The UAE’s June 1 introduction of its first corporate tax will undo some of the fiscal incentives that have prompted foreign businesses to flock to its more than 40 special economic zones (SEZs).

After years of not taxing company profits, the government has launched a 9% levy, in line with the global push towards a level playing field for corporate tax.

It is a step change for all businesses across the Emirates, but it creates particular challenges for businesses in SEZs. Despite their long-standing offer of tax-free holidays for up to five decades, these zones are not fully exempted from the new regime and do not benefit from concessions offered to onshore businesses. 

“Being set up in a free zone doesn’t, by default, make you eligible for 0% corporate tax,” says Lokesh Gupta, an associate director at consultancy Nexdigm UAE. 

Which SEZ profits will be taxed?

To be tax-exempt, SEZ profits must pass a two-step test. First, the business must meet criteria such as maintaining an ‘adequate substance’ in the UAE by, inter alia, having sufficient operations, employees and directors on the ground. For foreign-owned businesses with “directors who travel for a very limited time to the UAE”, Mr Gupta foresees challenges meeting this criteria.

For businesses that pass this test, the tax-exemption applies to their ‘qualifying income’: a term “the entire UAE is [still] waiting for the government to define”, Nishit Parikh, partner at Sudit K Parekh & Co, told fDi on May 30. Based on previous consultations and discussions with the tax office, many expected that revenue from international customers and other UAE free zones would be exempt, while income from onshore UAE entities would be taxed at the full 9%.

However the government confirmed on June 1 that 'qualifying income' includes transactions with other free zone entities, and revenues generated from specified activities - irrespective of whether the customer is onshore or overseas - including, inter alia, manufacturing of goods, reinsurance, fund management and logistics. In a LinkedIn post the same day, Thomas Vanhee, a partner at tax consultancy Aurifer, stated that if non-qualifying income generates 5% of total revenues or Dh5m ($1.4m) - whichever is lower - the SEZ business loses its right to an exemption and must pay the 9% tax on all its income.   

This backpedals from the government’s original promise, when announcing the tax scheme in February 2022, to honour SEZs’ tax incentives. Further, claiming the 0% tax rate on even a portion of revenues means the SEZ business cannot take advantage of concessions offered to onshore businesses. 

These include the Dh375,000 tax-free threshold and exemption for businesses with an annual turnover of Dh3m or less. SEZ businesses that are part of a bigger corporate structure cannot claim tax relief on intra-group transfers and restructuring, or join tax groups which file a single group-level tax return. 

More on free zones:

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• It's time for the EU to reverse its SEZ ban

Tough decisions

Over the past 20 years, the UAE has mobilised three times more FDI projects than any other Middle Eastern country, with its SEZs attracting 31% of them, according to fDi Markets. 

But the corporate tax regime changes their value proposition. “It’s a bit confusing for companies who had a 50-year guarantee of a tax-free environment to all of a sudden be taxed,” says Ludwar International Consultancy managing partner Mazdak Rafaty, who has licences to operate in UAE free zones RAK and DMCC.

Even if all their profits are exempt, SEZ businesses are now still obliged to get a tax registration number, have their accounts audited and file tax returns. Those earning both fully taxed and exempted income are preparing for compliance headaches when allocating costs between the two tax rates. Meanwhile those within corporate groups are weighing the impact of foregoing group-wide tax benefits. For these businesses, Mr Parikh says “there are pros and cons in terms of continuing with the benefit of a free zone” versus opting to pay the 9% tax rate on all profits which would entitle them to onshore benefits.

However, for tenants focused purely on tax-free activities, the corporate tax regime may boost SEZs’ attractiveness after recent reforms — such as 100% ownership of onshore businesses — have blurred the distinction between SEZ and mainland benefits. “Now, if you want to run a business involving 'qualified activities', then the free zone is the right place for you,” says SEZ advisor Andreas Baumgartner.

The original version of this story was updated to reflect the new rules that the UAE's government disclosed a few hours after publication.