The taxation framework for businesses operating in free zones is a crucial aspect of the United Arab Emirates' (UAE) economic policies. Free Zones provide attractive incentives and benefits to businesses, including tax exemptions. However, the tax treatment of income derived by Qualified Free Zone Persons (QFZPs) requires a careful examination of the interaction between Qualified Income (QI) and Excluded Income (EI) carve-out definitions.

In this write-up, we will delve into the provisions of the UAE Corporate Tax Law, relevant cabinet decisions, and ministerial decisions to analyze the tax efficiency of making an election under Article 19 of the UAE Corporate Tax Law for QFZPs. The primary objective is to determine whether it is advisable to elect for taxation under Article 3(1) or Article 3(2) of the UAE Corporate Tax Law.    

Understanding the Taxation Options

Taxation under Article 3(1):

A QFZP has the option to be subject to corporate taxation under Article 3(1) of the UAE Corporate Tax Law. This option entails a 0% tax rate on the first AED 375,000 of Annual Taxable Income and a 9% tax rate on the remainder of the income.

Taxation under Article 3(2):

Alternatively, a QFZP can choose to be taxed under Article 3(2) of the UAE Corporate Tax Law. This option involves a 0% tax rate on Qualified Income and a 9% tax rate on the taxable income that does not qualify under the provisions of Article 18 of the UAE Corporate Tax Law, Cabinet Decision No. 55 of 2023 (CD 55), and Ministerial Decision No. 139 of 2023 (MD 139). Notably, the AED 375,000 threshold does not apply to Article 3(2).

Determining Qualified Income (QI) and Excluded Income (EI)

To ascertain the tax efficiency of making an election under Article 19, it is essential to understand the definitions of QI and EI, as stipulated in CD 55 and MD 139.

Qualified Income (QI) - 0% Taxation:

CD 55, in conjunction with MD 139, outlines the following types of income as QI, eligible for a 0% tax rate:

a. Income derived from transactions with other Free Zone Persons (FZPs) that are not from Excluded Activities.

b. Income derived from transactions with non-Free Zone Persons, provided it relates to Qualified Activities and is not from Excluded Activities.

c. Any other income where Other Income/All Revenue of the QFZP is less than 5% (de minimis test). This income can arise from Excluded Activities or non-Qualifying Activities involving non-FZPs.

It's important to note that all income incidental to QI, as defined in points a and b above, also qualifies for a 0% tax rate.

Excluded Income (EI) - 9% Taxation:

Certain types of income fall under the category of EI and are subject to a 9% tax rate. The exclusions encompass:

a. Income attributable to Domestic Permanent Establishments (PEs) or Foreign PEs, which are treated separately from QFZPs and taxed under Article 3(2)(b) of the UAE Corporate Tax Law. Arm's length pricing rules apply to transactions with associated enterprises.

b. Income derived from commercial property (excluding residential or hotel properties) in free zones, sourced from non-FZPs.

c. Income derived from immovable property (including hotels) in free zones from any source.

Understanding Qualified Activities and Excluded Activities

To correctly classify income as QI or EI, it is crucial to comprehend the definitions of Qualified Activities (QAs) and Excluded Activities (EAs) as specified in MD 139.

Qualified Activities:

QAs encompass various activities, including:

• Manufacturing and processing of goods or materials.
• Holding of shares and other securities.
• Ownership, management, and operation of ships.
• Reinsurance services subject to regulatory oversight in the UAE.
• Fund management services subject to regulatory oversight in the UAE.
• Wealth and investment management services subject to regulatory oversight in the UAE.
• Provision of headquarters services to related parties.
• Provision of treasury and financing services to related parties.
• Financing and leasing of aircraft, including engines and rotable components.
• Distribution of goods or materials within or from a Designated Zone to customers involved in resale, processing, or alteration of such goods.
• Provision of logistics services.
• Ancillary activities to the above-mentioned QAs.

Excluded Activities:

EAs, on the other hand, consist of:

• Transactions with natural persons, except for specific QAs.
• Banking activities subject to regulatory oversight in the UAE.
• Insurance activities subject to regulatory oversight in the UAE, except for specified reinsurance services.
• Finance and leasing activities subject to regulatory oversight in the UAE, except for specific financing and leasing activities.
• Ownership or exploitation of immovable property, excluding commercial property in free zones involved in transactions with other FZPs.
• Ownership or exploitation of intellectual property assets.
• Ancillary activities to the EAs listed above.

Interplay between Qualified Activities and Excluded Activities

It is crucial to understand that Qualified Activities and Excluded Activities are mutually exclusive lists with carve-out provisions where activities overlap. For instance, any transactions with natural persons, except for a few QAs, fall under Excluded Activities. Therefore, income derived from transactions with natural persons is subject to a 9% corporate tax rate, except for the limited exceptions mentioned. If a QFZP receives income from distributing or selling goods to a natural person, considered an Excluded Activity, it will be taxed at 9% under Article 3(2)(b) of the UAE Corporate Tax Law.

De Minimis Test

The de minimis test, specified in Article 4(2)(a)(1) of CD 55 includes income derived from Excluded Activities. To qualify for the de minimis exception, in the above example, income from the distribution and sale of goods to natural persons (Excluded Activity) must meet the prescribed threshold Other Income/All Revenue of QFZP <5%.  This Other income can arise/ be derived from Excluded Activities or Activities that are not Qualifying Activities where the other party is a Non-FZP.

Conclusion

Considering the UAE Corporate Tax Law, cabinet decisions, and ministerial decisions, the taxation of QFZPs involves careful consideration of Qualified Income (QI) and Excluded Income (EI). By understanding the definitions of Qualified Activities and Excluded Activities and their interaction, businesses can make informed decisions on whether to elect for taxation under Article 3(1) or Article 3(2) of the UAE Corporate Tax Law.

For QFZPs, a comprehensive analysis of their income sources, nature of activities, and potential interactions between QIs and EIs is essential to determine the tax efficiency of making an election under Article 19. Consulting with tax professionals or legal experts well-versed in UAE tax laws is highly recommended to ensure compliance and optimize tax planning strategies for QFZPs of UAE free zones.

For any further inquiries, please feel free to reach out to Ms. Dhana Pillai via email at dhana.pillai@dptc.ae.