Free economic zones: Pathfinder Business

Posted on June 6, 2008 · Posted in Pathfinder Business

 

Free Zones

 

by Paul Gosling

 

Dubai and the other Gulf states have their free zones. India increasingly relies on special economic zones. Mauritius, though, has its freeport. But whatever their local names and differing local tax regimes, the various types of free zones are unquestionably making an enormous impact in the globalised economy.

 

Without an agreed single definition of what constitutes a free zone, statistics are difficult to compile. But it is generally agreed that there are 3,000 or so free zones in about 120 countries, generating employment for about 50 million people.

 

And for particular countries, free zones can be particularly important. Special economic zones are responsible for 80% of the Dominican Republic’s exports and 61% of foreign direct investment in Malaysia. Even in countries where their use is less well developed, it is already significant: in Bangladesh special economic zones generate 20% of exports and a quarter of foreign direct investment.

 

But choosing the right free zone is a daunting task for a business or investor. Each zone has its own tax regime, criteria for entry, different local infrastructure and labour skills, even minimum investment level. Nor is it even always easy to get into a free zone: the most successful have waiting lists that can be years long.

 

While some free zones are located in the developed nations, most are sited in the emerging markets. They operate with a very simple offer: ‘we will charge you less, or even no, tax, if you locate here and employ local labour’. The calculation is that any lost tax is more than balanced by reduced state expenditure on supporting people who are jobless. For many countries, an additional attraction is earning hard currency.

 

Frequently – notably in Saudi Arabia and the other Gulf states – the creation of free zones is part of a broader industrial and economic strategy, promoting the development of sectors that are seen as important for their long-term future. Saudi Arabia plans to create a new industrial infrastructure that generates jobs for the large numbers of its country’s unemployed, building up their skills to give the country an ability to compete in many more markets than just the oil industry. The use of zones backs up its development of key sectoral clusters – for example, in information technology and healthcare – that can reach ‘tipping point’ much more quickly through the use of substantial tax breaks.

 

It is, in fact, the Gulf region where free zones have proved especially effective. Jafza – the Jebel Alif Free Zone in Dubai – claims to be the largest and fasting growing such zone anywhere in the world. Indeed, it is so successful that it has spawned a series of associated zones not just across Dubai, but also in Dakar in Senegal, with the prospect of exploiting close links with the parent Jafza zone. And Jafza has major ambitions – it aspires to be the international business hub of the Middle East. Yet it was only established in 1985. Initially it provided standard office units and warehouses that enabled companies to operate under the traditional model of a free port: to import and quickly re-export goods.

 

The old free port model, successfully used in the 19th Century, involved bonded warehouses, secure perimeters and controlled access with the outside world. While those characteristics are also used by free zones today, in many other ways they have evolved significantly from simply being small import/export areas.

 

Today, a free zone is usually much more than a distribution centre. Often they are service centres: some contain hotels, leisure and tourist facilities; others are the base for call centres. Many have manufacturing capacity: an offshoot of Jafza is home to car assembly factories. Others specialise in research and development: the Michigan State University has a campus on one. There is even a healthcare zone in Dubai. And what lies within the permimeter fence has gone far beyond what is directly needed for trade: Jafza has residential accommodation and the leisure facilities to service their occupants.

 

Altogether, Dubai now has eight free zones. Jafza alone generates an income of nearly £20bn a year and has a thousand companies that want to move in, if only there were more capacity. The associated Dubai Airport free zone itself has over a thousand companies on its site. Together, the various Dubai free zones have placed the small Gulf state as a centre for international shipping, as a key point linking the Far East and the West.

 

The Dubai zones have thrived on the back of generous tax breaks: the zones across the United Arab Emirates promise they will not levy corporation tax for 15 years, with the prospect of renewing the arrangement for a further 15 years. In addition, there are full exemptions on import and export taxes; permitted full repatriation of profits and capital; and no income tax on the zones’ residents. Just as important is the commitment to high quality, modern infrastructure: the new Dubai World Central zone will cost £16bn to build. The zone authorities promise to assist with recruiting labour and finding residential accommodation.

 

While such arrangements are typical for a free zone, there are significant variations in what is expected in return. In the Ukraine, which has 20 special economic zones, foreign investors will normally be required to make a minimum commitment – which may be US $200,000, or as much as US $1m. Yet in other zones, government money may pay for factories: some zone administrators will provide tailor-made accommodation.

 

Tax concessions also vary widely and can change. China operates a special 15% tax rate for ‘Foreign Investment Enterprises’ in its special economic zones, compared to a standard rate of corporation tax of 25% (reduced from 30% at the beginning of this year). In principle, FIEs may be subject to an additional 3% local tax, though this will not always be levied.

 

Chas Roy-Chowdhury, head of tax at the Association of Chartered Certified Accountants, explains: “What businesses need to be aware is that to take advantage of the tax regimes they need to comply with the type of businesses specified in a free zone; for example, IT or cars. Usually there is a special class of business that will qualify – though usually they will not be given the right to set-up unless they qualify.”

