New Corporate Tax Decisions for Free Zones in the UAE

UAE Tax

The UAE Ministry of Finance (the “MoF”) has announced the issuance of Cabinet Decision No. 100 of 2023 (“Decision 100 of 2023”) on Determining Qualifying Income, as well as Ministerial Decision No.265 of 2023 (“Decision 265 of 2023”) on Qualifying Activities and Excluded Activities revising the Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023, respectively. However, the MoF has repealed the Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023.

In accordance with the revised Cabinet Decisions, the scope of Qualifying Income is extended to include the amount of Qualifying Income derived from the ownership or exploitation of Qualifying Intellectual Property calculated based on the methodology of the OECD’s modified nexus approach, which is prescribed in Decision 265 of 2023.

In addition to including Qualifying Intellectual Property, MoF included trading of Qualifying Commodities in the Qualifying Activities in Decision 265 of 2023, which allows free zone companies to benefit from 0% corporate tax rate over their earnings from the physical trading of metals, minerals, energy, and agricultural commodities traded on a recognized stock exchange, as well as the associated derivative trading income used to hedge against, the risk of such trading activities.

And finally, Decision 265 of 2023 clarifies the intended scope of Qualifying Activities and Excluded Activities thereby providing clarity and certainty to free zone businesses.

Let’s take a closer look at the main revisions in those Decisions for you in this bulletin reviewing the main differences and the clarifications.

Trading of Qualifying Commodities has been Included

in the List of Qualifying Activities

In Article 1 of Decision 265 of 2023, the “qualifying commodities” are defined as metals, minerals, energy and agriculture commodities that are traded on a “recognized commodities exchange market” in raw form.

Subsequently, the “recognized commodities exchange market” is defined in the same Article as any commodities exchange market established in the UAE that is licensed and regulated by the relevant competent authority, or any commodities exchange market established and recognized outside the UAE of equal standing.

Within the scope of those definitions, trading of qualifying commodities has been included in the Qualifying Activities in Article 2 of the concerned Cabinet Decision. Therefore, trading of qualifying commodities, defined above, and associated derivative trading used to hedge against risks involved in such activities will be considered a Qualifying Activity and accordingly, the earnings derived from which will be subject to 0% corporate tax.

Income Derived from Exploitation and Ownership of

the Qualifying Intellectual Property will be Considered a Qualifying Income

Legal background

In the repealed Ministerial Decision No. 139 of 2023, ownership or exploitation of intellectual property was considered an Excluded Activity and therefore the income derived from that activity was prescribed to be subject to 9% corporate tax.

By Decision 100 of 2023, income derived from ownership or exploitation of “qualifying intellectual property” was included within the scope of “qualifying income” provided that such income must meet the requirements laid down in Decision 265 of 2023. The main requirement thereof is that the Free Zone company, engaged in ownership or exploitation of “qualifying intellectual property” activities, must carry out research and development (“R&D”) activities itself or it should outsource those activities to a third party, in or out of the UAE, provided that the third party is not a Related Party. In the event of outsourcing the R&D activities, the Free Zone company must fund those activities by having incurred R&D expenditures indirectly.

In summary, Free Zone companies must engage in R&D activities directly by themselves or indirectly by a non-related third party in order to have their earnings, derived from ownership or exploitation of qualifying intellectual property, to be subject to 0% corporate tax.

Definitions

In Article 1 of Decision 100 of 2023, the “qualifying intellectual property” is defined as follows:

Patents, copyrighted software and any right functionally equivalent to a patent that is both legally protected and subject to a similar approval and registration process to a patent such as utility models, intellectual property assets that grant protection to plants and genetic material, orphan drug designations, and extensions of patent protection, but not including any marketing related intellectual property assets, such as trademarks.

In same Article, the patents are defined as any patent granted under the law regulating patents in the UAE or granted under the relevant law of a foreign jurisdiction, and thecopyrighted software is defined as any copyright subsisting in software granted under the law regulating copyrights in the UAE or granted under the relevant law of a foreign jurisdiction.

Calculations of Qualifying Income

Qualifying income

In this equation based on the methodology of the OECD’s modified nexus approach, the definition of concepts are as follows:

“Qualifying Expenditures” means expenditures incurred to fund research and development activities, conducted either by the Qualifying Free Zone Person or outsourced to any Person in the UAE or any Person outside the UAE that is not a related party, directly connected with the creation, invention or significant development of the Qualifying Intellectual Property.

