The establishment of Free Zones in the UAE was a strategic move aimed at strengthening UAE’s global market presence and enticing foreign investments. However, there persists a common misconception surrounding Free Zones, particularly regarding the free zone being free from taxes. Contrary to popular belief, not all Free Zones are entirely exempt from taxation, specifically Corporate Tax (CT). The CT legislation has explicitly outlined that Free Zones are subject to taxation unless they meet specific criteria stipulated in the law.
Moreover, the zero per cent tax rate, often associated with Free Zones, is available only when an entity derives income from a transaction with another free zone person provided the service recipient is the beneficial recipient of the service.
Another stream of income which can avail the benefit of zero per cent regime, is income derived in respect of list of activities which qualify for beneficial regime, subject to few other conditions i.e. the qualifying activities, except when revenue are derived from certain activities specifically excluded from the beneficial regime i.e. excluded activities.
Indulging into discussion about distributors, the key condition for availing the beneficial tax rate of zero per cent, for a distributor is to hold title to the products. Thereby, distinguishing a distributor from a sales agent who doesn’t hold title to the products and therefore, are not eligible to avail the beneficial tax rate of zero per cent.
The recent guide issued by Federal Tax Authority (‘FTA’) dedicated to free zones has addressed numerous ambiguous territories to provide definitive clarity. One of such instances is including definition of the term ‘goods’. While goods are defined as tangible and physical items, it has been clarified that distribution of intangible products and services such as licenses, software and financial products/ services will not be covered under distribution activity. However, the guide has further clarified that if the software is embedded onto a hardware, income for which is not separately identifiable, they can still qualify for Distribution activity.
Another area of clarification involves the taxation of ‘High Sea Sales’ within designated zones. The guide has clarified that the requirement of foreign goods to be imported through the designated zone only applies to the distribution of foreign goods to customers in the UAE which means that the activity of ‘High Sea Sales’ conducted by a designated free zone person would be a qualifying activity and any income derived from such activity would be considered as a qualifying income i.e. zero per cent tax rate. Let’s say, Company A is performing activity of distribution of goods, from a designated zone, purchases goods from Country-X and sells it directly to a retailer in Country-Y after adding a markup, then even if the goods do not enter a designated zone in UAE, it will still be considered as a qualifying activity.
The guide has also at several instances emphasized over the fact that the distribution activity which is the qualifying activity has to be undertaken from the designated zone. This implies that goods that are manufactured in the UAE do not need to pass through a Designated Zone, however, the distribution activity is required to be conducted in or from a Designated Zone in order to be a Qualifying Activity.
For example, Company A is a free zone person in a Designated Zone that buys goods from a juridical person in the UAE (outside a free zone) and sells it directly to another juridical person in the UAE (outside a free zone) after adding a markup. In such scenarios, even if the goods do not enter the designated zone, it will be considered as a qualifying activity for Company A since the activity is performed from a designated zone and the goods are already in the UAE. The requirement of distributed goods to enter a Designated Zone only applies in case goods are imported into the UAE and then sold.
Another interesting aspect is that the beneficial tax rate of zero per cent is only available when the distribution service is provided to a customer who is not the ‘end user’. The concept of end-user which was not defined or discussed in the earlier decisions, is now defined and discussed. ‘End user’ is defined as a person who eventually uses the product for its intended purpose, whether personal, commercial, or industrial. To ensure compliance, Free Zone entities are advised to conduct due diligence, including Know Your Client (KYC) procedures and obtaining confirmations through contracts or undertakings.
It’s imperative to highlight that maintaining substance within the entity, including adequate assets, employees, and operations, is crucial for availing these tax benefits. Another crucial compliance to highlight, is compulsory requirement to get the financial statements audited.
In conclusion, while Free Zones offer numerous advantages for businesses, navigating the complexities of taxation requires a thorough understanding of the applicable laws and regulations.
The writer is Partner — MICS.