Understanding Expense Allocation for Free Zone Companies in UAE

Hey there!

Let's dive into the world of expense allocation for Free Zone Persons (QFZP). I know, it sounds complicated, but stick with me – we'll break it down together and make it as simple as chatting over coffee.

What is Expense Allocation?
Imagine you're running a business in a Free Zone and you're earning two types of income: Qualifying Income (which is tax-free) and Taxable Income. To figure out how much tax you owe, you need to split your expenses between these two income types. This is called expense allocation.

The Arm’s Length Principle
Here’s a fancy term: the arm’s length principle. It means treating your Free Zone parent company and its branches (like foreign or domestic establishments) as if they were independent entities doing business with each other at fair market prices.

How Do You Allocate Expenses?
To allocate expenses properly, we follow a two-step approach:

Functional Analysis: Identify the roles of each part of your business – what functions they perform, what assets they use, and what risks they take on. This helps you understand how much each part contributes to your overall business.

Determine Compensation: Figure out what each part should be paid for its contributions. This involves looking at the work done, assets used, and risks taken by each part of your business.

Practical Case Studies
Let’s make this real with a couple of examples.

Case Study 1: Company K
Company K has two parts: a Free Zone parent and a Domestic Permanent Establishment. Each part does its own thing and earns money from sales. They share HR, finance, and IT departments.

Revenue Split: Both parts generate AED 12,500,000 each, totaling AED 25,000,000.
Employee Split: The Domestic Permanent Establishment has 60 employees, and the Free Zone parent has 40.
Now, how do we split the shared costs?

HR and Finance Costs: These are allocated based on headcount and revenue. Since the cost tends to follow the number of employees and revenue, you might allocate 40% of these costs to the Qualifying Income component.
IT Costs: Allocate based on the number of IT support tickets each part raises. This shows the level of IT activity for each part.

Case Study 2: Company Z
Company Z operates in a Free Zone and has a Foreign Permanent Establishment (FPE) in another country. They need to split their expenses fairly between their tax-free and taxable income.

Functional Analysis: The Free Zone parent handles sales and marketing, while the FPE manages production.
Revenue Split: The Free Zone parent generates 70% of the revenue, and the FPE generates 30%.
To allocate expenses:

Sales and Marketing Costs: Mostly incurred by the Free Zone parent, so allocate 70% of these costs to the Qualifying Income.

Production Costs: Primarily incurred by the FPE, so 30% goes to the Taxable Income.

Choosing the Right Allocation Key
An allocation key is a method to split costs. You might use headcount, revenue, usage, or any logical basis that reflects how the expense benefits each part of your business.

Cause and Effect: Match expenses with the activities that cause them. For instance, use machinery running hours to allocate maintenance costs.
Benefits Derived: Allocate based on the benefits received. The key must fairly represent the benefit the expense provides.

Why Bother?
Properly allocating expenses ensures you're compliant with tax laws and helps you understand your business better. Plus, it optimizes your tax strategy, making the most of your Free Zone status.

Need Help?
Feeling a bit overwhelmed? Don't worry, that's where Fastlane comes in. We're corporate tax experts ready to help you navigate these complexities. We'll ensure you understand your obligations and help optimize your tax strategy.

So, let's make expense allocation a breeze and keep your business running smoothly!
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