Free Zone Corporate Governance Updates: Key Changes for 2024

On May 1, 2024, the Federal Tax Authority (FTA) released a guide to clarify the application of the corporate tax (CT) law for free zone persons (FZPs) in the UAE. This guide, while not legally binding, aims to assist businesses in understanding how the CT law applies, particularly regarding the taxation of income from qualifying activities at a zero rate. It highlights the significance of free zones in the UAE’s economy, which offer numerous advantages such as relaxed ownership restrictions and streamlined procedures, thus contributing to economic growth.

Purpose: The guide explains how free zone companies (referred to as Free Zone Persons, or FZPs) can benefit from a 0% tax rate on certain types of income.

Key Conditions for Qualifying for 0% Corporate Tax

For a free zone company to qualify for the 0% tax rate, it must meet several conditions:

Maintain Adequate Substance: The company must have a real presence in the free zone, meaning it needs to have sufficient resources, staff, and operations there.

The guide outlines important rules for businesses in free zones about maintaining “adequate substance.” A Free Zone Person (FZP) must conduct its main income-generating activities within the free zone, or in a Designated Zone if it involves distributing goods. While non-core activities can be performed outside the free zone, they should not directly impact sales or be routine. If an FZP chooses to outsource tasks, it must maintain oversight to ensure quality and efficiency, documenting these arrangements in agreements to ensure both parties fulfil their obligations. To demonstrate adequate substance, the FZP must have sufficient physical resources, qualified full-time employees, and reasonable operating costs within the free zone or Designated Zone.

Generate Qualifying Income: The income must come from activities that are recognized as qualifying under the corporate tax law. The guide provides details on various qualifying activities. Manufacturing involves creating tangible goods, including contract manufacturing, but excludes repair services. Processing refers to the intermediate steps in production, which can sometimes be the final stage, focusing on continuous actions applied to tangible items. Trading covers raw commodities and those with minor processing, such as cleaning or grading. Holding shares and securities for investment requires them to be held for at least 12 months, demonstrating a clear investment intention, including cryptocurrency.

Opt-Out of Standard CT Rules: The company must not choose to be taxed under the regular corporate tax rules and rates.

Arm’s Length Principle Compliance: The company must ensure that transactions with related parties are conducted as if they were between unrelated parties, meaning prices should be fair and market-based.

Transfer Pricing Documentation: The company must keep proper documentation that justifies the pricing of its transactions with related parties.

Audited Financial Statements: The company must have its financial records audited by a qualified professional to ensure accuracy and compliance.

De Minimis Test: This is a specific test to check that non-qualifying income does not exceed a certain limit. For example, the company’s non-qualifying income should be less than AED 5 million or less than 5% of its total revenue.

Additional Ministerial Conditions: There may be other specific requirements set by the minister that the company must also meet.

Key Highlights for 2024

The guide builds on existing laws and decisions regarding corporate tax (CIT) for companies in free zones. It clarifies some areas that were previously uncertain.

Eligibility of Free Zones:

The guide states that companies wanting to benefit from the Free Zone Tax Regime should check with their Free Zone Authorities to confirm whether they operate in a qualifying Free Zone or Designated Zone for tax purposes.

Qualifying Income for New Ventures:

One requirement is that companies must generate “Qualifying Income.” Initially, it seemed that companies without any income would not qualify. However, the guide clarifies that if a company hasn’t started making revenue yet, this won’t disqualify it from being considered a Qualifying Free Zone Person (QFZP). This is particularly helpful for startups.

Employee Count for Substance Criteria:

To qualify, companies need to show they have sufficient substance (assets, employees, etc.) in the free zone. The guide explains that if a company has multiple activities (called CIGAs), each activity needs to be assessed separately regarding the number of employees. An employee can only be counted for one activity, even if they contribute to multiple activities.

Clarifications on Qualifying Activities:

The guide offers examples of what constitutes qualifying and excluded activities. For instance, for the activity of distributing goods from a Designated Zone, goods must enter the zone only if they are foreign goods meant for customers in the UAE outside the zone. Distribution to end users doesn’t qualify.

Income from Qualifying Intellectual Property: Companies can benefit from the 0% tax rate on income derived from qualifying intellectual property (like patents and copyrighted software) if there’s a direct connection between that income and specific qualifying expenses. The guide provides a formula for calculating this qualifying income.

Handling of Tax Losses for QFZPs:

The guide clarifies how tax losses are treated:

• Losses related to Qualifying Income cannot be offset against other taxable income or carried forward to future years.
• Losses from regular taxable income can be carried forward to offset future taxable income, but not against income from intellectual property.
• Companies cannot use losses incurred before the CIT system was implemented.

Satisfaction of Beneficial Recipient:

If a free zone person (FZP) sells goods or services to another FZP, they can accept a written statement from the buyer confirming that they are the intended recipient and will use the goods or services for their business in the free zone. This is acceptable unless there is a good reason to doubt the accuracy of this statement.

No Qualifying Income in First Taxable Period:

If an FZP does not generate any income during its first tax period because it has not started making sales, it will still be considered to meet the qualifying income criteria as long as it does not earn any income from activities that do not qualify for the tax benefits.

Re-evaluating Eligibility After the First Taxable Period:

If an FZP does not meet the qualifying conditions during its first taxable period, it can still choose to qualify for tax benefits after five years. Failing to meet the conditions in the second to fifth years will not affect its ability to re-qualify later.

Loss Setoff:

Tax losses that an FZP incurs can be used to offset future taxable income. This means if an FZP has a loss in one year, it can reduce its tax bill in future years. However, losses from non-qualifying intellectual property can only be set off against income from the same type of intellectual property, not against other types of income.