Ensuring FZE Status as a Qualified Free Zone Entity (QFZE)

Important Year-End Corporate Tax (CT) Considerations for Free Zone Entities (FZE):
Ensuring FZE Status as a Qualified Free Zone Entity (QFZE)

• A free zone entity is not automatically, by default, a qualified free zone entity (QFZE) for the UAE’s CT purpose, which can benefit from a zero rate CT on qualifying income activities.
• FZE which is not a QFZE for CT purposes in the UAE, is fully taxable for all its activities.
• The essential requirement for a QFZE is the De Minimis threshold
• If an FZE does not meet the de minimis requirement, it will be taxable in all its activities in the UAE.
• FZE is subject to more CT requirements than mainland entities. For example, record keeping, transfer pricing, applicable accounting standards, tax payment, and audited financial statements are required regardless of income, etc.

Tax Planning for UAE Free Zone Companies Not Automatically Qualifying for Free Zone Entity Status Under UAE Corporate Tax Law

The introduction of Corporate Tax (CT) in the United Arab Emirates (UAE) has significantly changed the business landscape in the region. While Free Zone Companies traditionally enjoy tax-free benefits, not all entities are automatically classified as Free Zone Entities (FZEs) under the new CT law. This distinction requires strategic tax planning to navigate the evolving regulatory landscape effectively.

A Free Zone Entity is a juridical person who is incorporated, established, or otherwise registered in a Free Zone. This includes branches of Non-Resident Persons or UAE juridical persons registered in a Free Zone. It also encompasses relevant Free Zone authorities and other Government Controlled Entities established in a Free Zone. A Free Zone Person can have its head office in a Free Zone with a branch outside the Free Zone, or vice versa. However, entities without a separate legal personality, such as Unincorporated Partnerships or natural persons, cannot be Free Zone Entities.

This article delves into the key tax planning considerations for UAE Free Zone companies and the requirements for meeting the conditions to be taxed at 0% on Qualifying activities, particularly the De Minimis threshold requirement.

1. Understanding the Criteria for FZE Status

Under UAE Corporate Tax law, one important criterion for companies established in Free Zones to enjoy a preferential CT rate of 0% on qualifying income is meeting the De Minimis threshold requirements. This means that the company’s non-qualifying revenue must not exceed the lower of AED 5,000,000 or 5% of its total revenue.

2. Requirements of the De Minimis Threshold:

1. Non-Qualifying Revenue Limit: The de minimis requirements are met if the Free Zone Entity’s non-qualifying Revenue does not exceed the lower of:

1. • AED 5,000,000, or
   • 5% of its total Revenue.
2. Non-Qualifying Revenue: This includes Revenue derived from:
   • Excluded Activities.
   • Activities that are not Qualifying Activities where the other party to the transaction is a Non-Free Zone Entity.
   • Transactions with a Free Zone Entity where such Free Zone Entity is not the Beneficial Recipient of the relevant services or Goods.

3. Impact of the De Minimis Threshold:

1. Maintaining QFZE Status: If a Free Zone Entity meets the de minimis requirements, it can maintain its status as a Qualifying Free Zone Entity (QFZE) and benefit from the 0% Corporate Tax rate on its Qualifying Income.

1. Losing QFZE Status: If the de minimis requirements are not met, the Free Zone Entity will lose its QFZE status and will be subject to the standard Corporate Tax rules and rates from the beginning of the relevant Tax Period and for the subsequent four Tax Periods.
2. Revenue Segregation: When assessing the de minimis requirements, Revenue from certain sources (e.g., Revenue attributable to a Foreign Permanent Establishment, Domestic Permanent Establishment, or specific types of Immovable Property) is excluded from the calculation.

Example:

• If a Free Zone Entity derives AED 10,000,000 in total Revenue, with AED 2,000,000 from a Domestic Permanent Establishment, the total Revenue for the de minimis calculation would be AED 8,000,000.
• If the non-qualifying Revenue is AED 500,000, it would be 6.25% of the total Revenue (500,000/8,000,000), exceeding the 5% threshold, thus failing the de minimis requirement and losing QFZE status.

