One of the most interesting aspects of the upcoming corporate income tax regime in the United Arab Emirates is the interplay between free zone entities and mainland entities. It may look attractive for a business set up in the mainland to move to a free zone as they plan for the upcoming regime. However, doing so is not so simple and there are consequences involved, as will be discussed in this article.
Current Status of Pillar Two and Impact of UAE Corporate Income Tax
First, any group entity with global turnover of more than 750 million euros ($735 million/2.70 billion UAE dirham) would anyway be subject to a minimum tax of 15%, assuming that the Organisation for Economic Cooperation and Development Pillar Two regime fructifies in the upcoming years. There is now certainly traction to the transition towards Pillar Two in some countries, including the UK and Switzerland, but the momentum in other countries is quite slow.
Still, Pillar Two appears to have more public acceptance as compared to Pillar One, and large businesses operating in the UAE must note that even while operating in the free zones, the profits of such free zone entities will anyway be subject to 15%. Even if the UAE government does not tax such free zone entities, by operation of the Income Inclusion Rule, the residence state would tax the profits arising from the UAE free zones anyway. Hence, for large businesses with global turnover above 750 million euros, operating in the free zones would not practically offer too many tax benefits.
It was recently reported in a news item that the UAE CIT draft legislation would include a definition of a “large company” as one which would have global turnover of more than 750 million euros. Most likely, any tax exemption that would arise from operating in the free zones would be neutralized with the inception of Pillar Two. Likewise, because the rate of tax for mainland entities is also rather moderate (9%, which is less than the global minimum tax of 15%), large companies operating in the mainland would also lose the benefit of a tax regime of 9% as compared to their competitors with turnover less than 750 million euros.
Considerations for Large Companies
One interesting aspect worth discussing is whether the 15% minimum tax threshold will only apply to UAE businesses when most of the OECD/G-20 Inclusive Framework countries apply it in their own domestic tax regimes, or will apply immediately as and when the CIT regime is implemented in the UAE? After all, the public consultation document clearly says that one of the reasons the CIT regime is implemented is in response to the expected Pillar Two regime. We will have to examine the draft CIT law to answer the above question. Logically, the minimum tax of 15% for large companies should apply only when the majority of the Inclusive Framework by and large accepts the Pillar Two regime, because the UAE does not have the incentive to apply a tax at 15% on such large corporations otherwise.
This brings us to another interesting question. If our hypothesis above is correct, what happens for those mainland entities that are large companies and move to the free zones in expectation of the upcoming CIT regime, enjoy the benefits of a 0% tax rate until Pillar Two is implemented, and, once Pillar Two is implemented, are liable to 15% minimum tax? This is perhaps the best option that large companies can adopt before the implementation of Pillar Two, because even had a business continued its operations in the mainland, it would still have suffered 15% minimum tax—as against its competitors who are not large companies who would only suffer 9% tax in the mainland.
For moving from the mainland to a free zone, the CIT implications should not be the only factor to be considered. The business will have to weigh the pros and cons independent of any CIT benefits that may be accrued to the business. The business may need to consider other factors such logistical infrastructure, rent, operational fees, banking infrastructure/credit availability, and value-added tax consequences when deciding whether to stay in the mainland or move to a free zone.
There is one obvious advantage of staying in the mainland if the tax rate for the business is effectively going to remain 15%. In the mainland, the business can undertake transactions with unrelated parties in the mainland itself without losing any tax benefits. Of course, the mainland entity can also generate income from outside the UAE, and obtain passive income while ensuring that the other party can retain its tax expense deductions, etc.
Free zone entities, on the other hand, are a lot more at risk when it comes to ensuring that active income is not generated from unrelated mainland entities, because that would deprive the free zone business of all its free zone benefits. Such businesses would have to be much more stringent in their processes and compliance to ensure that not even one active business transaction takes place with an unrelated mainland entity.
Effectively, this is a decision where a business would have to weigh the advantages against the disadvantages.
For businesses with a turnover of less than 750 million euros, the choice is a lot simpler—shifting to the free zones is better from a tax point of view for the reasons discussed above, assuming that it is practicable to do so from an operational/finance point of view. All that such a business ought to take care of, again, is to make sure that it does not earn active income from unrelated mainland entities, to ensure that it retains its free zone 0% tax benefits.
It is also a reality that operating a business from a free zone is more expensive (higher rent, local compliance costs, etc.), and not every business can transfer their operations so easily, especially if they are more brick-and-mortar oriented. In that case, the option can be to either incorporate a subsidiary in one of the free zones and transfer some operations there as much as practicable; and then book the profits in the free zone subsidiary based on the Functions, Assets and Risk analysis (the OECD Transfer Pricing Guidelines will also be applicable to the UAE after the CIT regime goes live).
We will have to wait and see how the draft CIT law is structured to answer the questions raised in this piece. Tax advisers and tax managers are already very busy preparing for the new law, and they are going to become even busier in the next few months. Many more open questions will come up for businesses in the free zones and the mainland. It is important also to keep track of the Pillar Two developments in other countries, because the UAE will most likely formulate their policies based on how successful the Pillar Two proposals may be in other countries.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
The comments in this article are for general information and are not intended as advice. Readers should seek professional advice where relevant.
Parwin Dina is Global Tax Leader, Global Tax Services
The author may be contacted at: email@example.com