Adequate Substance Requirements under the UAE Free Zones Regime

The Ministry of Finance has recently issued 1 Cabinet Decision No. 100 of 2023 and Ministerial Decision No. 265 of 2023 with regard to the Qualifying Free Zone Persons (QFZP). These decisions are effective from June 1, 2023. In this write-up, we have summarized one of the key aspects clarified in Cabinet Decision No. 100 of 2023, i.e. adequate substance requirement to be satisfied by the QFZP.

Background

Under the UAE Corporate Tax Law, QFZP are subjected to Nil tax rate on qualifying income, while 9% tax rate applies on other income. In order to be categorized as a QFZP, such entity is required to comply with certain conditions, one of them being having and maintaining adequate substance in the UAE. Cabinet Decision No. 100 has issued certain clarifications as set out below.

Core-income generating activity

Prior to the decision announced in November 2023, the extant provisions required that QFZP shall undertake its core income generating activities in a free zone. Further, considering the level of activity carried out by such QFZP, it shall have adequate assets, adequate number of qualified employees and incur adequate amount of operating expenditure. The Cabinet decision No. 100 of 2023 has modified the above parameters to the extent that –

o QFZP can now undertake its core income generating activity in a free zone or a designated zone depending upon where such activities are required to be conducted.

o The qualified employees need to be employed on full time basis in free zone or designated zone depending upon where such activities are required to be conducted.

For this purpose, a designated zone is defined as a designated zone according to what is stated in Federal Decree-Law No. (8) of 2017 on Value Added Tax, and which has been included as a Free Zone under the Corporate Tax Law. Though the parameters of having adequate assets, employees, etc. have been laid down, what is considered to be adequate is still a subjective test. There are no monetary thresholds or other parameters defined for determination of ‘adequacy’. 

Inclusive meaning of core income generating activity

The Cabinet decision provides that the core income-generating activities may vary according to the specific activity but mainly consist of those significant functions that drive the business value for each activity. These are not exclusively or mostly support activities. Thus, depending upon the activity carried out by the QFZP, it will have to be ensured that the core functions qua that activity are carried out in free zone or designated zone.

Outsourcing of activity

Under the erstwhile provisions, QFZP had an option to outsource the core income generating activities to a related party or a third party in a free zone, provided it has adequate supervision over the outsourced activity. This outsourcing criterion has been amended in Cabinet decision No. 100 of 2023 to permit outsourcing of core income generating activities to another person in free zone or designated zone depending upon where such activities are required to be conducted, subject to adequate supervision of QFZP. The Cabinet decision incorporates a specific provision allowing outsourcing of core income generating activities in respect of qualifying intellectual property to any person in the UAE or to an unrelated party outside the UAE, with adequate supervision by QFZP. Thus, the substance requirements for qualifying intellectual property are significantly diluted as compared to other activities.

Conclusion

Though the recent decisions have expanded the meaning of ‘adequate substance’, there is significant amount of subjectivity involved. QFZPs will have to gear up to prove the satisfaction of adequate substance test by having adequate business presence in the UAE, backed up by contemporaneous documentation.

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