4. Impact on Free Zone Entity if the De Minimis Threshold is Exceeded:

If a Free Zone Entity (FZE) exceeds the de minimis threshold, it will lose its status as a Qualifying Free Zone Entity (QFZE). This has several significant implications:

1. Loss of QFZE Status:

1. • The FZE will no longer be considered a QFZE from the beginning of the Tax Period in which the de minimis threshold is exceeded.
   • The FZE will also lose its QFZE status for the subsequent four Tax Periods.
2. Corporate Tax Rate:
   • The FZE will be subject to the standard Corporate Tax rules and rates.
   • This means the FZE will be taxed at the standard Corporate Tax rate of 9% on its Taxable Income rather than benefiting from the 0% Corporate Tax rate on Qualifying Income.
3. Ineligibility for Certain Benefits:
   • The FZE will not be eligible for the 0% Corporate Tax rate on its first AED 375,000 of Taxable Income.
   • The FZE also does not qualify for specific relief provisions available under the Corporate Tax Law, such as Small Business Relief, Qualifying Group Relief, Business Restructuring Relief, and transfer of Tax Losses.

By understanding and managing the de minimis requirements, Free Zone Entities can better maintain their QFZE status and benefit from the 0% Corporate Tax rate on Qualifying Income.

5. Definition of Qualifying Income for a QFZE:

Qualifying Income for a Qualifying Free Zone Entity (QFZE) is defined in relation to the following categories:

1. Transactions with Free Zone Entities:

1. • Income from transactions with another Free Zone Entity, which is the Beneficial Recipient of the transaction, provided the transactions do not relate to Excluded Activities.
2. Qualifying Activities:
   • Income from transactions relating to Qualifying Activities that are not Excluded Activities.
3. Qualifying Intellectual Property:
   • Income derived from the ownership or exploitation of Qualifying Intellectual Property.
4. Other Sources:
   • Any other income provided the QFZE meets the de minimis requirements.

6. Exclusions from Qualifying Income:

Even if the income falls within the categories listed above, the following sources of income will not be considered Qualifying Income and will be subject to the standard 9% Corporate Tax rate (unless exempt under another provision):

• Foreign Permanent Establishment:
  • Revenue attributable to a Foreign Permanent Establishment.
• Domestic Permanent Establishment:
  • Revenue attributable to a Domestic Permanent Establishment.
• Immovable Property:
  • Revenue from Immovable Property, except for Commercial Property located in a Free Zone when the income arises from a transaction with a Free Zone Entity.
• Intellectual Property:
  • Revenue from the ownership or exploitation of intellectual property, other than Qualifying Income from Qualifying Intellectual Property.

Example:

• Company A (a QFZE) provides legal services to other Free Zone Entities who are the Beneficial Recipients. The income from these transactions will be considered Qualifying Income, provided the services are not Excluded Activities.

By adhering to these definitions and exclusions, a QFZE can determine which portions of its income qualify for the 0% Corporate Tax rate.

7. Excluded Activities:

Excluded Activities are specific activities that do not qualify for the 0% Corporate Tax rate under the Free Zone regime. These activities include:

1. Banking Activities:
   • Any activities related to banking.
2. Insurance Activities:
   • Any activities related to insurance.
3. Finance and Leasing Activities:
   • Any activities related to finance and leasing.
4. Ownership or Exploitation of Immovable Property:
   • Income from the ownership or exploitation of immovable property, except for Commercial Property located in a Free Zone when the income arises from a transaction with a Free Zone Entity.
5. Ownership or Exploitation of Intellectual Property:
   • Income from the ownership or exploitation of intellectual property other than Qualifying Income from Qualifying Intellectual Property.
6. Natural Resource Extraction:
   • Any activities related to the extraction of natural resources.
7. Non-Free Zone Business:
   • Any activities conducted outside the Free Zone.

Impact of Excluded Activities:

• Non-Qualifying Income: Income derived from Excluded Activities will not be considered Qualifying Income and will be subject to the standard 9% Corporate Tax rate.
• De Minimis Calculation: Revenue from Excluded Activities is considered non-qualifying Revenue and is included in the de minimis calculation to determine if a Free Zone Entity can maintain its QFZE status.

Example:

• Company B (a QFZE) engages in banking activities within a Free Zone. The income from these banking activities will be considered non-qualifying Revenue and will be subject to the standard 9% Corporate Tax rate.

By understanding and adhering to these exclusions, Free Zone Entities can better manage their tax obligations and maintain their QFZE status.

