the Free Zone Tax Regime was already anticipated through the CIT Law and subsequently developed by means of Ministerial Decision No. (265) of 2023 Regarding Qualifying Activities and Excluded Activities and Cabinet Decision No. 100 of 2023 on Determining Qualifying Income for the Qualifying Free Zone Person, the Free Zone Persons Guide sheds further light on aspects which remained uncertain under the preexisting regulations.

Below are some of the most relevant/impactful insights, which have been clarified with the new Guide.

Free Zones covered under the Free Zone Tax Regime

Based on the relevant applicable regulations, it appeared that the Free Zone Tax Regime would only be applicable to entities incorporated in certain Free Zones, and potentially some of the Free Zones would be left out of scope.

Whilst this has not been clarified in the recently issued Guide, it does specifically state that taxpayers willing to benefit from the Free Zone Tax Regime should obtain confirmation from their respective Free Zone Authorities on whether they operate in a Free Zone or Designated Zone, for CIT purposes.

Qualifying Income requirements for entities not yet deriving revenue

As mentioned, one of the requirements to be considered a QFZP is to “derive Qualifying Income”, which, strictly interpreted would entail that entities which do not (yet) derive any income would be excluded from the applicability of the regime. This would in turn imply that those entities would be disqualified for the regime, not only for that tax period, but also for the following four (4) tax periods.

The Guide now clarifies that the fact that a Free Zone Person does not earn Qualifying Income in a particular tax period when it has not yet started to generate revenue, will not be sufficient to disqualify it from being considered a QFZP.

This ensures that entities which are just starting to operate (e.g., in start-up phases) do not lose the possibility to benefit from the Free Zone Tax Regime strictly based on the fact that they are not yet deriving revenue.

Computation of employees for substance purposes

Another key requirement to be eligible for the Free Zone Tax Regime is for entities to conduct their CIGA from the Free Zone, with a sufficient level of substance in the Free Zone in terms of assets, employees, and expenditure, in relation to the nature of the activity being conducted.

The Guide specifies with illustrative examples the criteria for assessing whether an entity has sufficient substance.

As a key addition to the previous regulations, the Guide now provides a clarification with regards to the required employees, by stating that the same employee of a Free Zone Person cannot be counted towards two different CIGAs.

The above entails that, if an entity performs more CIGAs in relation to deriving Qualifying Income, each CIGA will need to be assessed separately in terms of employees, in a way that, if an employee contributes to several CIGAs, it will only be considered for substance purposes for one of those.

Clarifications regarding certain Qualifying Activities

Whilst the list of Qualifying and Excluded Activities was already detailed under Ministerial Decision No. (265) of 2023 Regarding Qualifying Activities and Excluded Activities, the Guide provides a number of illustrative examples on these activities, which serves as a valuable framework for assessing the activities performed by QFZPs.

Particularly relevant are the Guide’s clarifications with respect to the Qualifying Activity of “Distribution of goods in or from a Designated Zone”.

In that regard, the Guide states that goods are only required to enter a Designated Zone in case of foreign goods being distributed to customers in the UAE (but based outside a Designated Zone). For any other situations, the goods are not required to physically enter the Designated Zone. Whilst already suggested in the previous regulations, the Guide also confirms that the goods must be distributed to a customer that further resells or to a person that processes the goods or part thereof for the purpose of resale. Distribution of goods to end users remains out of scope of this Qualifying Activity.

Qualifying Income from Qualifying Intellectual Property

As anticipated in the previous available guidance, a QFZP can also benefit from the 0% rate on income derived from Qualifying Intellectual Property, as long as there is a direct nexus between the income derived from the Qualifying Intellectual Property and certain expenses (defined as Qualifying Expenditures) incurred by the taxpayer.

For the purpose of the above, the Guide clarifies that the following are considered as Qualifying Intellectual Property:

• Patents which are granted under the relevant patents law either in the UAE or outside.
• Copyrighted software granted under the relevant applicable laws in the UAE or outside.
• Any right which is functionally equivalent to a patent (i.e. legally protected and subject to a similar approval and registration process to a patent), including utility models or extensions of patent protection.

The Guide also provides further detail on the method for calculating the amount of income which will be eligible to apply the 0% rate (Qualifying Income from Qualifying Intellectual Property as per the terms of the UAE regulations). Specifically, taxpayers will be required to determine the amount of Qualifying Income as per the following formula:

 

$\mathrm{Qualifying Income}=\frac{\mathrm{Qualifying Expenditures}+\mathrm{Uplift Expenditure}}{\mathrm{Overall Expenditures}}\times \mathrm{Overall Income<br>}$

$$

On that basis, the Guide includes several sections specifically dedicated to each of the elements which form the above formula, which provide the reader with illustrative examples and insights on items which will need to be considered when calculating the amount of income eligible for the 0% rate.

Treatment of tax losses incurred by QFZPs

The Guide clarifies that the treatment of tax losses suffered by a QFZP will depend on whether they are incurred in relation to Qualifying Income or whether they are incurred in relation to income which is taxable at the standard CIT rate of 9% (“Taxable Income” as per the terms of the Guide), as per the following:

• Tax losses incurred in relation to Qualifying Income may not be offset against Taxable Income derived by the QFZP and may not be carried forward or transferred to a different entity.
• Tax losses which are incurred in relation to Taxable Income may be carried forward and offset against Taxable Income derived by the QFZP in future tax periods. However, such tax losses may not be offset against income from intellectual property (which does not include income derived from Qualifying Intellectual Property, as per the Free Zone Tax Regime.

In line with the provisions applicable for regular taxpayers, QFZPs may not utilise losses incurred prior to CIT being implemented or prior to the QFZP being considered as a taxable person. Finally, the Guide also confirms that a QFZP is not entitled to transfer or receive tax losses from another taxable person.

All Guides issued by the FTA are intended to provide guidance on the practical application of the CIT regime for UAE taxpayers, but are not legally binding documents and, hence, should be read and interpreted in combination with the CIT Law and the applicable Cabinet Decisions and Ministerial Decisions.

 

Conclusion

The Free Zone Persons Guide provides helpful clarifications and confirmations on certain key aspects of the Free Zone Tax Regime. Besides the CIT Law and the previously issued tax regulations for Free Zone Persons, taxpayers that wish to benefit from the 0% Free Zone Tax Regime should also consult the latest Guide to confirm their tax position.