Firms in UAE's designated zones: Are all your supplies VAT-free?
The basic tenet of identifying and listing some of the free zones in the UAE as 'designated zones' under the country's's value-added tax legislation was to make them VAT free and consequently, be consistent with the tradition of keeping free zones typically free from taxes.
Though in intent and spirit it appears the legislation has achieved the objective, in practice, there are still instances and activities that result in the application of VAT on transactions within the designated zones. Consequently, the companies can blindly not apply VAT on any transaction it enters within the designated zones.
For all practical purposes (including obtaining trade licence, ownership structures, etc) through the designated zones are considered outside the UAE mainland, the VAT treatment on the supply of goods and supply of services has been legislated differently, with the supply of services being taxed even when supplied in the designated zones. For the supply of goods, VAT treatment differs depending on whether the goods are supplied within the designated zones or in the UAE mainland.
Supply of goods within the designated zones is typically out of scope from VAT only if the goods are "not consumed" but are to be "incorporated into, attached to or otherwise form part of or are used in the production of other goods located in the same Designated Zone and itself is not consumed". In the absence of a definition for the term 'consumed', the real challenge lies in identifying 'consumption' of the goods supplied.
Though the Federal Tax Authority (FTA) has issued a VAT guide on designated zones, in practice we have seen companies still unclear on applying VAT on their supplies. For example, what will be the VAT treatment of a forklift used in the factory shop floor to pick up goods and move them within the factory? The FTA guide mentions the establishment of a direct connection between the purchased goods and the production of other goods and consequently, in the absence of a direct connection, the supply of the forklift should be subject to VAT. One can, however, still argue that the forklift is a part of the production process and should, therefore, be considered out of scope.
Similarly, companies engage contractors to build factories within the designated zones. Does supply of civil goods (cement, stones, etc) be considered to be used in the production of the goods and not subject to VAT, though there is no direct connection of these goods with the finished product? One can argue these goods are used in setting up of a factory that in itself is used to produce the final product. Though not direct but indirectly, these goods are used in the production and consequently, should be outside the scope of VAT.
Similarly, VAT treatment is unclear on supplies including the supply of spare parts for machinery (that is used for manufacturing the final product), raw materials used to manufacture products that are subsequently used in the manufacturing of final product etc.
Furthermore, determining correct VAT on the supply of goods from designated zones to the mainland becomes a challenge in cases involving the supply of goods either ex-works or DDP (delivered duty paid). For ex-works contracts, the title of the goods is transferred in the designated zone at the factory gate. Since in ex-works the obligation to take delivery and get them to the UAE mainland rests with the buyer, the transaction for the supplier should be out of scope but the same results in an import for the buyer. Where the buyer's tax registration number is linked with the customs, the VAT liability would auto-populate in the buyer's VAT return.
Greater complexity and practical challenge arise for DDP shipments where delivery is managed by the supplier until the buyer's premises in the mainland. The seller needs to first clear the goods at the customs, thus accounting for VAT under reverse charge. Thereafter, the title gets transferred to the buyer in the mainland that should result in the obligation to charge VAT on local supplies of goods (i.e., sale is concluded in the UAE). While the supplier has an option to mention buyer as the importer on record in the customs, it's not clear whether this treatment would absolve the supplier from charging VAT for delivering the goods at customer's premises. Also, whether the buyer would be able to recover import VAT considering he's still not the owner of the goods, is also a question.
A legal issue that companies located in the designated zones face is undertaking business transactions outside the free zone. Though that may not be allowed under the local laws, from the VAT perspective one needs to figure out the right way of transacting and its consequences.
A clarification from the FTA on such contracts would be welcomed to give a right perspective to the companies undertaking such transactions.
It is critical for companies to carefully draft the terms and conditions for the sale and delivery of goods in designated zones and also re-look at existing contracts to ensure correct VAT was applied on previous supplies. The IT system to track and account for supply and consequent VAT liability also needs to be correctly configured ensuring appropriate VAT treatment.
The author is partner at WTS Dhruva Consultants. Views expressed are his own and do not reflect the newspaper's policy.