Corporate Tax in the UAE—Are You Ready? (Part 4)

This article will consider the potential impact of Pillar Two on the UAE’s corporate tax, particularly as regards the UAE free zones regime.

UAE Free Zones and Pillar Two

The impact of the Pillar Two GloBE rules on the UAE’s free zones may be considerable.

The FAQs on corporate tax (CT) issued by the Ministry of Finance state that businesses operating in free zones will be subject to UAE CT, but the UAE CT regime will continue to honor the CT incentives currently offered to free zone businesses, providing they comply with the regulatory requirements and do not conduct business with mainland UAE.

As such, entities operating in free zones will be subject to a 0% CT rate on their taxable income providing the income derives from transactions with entities located outside the UAE, in the same free zone, or in another free zone. If an entity located in a free zone derives non-passive income from mainland UAE all its income will be subject to the general CT regime.

Income-based tax incentives, such as the UAE free zones which offer a 0% tax rate, are a key driver of a low GloBE effective tax rate (ETR) and will be a significant issue in a post-Pillar Two environment. Importantly, tax incentives that affect a wide taxable base, such as free zones, have the potential to have the greatest impact on ETR.

Provided there are no trading activities with mainland UAE, the income is tax free. When calculating the GloBE ETR, tax incentives that directly impact the numerator (covered taxes) as opposed to the denominator (GloBE income) have the most impact on the GloBE ETR.

As such, multinational enterprises (MNEs) operating in 0% tax-free zones could potentially be subject to significant Pillar Two top-up tax.

Taken in isolation, an in-scope MNE with a single free zone entity that qualified for the 0% CT rate may derive no tax benefit from the 0% rate, as it would be subject to Pillar Two top-up tax to bring its GloBE ETR to 15%. This then (dependent on the eventual UAE CT rate that will apply to MNEs in the UAE) raises the issue of whether there would be any benefit in retaining free zone status and, for example, conducting trade with mainland UAE.

This is subject to a number of caveats.

Jurisdictional Blending

First, the GloBE Rules apply jurisdictional blending. This effectively allows MNEs operating in the UAE to blend the results of low- and high-taxed entities in the UAE when determining the jurisdictional ETR. It is this jurisdictional ETR that is then compared with the 15% global minimum rate.

Therefore, an MNE that operates an entity in a UAE free zone (that does not carry out trading activities in mainland UAE) and other entities in the UAE mainland, would have a GloBE ETR above 0%, as the tax paid by the MNE on its mainland operations (at whatever rate is announced) would push the jurisdictional ETR up.

Whether this is significant enough to raise the GloBE ETR above 15%, such that no top-up tax was due, would depend on a number of factors, including the UAE CT rate for MNEs, GloBE adjustments, and the relative profits of the free zone and mainland entities. Relatively low profits in the free zone with substantial profits in mainland entities taxed at a much higher rate, could significantly increase the GloBE ETR, and it may be that no top-up tax is payable.

For example, take this simple scenario:

All companies are members of an MNE group subject to the GloBE Rules.

Free Zone Co has profits/GloBE income of 1 million UAE dirham ($272,000).

Sub Co 1 has profits/GloBE income of 10 million UAE dirham.

Sub Co 2 has profits/GloBE income of 20 million UAE dirham.

If we assume the CT rate for large MNEs in the UAE is 16%, and both Sub Co 1 and Sub Co 2 are subject to that rate, CT of 1.6 million UAE dirham would be paid by Sub Co 1, with 3.2 million paid by Sub Co 2.

The GloBE ETR would be 4.8 million/31 million = 15.4839%. As the jurisdictional ETR is above 15%, no top-up tax would be due under Pillar Two.

Substance-Based Income Exclusion

Second, the substance-based income exclusion can have a significant impact on the effectiveness of tax incentives in a post-Pillar Two environment.

The substance-based income exclusion amount is based on the total of the payroll carve-out and the tangible asset carve-out for each in-scope entity in a jurisdiction. The payroll carve-out is equal to 5% of the entity’s eligible payroll costs of eligible employees that perform activities for the MNE Group in the jurisdiction, while the tangible asset carve-out is equal to 5% of the carrying value of eligible tangible assets of an entity in a jurisdiction (subject to enhanced rates under transitional rules).

The amount of the substance-based income exclusion feeds directly into the Pillar Two top-up tax calculation as it reduces excess profits which are then used to calculate the initial top-up tax based on the top-up tax percentage.

In general, expenditure-based tax incentives are likely to benefit more under Pillar Two, as they are more likely to lead to investment in tangible assets and payroll that benefit from the substance-based income exclusion.

However, even income-based tax incentives, such as the 0% CT rate in a UAE free zone, could eliminate any potential top-up tax if the free zone profits were low but there was significant investment in tangible assets and payroll.

Take this much simplified example:

In this case, the top-up tax percentage would be 15%, assuming no other covered taxes. In the absence of the substance-based income exclusion top-up tax would be 150,000 UAE dirham.

However, if the 20 million UAE dirham investments were in tangible assets and payroll, the substance-based income exclusion would be 1 million UAE dirham, which would eliminate the profits for Pillar Two purposes, and there would be no top-up tax.