Other criteria requirements to qualify as a QFZE are as follows:

1. Be a Free Zone Entity (QFZE): The company must be a juridical person incorporated, established, or registered in a Free Zone, including branches of non-resident persons or UAE juridical persons registered in a Free Zone.
2. Maintain Adequate Substance: The company must undertake its core income-generating activities in the Free Zone, have adequate assets and full-time employees, and incur adequate operating expenditures in the Free Zone. Distribution activities as a qualifying activity must be performed from a Designated Free Zone Jurisdiction and not only a Free Zone Jurisdiction unless all the customers of the FZE are also FZEs.
3. Derive Qualifying Income: The company must derive income from transactions with other Free Zone Entities, transactions relating to Qualifying Activities, income from Qualifying Intellectual Property, or other income that meets the de minimis requirements.
4. Not Elect to be Subject to Standard Corporate Tax Rules: The company must not have elected to be subject to the standard Corporate Tax rules and rates.
5. Comply with the Arm’s Length Principle: The company must comply with the arm’s length principle for transactions with Related Parties and arrangements between the Free Zone parent and its Foreign or Domestic Permanent Establishments.
6. Maintain Transfer Pricing Documentation: The company must maintain appropriate Transfer Pricing documentation for transactions with Related Parties and Connected Persons.
7. Maintain Audited Financial Statements: The company must prepare and maintain audited Financial Statements, regardless of the amount of revenue it earns.

Companies that fail to meet these conditions may not be eligible for the FZE designation and would be subject to the standard CT rate of 9% on taxable income.

Other Important Considerations for QFZEs:

Assessing Business Activities and Income Sources

Free Zone companies must scrutinize their business activities and income sources to determine their tax status. Key considerations include:

• Segregation of Income: Distinguish between qualifying income (e.g., transactions with entities outside the UAE) and non-qualifying income (e.g., business with mainland UAE entities).
• Activity Compliance: Ensure that business operations align with the Free Zone’s permitted activities to maximize eligibility for FZE status.
• Mainland Transactions: Evaluate the extent of business conducted with mainland UAE entities, as this income could subject the company to standard CT rates.

Structuring and Substance Requirements

Companies not automatically qualifying for FZE status must assess their operational structure and economic substance in the UAE. This involves:

• Economic Substance Regulations (ESR) Compliance: Demonstrating adequate presence in the UAE by meeting requirements related to management, employees, and operations.
• Restructuring Opportunities: Consider restructuring to align with qualifying criteria, such as establishing separate legal entities for mainland operations and Free Zone activities.

Leveraging Tax Incentives and Deductions

While standard CT rates may apply, companies can optimize their tax liabilities by:

• Maximizing Deductions: Deduct legitimate business expenses, such as operational costs, employee salaries, and depreciation of assets, to reduce taxable income.
• Utilizing Double Tax Treaties: Leverage the UAE’s extensive network of Double Taxation Avoidance Agreements (DTAAs) to mitigate cross-border tax exposure.

Exploring Alternative Structures

Companies unable to secure FZE status should consider alternative corporate structures:

• Holding Companies: Establish holding structures within Free Zones to consolidate profits and manage tax liabilities effectively.
• Joint Ventures: Explore joint venture arrangements to segregate Free Zone and mainland activities.

Compliance and Reporting

Ensuring compliance with UAE CT laws is paramount to avoid penalties. Companies should:

• Maintain Accurate Records: Document all financial transactions, income sources, and expenses meticulously.
• File Timely Returns: Adhere to the CT filing deadlines to avoid penalties and interest.
• Engage Professional Advisors: Work with tax consultants to ensure compliance and identify optimization opportunities.

Scenario Planning and Forecasting

Conducting scenario planning helps companies understand the financial implications of different tax treatments. This includes:

• Tax Liability Projections: Forecast potential tax liabilities under various scenarios to inform decision-making.
• Sensitivity Analysis: Assess the impact of changes in income classification or business activities on tax obligations.

Conclusion

The UAE Corporate Tax regime introduces new challenges and opportunities for Free Zone companies that do not automatically qualify for FZE status. By understanding the criteria, optimizing structures, leveraging incentives, and ensuring compliance, FZE businesses can effectively navigate the changing tax landscape. These companies must consider excluded activities and de minimis requirements, as they can significantly affect their eligibility for Free Zone benefits. Excluded activities may involve certain types of mainland transactions or non-core activities, while de minimis thresholds allow for limited non-qualifying income within specific limits.

At XB4, we engage in proactive tax planning and offer expert advice to minimize liabilities and maximize opportunities within the new regulatory framework.

Previous articles on FZEs.

• UAE’s Corporate Income Tax update – Free Zones Qualifying Income
• Corporate Income Tax for Free Zones Entities in the UAE