“Overall Expenditures” means total expenditures incurred to fund research and development activities, conducted either by the Qualifying Free Zone Person or outsourced to any Person, directly connected with the creation, invention or significant development of the Qualifying Intellectual Property, including acquisition costs of the Qualifying Intellectual Property.

“Overall Income” means royalties or any other income derived from Qualifying Intellectual Property as determined according to the provisions of the Corporate Tax Law, including embedded intellectual property income derived from the sale of products and the use of processes directly related to the Qualifying Intellectual Property as determined in accordance with the arm’s length principle under Article 34 of the Corporate Tax Law.

“Uplift Expenditures” means the Qualifying Expenditure increased by 30%.

In reference to our explanations in the “Legal background” section, definitions and the method for calculating qualifying income above, there must be a qualifying expenditure amount in order to benefit from the 0% corporate tax rate. This means Free Zone companies, engaged in ownership and exploitation of qualifying intellectual property, must engage in R&D activities directly or indirectly through a non-related Party in accordance with the definition of “qualifying expenditure”.

Additionally, Free Zone companies will be able to increase the qualifying expenditure amount by 30% resulting in increasing the proportion of qualifying income that will be subject to 0% corporate tax. But when using uplift expenditure, Free Zone companies should carefully consider that the total of the qualifying and uplift expenditure amount cannot exceed the overall expenditure amount.

The Term “Ancillary Activity” in Relation to Qualifying Activities has been Clarified

In the repealed Ministerial Decision No. 139 of 2023, an activity was prescribed to be considered “ancillary” where it serves no independent function but is necessary for the performance of the main Qualifying Activity.

In Decision 265 of 2023, the term “ancillary activity” has been intended to be clarified by putting forth the context of nexus approach in the form of more unambiguous literal expression. Based on this clearer nexus approach, an activity will be considered ancillary where it is necessary for the performance of the main activity or where it makes a minor contribution to it and is so closely related to the main activity that it should not be regarded as a separate activity.

The definition of ancillary activity term is very critical when interpreting whether an activity should be considered ancillary or not where this activity is not directly included in the list of qualifying activities in Decision 265 of 2023, but directly associated with the main qualifying activity in substance. Therefore, the MoF intended to clarify this term which serves good for an unambiguous interpretation of ancillary activities in the course of implementation of corporate tax law.

High Sea Sales Trading Activity to be Considered or Not within the Scope of Distribution of Goods

There are many companies engaged in high sea sales trading in the UAE Free Zones. However, the MoF has not announced any particular regulation as to “high sea sales trading activities” whether they will be considered within the scope of qualifying activities or not.

This topic remains high on the agenda of those Free Zone companies as they want to know for sure if their earnings derived from high sea sales trading activities will be subject to 0% or 9% corporate tax.

The only official document in relation to this topic was the public consultation, the MoF opened from 19 July to 2 August 2023 and then extended the deadline for feedback and comments to 9 August 2023. This public consultation was for a draft Cabinet Decision, to be announced based on the repealed Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023, by which the scope of qualifying and excluded activities were intended to be detailed.

In this draft Cabinet Decision, high sea sales trading activities were considered to be included within the scope of distribution of goods only for Designated Zone persons in an illustration. However, the literal interpretation of that illustration was very problematic for the reasons we put forth in our previous bulletin. Therefore, if the MoF had insisted on providing 0% corporate income tax benefit to only Designated Zone companies over their high sea sales earnings, it would have led other Free Zone companies to shift their headquarters to Designated Zones for tax purposes. This kind of measure that companies in Free Zones would have caused an unfair and unjust situation for Free Zone Authorities resulting in them losing their members to Designated Zones for tax purposes.

However, the aforementioned draft Cabinet Decision will not be finalized and announced by any means due to the reason that the underlying Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023 have been repealed by Decision 103 of 2023 and Decision 265 of 2023, respectively.

But we are looking forward to MoF announcing a new draft Decision detailing the activity of Distribution of Goods which would comprise the high sea sales trading activities not only for Designated Zone persons but all Free Zone persons in the very near future.