UAE has had a positive environment that has made it an attractive choice as a regional base of operations, however its legal framework is quite complex
Sherif RahmanPartner,Corporate Structuring
Nazanin MaghsoudlouSenior Associate,Corporate Structuring
Darya GhasemzadehTrainee Lawyer,Banking & Finance
The United Arab Emirates (UAE) has long had a positive environment that, along with other advantages, has made it an attractive choice as a regional base of operations. However, the UAE’s legal framework is quite complex.
One of the first questions that new and aspiring businesses are faced with when opting to set up in the UAE is where to incorporate their company. The UAE is divided into seven different emirates, each of which, as per the UAE constitution has personal jurisdiction in all matters that are not assigned to the exclusive jurisdiction of the federal government.
There are also a number of free zones, which are essentially autonomous jurisdictions with their own regulations and for financial free zones, even in certain cases with their own court systems.
Despite the free zones being autonomous their regulations are superseded by the federal laws and by the UAE constitution wherever there is a legislative gap / discrepancies.
Therefore, operators of businesses setting up in the country have traditionally had a choice: to set up in a free zone or to set up in the mainland of the UAE.
Traditionally, one of the main advantages of setting up in a free zone, rather than in the mainland, has been the potential for 100% foreign direct ownership.
However, recent amendments to the “Federal Law No. 2 of 2015 concerning commercial companies”, as amended (“Companies Law”), have eased many of the foreign direct investment (“FDI”) restrictions that had previously applied to mainland companies.
Previously, the Companies Law had required that an LLC established in the mainland in UAE had to be either:
at least 51% owned by a UAE national (company or individual); or
owned entirely by a Gulf Cooperation Council (“GCC”) national (“Local Ownership Restriction”).
These restrictions did not apply to free zones.
Following the latest changes, non-UAE nationals are now permitted to set up companies in the mainland that are wholly owned by them. As a result, the Local Ownership Restriction is now only applicable to those businesses, which are deemed to have a “strategic impact”.
Activities having “strategic impact” have been defined in a subsequent resolution, and include regulated activities such as telecommunications, banking, insurance or any activities related to defence.
One of the main implications of this change to the Companies Law is that registering a company in a free zone as opposed to the mainland is less of an advantage than it may have been in the past. However, there are other factors to bear in mind.
Points to consider when choosing whether to register in a free zone or in the mainland is the nature of the business that is going to be conducted, the location of its customer base, and whether the business is actually going to be conducted from or in the UAE. A licence issued by the applicable commercial authority is necessary for any company that is going to conduct business in the UAE, be it in a free zone or in the mainland. Any free zone authority or federal commercial authority (e.g. Dubai Economy and Tourism authority and Abu-Dhabi Department of Economic Development) is an autonomous regulator with its own list of licensable activities applicable within its respective territory. Therefore, there could be restrictions depending on the nature of the business activity and where the company is set-up.The limited geographical scope of free zones means that trading companies incorporated therein will be subject to more activity related restrictions than mainland companies. For example, free zone companies strictly speaking, cannot directly sell from the free zone into the mainland unless they are properly licenced to do so, or unless they are simply providing services to customers in the mainland (rather than engaging in direct trade).
The UAE’s federal legal system is based on the Civil Law legal tradition, in which there are influences from Egyptian, French and Islamic (Sharia) legal principles.
In contrast, the two financial free zones (the Dubai International Financial Centre (“DIFC”) and the Abu Dhabi Global Markets (“ADGM”) have legal systems that are based primarily on English Common Law, but that have also taken commendable steps to incorporate international best practice from other jurisdictions around the world.
Moreover, the DIFC and ADGM courts follow the common law system of precedent, which essentially means that judges are bound by rulings of previous courts. This therefore enhances certainty regarding how laws are going to be applied. This is in stark contrast to the mainland, where courts have a much broader scope of discretion when applying the law to the facts, often leading to discrepancies in judgements in similar cases.
Many commentators have argued that common law legal system provides a better framework for financial development than the civil law tradition, and point to the fact that all of the world’s main international financial markets (“IFCs”) are based in common law jurisdictions. Without getting into the merits of such a claim, we simply note that both the ADGM and DIFC have in fact been very successful in attracting a plethora of banks, and financial services companies to their respective jurisdictions.
Therefore, where a foreign company operates in the banking, finance or funds sector, they may find that the financial free zones offer a more familiar legal environment than the mainland.
As for tax implications, companies incorporated in the mainland and free zones (unless qualified as a designated zone) are subject to Value-Added Tax (“VAT”). Federal Corporate Income Tax is expected to be introduced in 2023 and should be effective for financial years starting on or after 1 June 2023. Accordingly, all mainland companies will be subjected to corporate tax at the rate of 9%.
In contrast, free zones, as autonomous jurisdictions in the UAE, have to date been offered various tax incentives such as tax-free periods of up-to 50 years pursuant to their own regulations. However, in light of recent changes to the UAE’s federal tax regime, it remains to be seen whether the Federal Tax Authority (“FTA”) will impose corporate tax requirements on free zones, or whether they can continue to enjoy lengthy tax-free periods as before.
Having said that, pursuant to the information shared by the Ministry of Finance (“MOF”), the existing tax benefits applicable in free zones will be preserved subject to certain limitations. Entities established in free zones will be taxable at the rate of 0% provided that they comply with all regulatory requirements and do not conduct business with UAE mainland.
Furthermore, based on the information provided by the MOF, a free zone entity will not be considered as doing business with the mainland if the income derived from the UAE mainland is limited to ‘passive’ income (e.g. interest and royalties, dividends and capital gains arising from the sale of shares in UAE mainland companies) and therefore such income will be subject to tax at 0%. In addition, if free zone entities receive income from related entities within the UAE mainland the income will be subject to tax at 0%.
Any other income derived from the UAE mainland will result in the entire income of the free zone entity to be taxable at the standard rate of 9%.
Companies should also consider employment law differences, such as Emiratisation requirements, which are applicable to mainland companies operating within the private sector but do not currently, apply to free zones. Emiratisation requirements were promogulated by Ministerial Resolution No. 279 of 2022, which will be effective from January 2023, which requires mainland companies operating within the private sector, who have more than 50 employees to ensure that at least 2% of their ‘skilled workers’ which they have hired are Emirati. There are other ongoing Emiratisation programmes such as ‘Nafis’, which requires that onshore companies with 50 or more skilled employees employ at least 2% UAE nationals to increase on an incremental basis by 2% per annum with a view to 10% of the skilled employee population being UAE nationals by 2026.
The latest change to the Companies Law goes a long way towards ‘levelling the playing field’ in terms of foreign ownership in favour of mainland companies.
However, there are numerous other issues to consider when deciding whether to incorporate in a free zone or the mainland. Our corporate structuring lawyers have extensive expertise in providing structuring advice in such a scenario and can help to ensure that your business is set up in a way that best suits your needs.
For further information, please contact Nazanin Maghsoudlou.
Published in January 2023