It is also worth noting that the jurisdictional blending approach also applies to the substance-based income exclusion. Therefore, if an entity operating in the UAE mainland had little Pillar Two GloBE income but a large substance-based exclusion amount, this would effectively be offset against the net Pillar Two GloBE income of the UAE including entities located in a free zone.

Other Factors

In addition, just because an entity is taxed at a 0% tax rate in a UAE free zone does not mean that its GloBE ETR would be 0%. Even ignoring the Pillar Two Rules, the effective tax rate of an MNE (tax payable/profits) will be significantly different to the headline statutory rate.

This is a result of the separate rules for calculating taxable profits as opposed to financial profits. Once you bring the Pillar Two GloBE Rules into play there is yet another subset of tax rules used to calculate not only GloBE income, but also covered taxes, and to allocate these to entities in an MNE group.

One example of this are controlled foreign company (CFC) rules. A number of jurisdictions have CFC regimes which target low-taxed passive income held in foreign subsidiaries. The CFC rules attribute some of the low-taxed income to the company that holds an interest in the CFC and it is then taxed under the domestic tax provisions.

For Pillar Two purposes, tax incurred under a CFC regime is allocated to the CFC when calculating its covered taxes and GloBE ETR (subject to a CFC pushdown limitation).

This means that even though a UAE free zone entity had a 0% CT rate, if it was subject to tax overseas under a CFC regime, that tax would be allocated to the UAE free zone entity and increase the amount of covered tax.

MNEs operating in the UAE going forward will therefore need to carefully model the impact of the Pillar Two GloBE rules to assess the extent to which they are subject to any top-up tax, particularly where they make use of the UAE free zone regime.

UAE Tax Policy

The 0% CT rate for free zones is a very attractive tax incentive; however, the benefit of this for MNEs within the scope of the Pillar Two GloBE rules may be significantly reduced. As noted above, jurisdictional blending, the substance-based income exclusion, and the general application of the GloBE rules can somewhat temper its application. However, there is a still a significant risk that foreign MNEs will be subject to top-up tax.

Broad income-based tax incentives can have a substantial impact on the jurisdictional ETR calculation. More limited base-narrowing provisions allow more room for the blending of other high-taxed income in the jurisdiction to push the overall ETR up.

For in-scope MNEs any top-up tax levied under the GloBE rules could negate or significantly reduce the benefit of the tax incentive offered to free-zone entities. This could see a loss of tax revenue for the UAE, and without further GloBE friendly policies could see a loss of foreign direct investment (FDI). While FDI may not represent a large number of taxpayers in the UAE, other indirect impacts can be significant, for example, the impact on supply chains.

As noted in a recent Organisation for Economic Cooperation and Development report Tax Incentives and the Global Minimum Corporate Tax, in contrast to income-based incentives, such as the UAE free zone regime, expenditure-based tax incentives are typically more targeted and have the benefit of incentivizing investments into capital assets.

This is important as tangible capital assets and payroll in a jurisdiction increase the substance-based income exclusion which in turn reduces Pillar Two top-up tax even when there is a low ETR.

Of course, it could be that entities that benefit from the UAE free zone regime are not typically in-scope entities for Pillar Two purposes in any case. However, if there is a significant risk of in-scope entities being within the free zone regime, the impact of this should be considered.

In particular, the ETRs of MNEs in the UAE, the amount of economic substance in the UAE, the revenue impact of the free zone tax incentives, and the revenue loss or gain from free zones should be considered, to determine the real impact on MNEs operating in the UAE.

One option could be for the UAE to renegotiate free zone agreements with in-scope MNEs. If MNEs were to derive limited tax benefits from free zones, a renegotiation of free zone agreements could allow the UAE to offer incentives that are more beneficial to MNEs in a post-Pillar Two environment. This could be GloBE friendly tax incentives such as accelerated depreciation, qualifying refundable tax credits, or other expenditure-based incentives such as investment tax allowances which have less of an impact on the GloBE ETR.

In a post-Pillar Two environment, other incentives will become even more important as they can be used to attract FDI without impacting on the GloBE ETR. This could include tax incentives that are not covered taxes for the purposes of the GloBE rules (for example, payroll taxes), trade incentives such as customs duties, and non-tax incentives such as grants and other support.

On a wider-level, government support such as subsidies and specific support can be offered, which has less of an impact on the GloBE ETR.

Concluding Remarks

As shown above, the application of the Pillar Two GloBE Rules to MNEs operating in the UAE’s free zones is very much fact-specific. The impact of jurisdictional blending, the substance-based income exclusion, and other GloBE specific adjustments will all interact to determine the ETR and any eventual top-up tax.

MNEs operating in the UAE will therefore need to carefully model the impact of the Pillar Two GloBE Rules to assess the extent to which they are subject to any top-up tax, particularly where they make use of the UAE free zone regime.

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.

Author Information

Parwin Dina is Global Tax Leader, Global Tax Services

The author may be contacted at: parwin.dina@global-taxservices.com