UAE Free Zone Businesses to Lose the 0% Corporate Tax Status?

“Disqualifying Income”: Entities Would Be Disqualified from 0% Tax Rate on all Its Income

The UAE has recently introduced changes to its corporate tax structure, potentially impacting businesses operating within its free zones. The UAE Corporate Tax Decree presents a different tax rate system for these entities based on their income classification. As the cabinet is set to clarify the scope of qualifying, non-qualifying, and disqualifying income, businesses must navigate the implications of the new tax rates and understand how they might affect their operations. This article examines the different income categories, their respective tax rates, and the potential impact on free zone businesses.

The UAE Corporate Tax Decree, issued on December 9, 2022, has two tax rates applicable on free zone registered entities. This Decree stipulates that even though the qualifying free zone entities shall be taxed at 0% on their qualifying income, they will be taxed at 9% on taxable income that is not a qualifying income.

So, even though free zone businesses in the UAE generally come under the 0% corporate tax mandate, some business services could cause them to lose out on this corporate tax status. It would be very beneficial for these entities to brush up on the points related to the abovementioned disqualifying income, which we will delve into in this article. However, an upcoming cabinet decision is set to specify further the scope of the qualifying and disqualifying types of income.

The concept of two tax rates in the Decree is acclaimed as a departure from the MoF’s public consultation document (PCD), released on April 28, 2022, because free zone entities thought they might continue their normal business operations without losing tax exemption benefits. However, the Decree appears to align with the PCD on free zone taxation because of the concept of ‘disqualifying’ income.

The MoF’s public consultation document (PCD) proposed a 0% tax rate on incomes earned from, but not limited to, the following:

• Transactions with companies located outside of the UAE.
• Trading with companies located in the same or another free zone.
• Certain regulated financial services that are directed at foreign markets.
• The sale of goods by entities located in VAT-designated zones to UAE mainland businesses if the latter remains the importer-on-record.

Such incomes (and others) listed in the MoF’s public consultation document (PCD) could be categorized as qualifying income, as per the Decree.

The differential tax treatment provided by the PCD is for free zone entities with a branch in the mainland, which will be taxed at 9% on its mainland sourced income. This income could include income earned from mainland customers or from activities performed, assets located, capital invested, rights used, or services performed in the mainland.

This aligns with the 9% tax rate proposed in the Decree for income that is not a qualifying income, which may be called ‘non-qualifying’ income. However, certain mainland-sourced income could be taxed at 0% if it’s ‘passive’ in nature, like royalties for the IPR rights used by a mainland customer or dividend earned from capital invested in a mainland company. This passive income would still qualify for a 0% rate.

What Counts as Disqualifying Income: 100% tax

Given that the PCD’s policy objective is to prevent free zone companies from gaining an unfair competitive advantage in comparison to mainland businesses, the document stated that if a free zone entity earns any mainland-sourced income other than qualifying and non-qualifying incomes, the entity will be disqualified from 0% tax rate on all its income. So, it should not be ruled out that free zone entities could be disqualified if their business operations include certain mainland activities or other prescribed activities. Free zone entities may forfeit their entire tax exemption if they provide installation services in the mainland or provide services to overseas clients and mainland clients.

The UAE Corporate Tax Decree introduces two tax rates for free zone registered businesses, and while qualifying income will be taxed at 0%, non-qualifying income will continue to be subject to a 9% tax rate. However, if a free zone entity earns disqualifying income, it may lose its 0% tax rate on all income, in accordance with both the Decree and the PCD.

So now, businesses must ask the right questions to understand the scope of taxation. Free zone entities may believe they could continue their normal business operations by paying tax on ‘non-qualifying’ income; however, they must delve into the implications of the disqualifying income. The latter could become a weakness for the free zone businesses, pending the much-awaited cabinet decision to provide the exact scope of free zone exemptions.