Substance vs DMTT: when can a 0% free zone rate still matter?

Understanding the Substance-Based Income Exclusion (SBIE)

The SBIE is a deduction applied in the top-up tax calculation based on the economic substance of an entity. The exclusion consists of:

• a payroll carve-out, calculated as a percentage of eligible payroll costs, and
• a tangible asset carve-out: A percentage of the carrying value of eligible tangible assets.

For Emirati businesses, these carve-outs are defined in Article 5.3 of the UAE Domestic Top-Up Tax Rules attached to the Cabinet Decision No. 142:

SBIE = (Carve-out rate for payroll × Eligible payroll costs) + (Carve-out rate for tangible assets× Carrying value of eligible tangible assets)

Under the transition rules in Article 9.2, the SBIE rates will gradually decrease:

• Payroll carve-out: Starts at 9,6% (2025) and decreases to 5% (2033).
• Tangible asset carve-out: Starts at 7.6% (2025) and decreases to 5% (2033).

Impact on ETR and Top-Up Tax Calculation

SBIE does not reduce the denominator when calculating the Effective Tax Rate (ETR) under Article 5.1, but it does reduce the taxable base (Excess Profit) for top-up tax purposes.

Excess Profit = Net GloBE Income− SBIE

Thus, SBIE can reduce or eliminate the top-up tax if it significantly lowers the Excess Profit.

Can a Qualifying Free Zone Person (QFZP) Still Elude a Top-Up Tax?

Yes, in some cases, a QFZP applying the 0% tax rate can still avoid a top-up tax if SBIE is large enough to push the jurisdictional ETR to 15% or higher.

To illustrate this, let’s compare three scenarios.

Scenario 1. No Substance-Based Exclusion Applied

Assume the UAE has:

• Mainland entity (CE1): first €375K of profit taxed at 0%, the remaining taxed at 9%.
• Free Zone entity (CE2): Profitable, taxed at 0%.
• Total UAE GloBE Income: 100M EUR.
• Total Taxes Paid: €8.97M (from CE1).

Step 1: Calculate Jurisdictional ETR

ETR = 8.97M / 100M = 8.97%

Since 8.97% is below the 15% minimum rate, a top-up tax applies at the rate 6.03% (15% - 8.97%).

Step 2: Compute Excess Profit (without SBIE)

Excess Profit = 100M −0 = 100M

Step 3: Compute Top-Up Tax

Top-Up Tax = (15%−8.97%) × 100M = 6.03M

Thus, the top-up tax due is €6.03M.

Scenario 2. SBIE Reduces the Top Up Tax

Assume that:

• Eligible Payroll Costs of mainland and free zone entities are 20M EUR.
• Eligible Tangible Assets of mainland and free zone entities are 80M EUR.
• SBIE Rates for 2025: 6% payroll, 7.6% tangible assets.

Step 1: Compute SBIE

SBIE = (9,6% × 20M) + (7.6% × 80M) = 1.92M + 6.08M = 8M

Step 2: Compute Excess Profit (After SBIE)

Excess Profit =100M − 8M =92M

Step 3: Compute Revised Top-Up Tax

Top-Up Tax = (15% − 8.97%) × 92M = 5.55M

Here, the top-up tax is reduced but still applies.

Scenario 3. Fully Eliminating Top-Up Tax

If SBIE is large enough to reduce Excess Profit to nearly zero, no top-up tax applies.

To completely eliminate the top-up tax, we need SBIE ≥ 100M. Let’s assume:

• eligible Payroll Costs of mainland and free zone entities are €91.8 million;
• eligible Tangible Assets of mainland and free zone entities are €1,200 million.

Step 1: Compute SBIE

SBIE = (9.6%×91.8M) + (7.6% × 1,200M) = 8.8M + 91.2M = 100M

Step 2: Compute Excess Profit (After SBIE)

Excess Profit is zero since SBIE exceeds Globe Income (100M).

Step 3: Compute Revised Top-Up Tax

Top-Up Tax=15% × 0 = 0

Therefore, Emirati free zone and mainland companies are not automatically subject to full top-up tax. If SBIE is high enough, it can either reduce or even eliminate the top up tax entirely. Substantial investments in payroll and tangible assets can help free zone and mainland companies preserve their tax advantage.

The Beneficiaries of the Substance-Based Carve-Outs

Industries that are capital-intensive and have high payroll costs relative to their profits are likely to benefit most from the Substance-Based Income Exclusion (SBIE) under Pillar Two.

Manufacturing and heavy industry serve as prime examples due to their significant investments in machinery, factories, and equipment. Within this sector, automotive manufacturing, aerospace production, and industrial machinery stand out as industries with substantial capital expenditures.

Similarly, the energy and utilities sector—including refining and other processing activity, renewable energy (solar, wind, hydro), electricity production, and water desalination—incurs high capital costs in power plants, refineries, oil rigs, and renewable energy infrastructure.

Transportation and logistics can also benefit significantly from the SBIE due to their high payroll costs (large workforce) and substantial tangible assets, such as fleets of trucks, aircraft, and warehouses. Examples include airlines, rail freight operators, and road transport companies.

Similarly, the pharmaceuticals and life sciences sector—including biotech firms, medical equipment manufacturers, and vaccine producers—incurs high payroll costs due to specialized R&D staff and requires significant capital investment in production facilities.

Conversely, industries with low tangible assets and payroll costs relative to profits benefit less from the SBIE. These include digital services and software companies, financial services firms that primarily rely on intangible assets and financial instruments, and holding companies with minimal physical operations.

The disclaimer

Pursuant to the MoF’s press-release issued on 19 May 2023 “a number of posts circulating on social media and other platforms that are issued by private parties, contain inaccurate and unreliable interpretations and analyses of Corporate Tax”.

The Ministry issued a reminder that official sources of information on Federal Taxes in the UAE are the MoF and FTA only. Therefore, analyses that are not based on official publications by the MoF and FTA, or have not been commissioned by them, are unreliable and may contain misleading interpretations of the law. See the full press release here.

You should factor this in when dealing with this article as well. It is not commissioned by the MoF or FTA. The interpretation, conclusions, proposals, surmises, guesswork, etc., it comprises have the status of the author’s opinion only. Furthermore, it is not legal or tax advice. Like any human job, it may contain inaccuracies and mistakes that I have tried my best to avoid. If you find any inaccuracies or errors, please let me know so that I can make corrections.