Decoding Substance Requirement in UAE Free Zones

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The United Arab Emirates (UAE) has introduced a corporate tax regime and it’s been almost an year since the CT regime is live over there i.e effective for the financial year beginning on or after June 1, 2023. It provides a 0% tax rate on Qualifying Income for Qualifying Free Zone Persons (QFZPs). To qualify as a QFZP, a Free Zone Person must meet specific conditions as per Article 18 of the Federal Decree Law No. (47) of 2022 (‘UAE CT law’), one of which is the requirement to maintain adequate substance within the Free Zone. This mandatory requirement is critical to ensure that businesses operating in Free Zones have an actual economic presence and are not merely on papers.

The substance requirement mandates that a QFZP must carry out its core income-generating activities (CIGAs) within the Free Zone although there is an extra requirement for distribution businesses to perform their CIGAs from the designated zones only. The list of designated zones for the purposes of corporate tax is not released yet as of June 2024. A freezone person can reach out to the respective Free Zone authorities via email to confirm whether the said freezone is a designated zone or not. These activities are the essential and value-adding functions that directly drive the company's revenue. Besides, the QFZP must also maintain adequate assets, qualified full-time employees, and operating expenditures within the Free Zone to support these CIGAs.

Core Income-Generating Activities

Core income-generating activities are central and most vital set of functions for any business. They are the activities that drive sales, generate revenue, and add value. These core activities vary depending on the nature of the business.

• For a manufacturing company, these activities could include production planning, the actual manufacturing process, and quality control.
• For a service-oriented business like a consultancy, these activities might involve client relationship management, project execution, and service delivery.
• For a trading company, activities such as sourcing products, negotiating contracts, and managing logistics could be CIGAs.
• For a holding company, the core activity could be investment related decision-making.

There is no set parameter or rule to classify an activity as CIGA. It should be based on a judgment that activities which are directly driving revenue for the business is its CIGA.

Adequate Resources

To demonstrate adequate substance, a QFZP must not only conduct core activities but also maintain sufficient resources within the Free Zone such as:

• Assets: Like offices, factories, warehouses, equipment, or any other physical assets crucial for carrying out business activities.
• Qualified Full-Time Employees: The company must have a sufficient number of qualified employees working full-time in the Free Zone. These employees should be directly involved in the core income-generating activities. The presence of employees in a Free Zone is crucial. There is no such ‘number of employees’ prescribed by the law. 
• Operating Expenditures: The company needs to incur operating expenses within the Free Zone. There is no prescribed threshold for the same. These expenses can include salaries, rent, and other costs in relation to operate the business.

Double Counting of Employees

One of the important aspects of the substance requirement in case of employees is the prohibition of double-counting them. This means that the same employee cannot be counted twice for fulfilling the substance requirements for multiple core income-generating activities. Each CIGA must have its dedicated employee/team to avoid double-counting. For instance, If a Free Zone company is engaged in both manufacturing and treasury activities, the employee involved in treasury operations cannot be double counted towards the substance requirement for manufacturing activities. 

Intellectual Property and Substance

The substance requirement also applies to income derived from intellectual property (IP). For a QFZP to benefit from the 0% tax rate on income from Qualifying Intellectual Property (QIP), such as patents or copyrighted software, it must demonstrate a direct nexus (link) between the income and the qualifying research and development (R&D) expenditures.

The QFZP must be able to show that it incurred the R&D expenses that led to the development of the QIP, either directly or through outsourcing to another person (not a related party outside the UAE). The company should have a system in place to track expenditures and income related to QIP to prove this nexus for meeting this requirement. 

Outsourcing 

While core income-generating activities must generally be performed within the Free Zone, there is an exception as it can outsource its activities as well and still meet the substance requirements. The only thing here is that the QFZP must have adequate supervision on these outsourced activities. 

• Outsourcing within the Free Zone: CIGAs can be outsourced to another person within the Free Zone, provided the QFZP has adequate supervision.
• Outsourcing for Qualifying Intellectual Property: R&D activities related to QIP can be outsourced to any person in the UAE or any non-related party outside the UAE, with adequate supervision. There should be a tracking mechanism to track the link between expenditures and income of the Qualifying Intellectual Property asset and provide evidence of this to the Federal Tax Authority upon request.

It is worthwhile to note that the R&D activities related to QIP can be outsourced to any person in the UAE (be it a mainland entity) and even to any non-related party outside the UAE whereas other activities can only be outsourced to another freezone person only. Also, for distribution businesses outsourcing with adequate supervision can only be done to another freezone person in a designated zone. 

Adequate supervision means that the QFZP should have mechanisms in place to monitor, control, and guide the outsourced activities' outcomes in terms of quality, etc. This can be done through contractual agreements between the parties involved.

Start-up Phase

A Free Zone Person in the start-up phase, with no revenue (or having losses), will still be qualified for 0% tax rate, as long as it doesn't derive any non-qualifying income and complies with other requirements laid out in Article 18 of the UAE CT law.

All in all, to maintain adequate substance and comply with the UAE CT law, key considerations for Free Zone Persons should be as follows:

• Identification of CIGAs is an important aspect as these have to be in a respective freezone.
• Ensuring that the Free Zone person has sufficient assets, qualified full-time employees, and operating expenditures within the Free Zone to support each CIGA.
• Another critical point is not to count the same employee twice towards the substance requirement for multiple CIGAs. 
• Maintaining the documentation of all activities performed within the Free Zone, including details of employees, assets, and expenditures to demonstrate substance related requests during audits, if any.
• Maintain adequate supervision over outsourced activities is necessary. Have contractual arrangements in place to satisfy this requirement. If outsourcing activities, it should be ensured that they are outsourced to entities within the Free Zone or, in the case of Qualifying IP, to non-related parties outside the UAE.
• Regularly review of the operations is recommended to ensure ongoing compliance with the substance requirements. As the business evolves, the required level of substance may also undergo change.

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