Other BriefingsQualifying “Adequate Substance” Now Key To Attaining UAE Free Zone Zero Per Cent Corporate Tax Rates
Discussions on qualifying for the 0 per cent tax rate for UAE free zone companies has focused on qualifying income (QI), qualifying activities (QAs), excluded activities and de-minimis rules. However, attention on maintaining ‘adequate substance’ has also become a key technical issue. In this article we explain what this is and how to achieve it.
UAE Free zone companies should ensure the adequate substance should not become an issue. Ignoring or being unaware of this could result in the loss of the zero per cent preferential tax rate, and also result in penalties and tax arrears.
Defining Adequate Substance
According to the UAE Ministry of Finance (MoF), a Qualifying Free Zone Person (QFZP) must have – and be able to demonstrate – “Adequate Substance” in a free zone relative to the nature and level of its activities and the qualifying income it earns.
Maintaining Adequate Substance involves having adequate staff and assets and incurring adequate operating expenditure in the relevant free zone for the purposes of undertaking its core income-generating activities (CIGAs). As to how much would be ‘adequate’ – and how much would be too less – is not a mathematical formula but a subjective assessment based on the level of activities and qualifying income.
The core income-generating activities is not a compliance checklist but will need to be independently identified based on each business activity. A study of existing Economic Substance Regulations (ESR) will provide a fair understanding of the concept.
Assessing Adequate Substance
In addition to the nature and level of activities and qualifying income earned, other relevant facts and circumstances have to be taken into consideration to assess the adequacy. The three important factors are staff levels, assets and operating expenditure.
Unlike transfer pricing, benchmarking comparable of fellow free zone companies may not directly apply to assess adequate substance. What is adequate for one free zone company would not be automatically adequate for another.
Place of Adequate Substance
A qualifying free zone person must maintain its economic and operational substance in the free zone where it is established or in any other free zone. In other words, the substance cannot be maintained on the mainland or outside the UAE.
It is not mandatory for a qualifying free zone person to undertake all the activities by itself; and it could outsource these activities to related or unrelated parties. However, these must also be in a free zone and the qualifying free zone person must exercise control and supervision over the outsourced activities.
It should be able to demonstrate that such control and supervision existed in the relevant financial year during any future audit.
Place of Management
The new UAE corporate tax law and guidance does not prescribe that the place of management of the qualifying free zone person should be in the free zone. Accordingly, it is easily assumed that the management can sit in the mainland as it manages other mainland businesses also.
However, if the place of management is outside the free zone, it is at a risk of creating a domestic permanent establishment (PE) in the mainland. The qualifying free zone person’s profits – to the extent attributable to such domestic permanent establishment – will be taxable at 9 per cent. The 9 per cent rate could apply even if the adequate substance is otherwise maintained in the free zone.
Future Risks
Business owners should be aware that the corporate tax assessment by the Federal Tax Authority (FTA) could be undertaken anytime in the next seven years from the relevant financial year. If a qualifying free zone person is found to be non-compliant for a particular financial year in those 7 years, the tax arrears and penalties will apply.
Further, the preferential 0 per cent tax rate claimed in the 4 years following the relevant financial year will also be automatically denied giving rise to tax arrears and penalties for 4 more years.
Misleading Interpretations
Discussion with businesses, especially free zone companies, underlines how important tax issues can be lost in translation and explanation. The ‘Adequate Substance’ requirement has on occasion been simplified to a belief that the free zone company should not be a ‘paper’ company.
This is incorrect and has led to some business owners having no reasons to doubt the status of their free zone companies as enough staff, assets and expenditure are devoted to the free zone operations. The subtle point that ‘Adequate Substance’ should be maintained in a free zone is easily misunderstood.
UAE businesses must not find themselves non-compliant. ‘Adequate Substance’ – or failure to ask the right questions – should not become a potential future burden for UAE businesses. If in doubt – ask.
Dezan Shira & Associates assist foreign investors into the UAE. For help with tax planning and establishment matters please contact us at dubai@dezshira.com
Related Reading
- Qualifying Income Tax In The UAE Free Zone: Pay Attention, Or Pay Tax
- UAE Free Zone Companies: Updated Zero Percent Tax Clarifications
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Middle East Briefing is one of five regional publications under the Asia Briefing brand. It is supported by Dezan Shira & Associates, a pan-Asia, multi-disciplinary professional services firm that assists foreign investors throughout Asia, including through offices in Dubai (UAE), China, India, Vietnam, Singapore, Indonesia, Italy, Germany, and USA. We also have partner firms in Malaysia, Bangladesh, the Philippines, Thailand, and Australia.
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