The introduction of the UAE’s corporate tax regime has brought significant changes for businesses, particularly those operating in Free Zones. To benefit from the 0% corporate tax rate as a Qualifying Free Zone Person (QFZP), companies must adhere to specific compliance standards, including the arms length principle. This principle ensures transparency and fairness in transactions between related parties.
What Is the Arms Length Principle?
The arms length principle, established under Article 34 of the UAE Corporate Tax Law, mandates that all transactions between related parties are priced as if conducted between independent, unrelated entities operating under comparable market conditions.
This rule is crucial to:
- Prevent profit shifting: Avoid artificially transferring profits to tax-exempt entities.
- Ensure accurate taxation: Reflect true economic activity in taxable income reporting.
For instance, if a Free Zone company sells goods to a related mainland company at below-market value, the profits may be unfairly shifted. The arm’s length principle ensures fair pricing to prevent such practices.
Who Qualifies as a Qualifying Free Zone Person (QFZP)?
To maintain QFZP status and benefit from the 0% corporate tax rate, companies must meet these conditions under Article 18:
- Earn Qualifying Income: Revenue from transactions with other Free Zone entities or international clients.
- Maintain a Real Business Presence: Operate a legitimate business presence in the UAE.
- Meet the De Minimis Requirement: Ensure non-qualifying income remains below a set threshold.
- Opt Out of Standard Corporate Taxation: Avoid electing the standard 9% rate.
- Comply with Arm’s Length and Transfer Pricing Rules: Adhere strictly to these regulations.
- Maintain Audited Financial Statements: Ensure accuracy in financial reporting.
Applying the Arms Length Principle in Practice
Expense Allocation
A critical application of this principle involves allocating expenses when a QFZP earns both qualifying (tax-exempt) and taxable income. Using the arm’s length method, companies must ensure:
- Each income category is assigned a fair share of costs.
- Allocation reflects true economic contributions.
Two-Step Profit Attribution Approach
The Federal Tax Authority (FTA) recommends the following steps for businesses with Foreign or Domestic Permanent Establishments (PEs):
- Functional Analysis: Examine the functions, assets, and risks of each entity.
- Determine Compensation: Assign appropriate compensation based on contributions to business performance.
Expense Allocation Guidelines
- Direct Expenses: Attributable to specific income (e.g., sales commissions).
- Indirect Expenses: Shared costs (e.g., overheads) allocated fairly using methods such as revenue ratio or headcount
Why Compliance Matters
Adhering to the arms length principle is mandatory for retaining QFZP status and the 0% corporate tax rate. Non-compliance risks disqualification, leading to the imposition of the standard 9% corporate tax rate on total income.
Final Thoughts
The arms length principle is pivotal for maintaining transparency, fairness, and compliance under the UAE’s corporate tax framework. Free Zone companies should:
- Consult experienced tax advisors.
- Review pricing strategies and intercompany agreements.
- Ensure audited financial statements are in order.
Taking a proactive approach to compliance safeguards QFZP status and optimizes tax benefits, allowing businesses to thrive in the UAE Free Zones. Unicorn Global Solutions is here to help! Text us on whatsApp or call us today .
Frequently Asked Questions (FAQs)
The arms length principle ensures that transactions between related parties are priced fairly, as if they were conducted between unrelated parties under similar conditions. It helps prevent tax avoidance by enforcing fair value pricing.
It is a mandatory requirement for a Free Zone company to maintain its Qualifying Free Zone Person (QFZP) status and benefit from the 0% corporate tax rate. Non-compliance can result in taxation at the standard 9% corporate tax rate.
They must evaluate all transactions with related parties using functional analysis and fair pricing methods. Expenses should be properly allocated between qualifying and non-qualifying income using recognized transfer pricing principles.
Failure to comply may lead to loss of QFZP status and exposure to full corporate taxation. Additionally, the Federal Tax Authority (FTA) may conduct audits and impose penalties for non-compliance.
Yes. A QFZP must prepare and maintain audited financial statements and proper transfer pricing documentation to prove that related-party transactions meet the arm’s length standard.
NOTE:
The above note is subject to further study and clarification. It does not constitute a formal opinion from our end. Before making any decisions based on the above, we recommend consulting our experts on the subject.