 

Roy-Chowdhury warns that while free zones appear to offer attractive tax rates, understanding exactly what these are can be difficult – especially in China. “There are different tax rates and exemptions, depending on whether the enterprise is fully foreign-owned, or partially foreign-owned, or domestically-owned,” he says. “So it’s a minefield. China has been reforming its tax regime this year, but even then you have to work your way through the requirements and you have to have local inter-personal skills because the way the tax breaks work is that they may be given to you and the decision is up to the local revenue authorities. It’s down to the people you know and that sort of thing.”

 

Given these complexities and complications, it is important to take specialist advice from people who understand the local tax and commercial environment, says Roy-Chowdhury. “Otherwise you are in trouble later on and you won’t optimise the tax breaks that are available,” he suggests.

 

There are, though, many other things to consider beyond tax rates when thinking about free zones. For a start there is the availability of labour, its reliability, cost and skills base. Then there is the question about a zone’s strategic positioning, sea and air connections – and the quality of road connections with the hinterland. Location advisers, often termed real estate advisors, situated in or near the free zones can provide local specialist information on all these questions.

 

But there is also the political context, which may even raise questions about the sustainability of tax concessions: free zones are often controversial. In India, a protest movement has been established against the country’s special economic zones, with farmers accusing the government of seizing their land for the zones, at prices that are below market value, while opposition parties accuse the government of losing tax revenues to provide multinationals with a source of cheap labour.

 

Some free zone host countries are politically unstable. Kenya has relied on export processing zones as part of its economic strategy (and been criticised for doing so, by the country’s human rights commission, which claims that working conditions are sometimes unacceptable). Ghana, which has had a difficult and unsettled history, promotes a very large export processing zone as part of its free zones programme. Palestine offers generous tax breaks for entrepreneurs investing in the Gaza strip’s industrial estate.

 

Dr Christian Ketels is one of the world’s leading advisers to governments on their economic policies and is principal associate at Harvard Business School’s Institute for Strategy and Competitiveness. He warns that neither countries nor companies should rush into the use of free zones. “For countries, free zones can be useful tools for economic development, but have to be handled with care,” he says. “Their defining character is the presence of tariff and taxation rules not available elsewhere in the economy. If the free zones are not more than that, they can have limited positive impact on attracting companies – but will otherwise mainly distort competition and have uncertain economic benefits. The recent debates around the mushrooming Indian special economic zones are an example of how this can go awry.

 

“If, however, free zones also become focal points for targeted infrastructure development and experiments with more effective government rules and regulations, they can become places in which companies are genuinely more productive, which will create more value for them and for the host economy. If, in addition, the economic activities in the free zones are linked with the local economy, for example through building local supplier relations, and changes in rules and regulations are then rolled out to the wider economy, free zones can become stepping stones to higher overall competitiveness. This is what Costa Rica strived for when attracting Intel to its free zone.

 

For companies, even the short-term benefits of exploiting lower taxes or tariffs in free zones can, of course, be beneficial. But making locational decisions on this basis alone means that a company systematically misses the opportunity to put activities in places where the company can create true competitive advantages rather than one-time financial benefits. This strategy also risks that companies become engulfed in political debates when they are being perceived as short-term investors that leave once the financial subsidies are no longer available. Working with governments to make free zones a combination of tax incentives, dedicated infrastructure, and government best practices is a better long-term approach for companies and can lead to a true win-win between host and investor.”

 

Thinking about the longer-term can be a challenge for a company. But the longer-term relationship is often the best – and by far the most profitable. The rewards for working out the right strategy in the right free zone location can be substantial.

 

Free zones: the definition

 

“The main purpose of free zones is to promote external trade and international commerce by granting relief from duties and taxes on goods imported to the territory. Additional benefits are the creation of employment in the free zones and the development of associated trade activities. Free zones are established on seaports, riverports, airports and places with similar geographic and economic advantages.

 

“Customs control exercised over goods placed in free zones is more flexible than that applicable to goods stored, for example, in customs warehouses or admitted under the inward processing procedure. In free zones, customs normally apply general surveillance measures only.

 

“In many customs territories a distinction is made between ‘commercial’ and ‘industrial’ free zones. In commercial free zones, no processing or manufacturing operations of the goods are allowed. The operations that are allowed are restricted to only those required to preserve the goods or to improve their packaging/marketable quality and which do not change the character of the goods. In industrial free zones, processing or manufacturing operations are allowed.”

 

Source: Kyoto Convention Guidelines on Free Zones

 

 

Local trading restrictions

 

Each free zone has its own rules and restrictions which can be onerous. In return for non-payment of local taxes, companies will usually have to undertake not to supply the local market in competition with higher tax paying local companies. If they do supply the local market, they are likely to have to pay local taxes – as is the case, for example, in the Tanger free zone in Morocco.

 

The situation is similar in Dubai. Ubhash Ambalavelil, an advisor with Jitendra business consultants – which specialises in advising companies setting-up in free zones in the United Arab Emirates – says: “If a company is incorporated within a free zone then they can do trade anywhere in the world. But they cannot sell to the local market. They can only sell to the local market through a local agent, with a 5% duty on local supplies.”

 

There are anecdotal stories that, particularly in Dubai, the rule is not enforced and some companies breach the obligations. However, companies that do this could face problems with the local tax authorities if the rules later become subject to enforcement. It is also potentially a major difficulty if the owner seeks to sell the business. Due diligence is likely to establish that all forward contracts that involve local supply without using local agents and paying additional duty are technically invalid and unenforceable.