Part 2 - UAE Corporate Tax Implications for Free Zone Companies: A Business Advisory Guide

 

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Legal Framework for UAE Corporate Tax in Free Zones

The UAE’s Corporate Tax regime is founded on Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses (“Corporate Tax Law”), which establishes the baseline tax rules and rates, and explicitly addresses Free Zone entities. Subsequent decisions – notably Cabinet Decision No. 100 of 2023 and Ministerial Decision No. 265 of 2023 – provide the detailed conditions under which Free Zone companies qualify for the 0% tax incentive. Additionally, the Federal Tax Authority (FTA) issued the Free Zone Persons Corporate Tax Guide (CTGFZP1) May 2024, offering practical guidance on applying these rules. Together, this legal framework defines the obligations and opportunities for Free Zone businesses under corporate tax:

The Corporate Tax Law is the primary legislation introducing corporate income tax in the UAE at a standard 9% rate on business profits, while including special provisions for Free Zone companies. Article 3(2) of the law sets out a dual-rate mechanism for Qualifying Free Zone Persons: 0% on Qualifying Income, and 9% on taxable income that is not Qualifying Income. In Article 18, the law defines a “Qualifying Free Zone Person” as any Free Zone Person (a juridical entity established in a UAE Free Zone) that meets all specified conditions. These conditions, outlined in Article 18(1), include:

• Adequate Substance in the UAE (having sufficient assets, employees, and operations in the state).
  
  
• Earning Qualifying Income as defined by the Cabinet (to be detailed in subsequent decisions).
  
  
• Not electing to be subject to the standard corporate tax regime (i.e. not opting out of the Free Zone 0% regime).
  
  
• Compliance with Transfer Pricing requirements (Article 34 on arm’s length pricing and Article 55 on documentation).
  
  
• Any additional conditions prescribed by the Minister.

If a Free Zone company fails to meet these conditions at any time during a tax period, it ceases to be a Qualifying Free Zone Person from the beginning of that period (losing the 0% rate). However, the law empowers the Minister to allow certain exceptions or different cessation timing (e.g. to provide relief in marginal cases). The 0% preferential rate for QFZPs (Qualifying Free Zone Person(s)) is generally aligned with Free Zone incentive periods (up to 50 years) as allowed under the Free Zone’s regulations. In essence, the Corporate Tax Law provides the framework and intent, to honor Free Zone tax incentives (0% tax) for companies that qualify – while leaving it to Cabinet/Ministerial decisions to spell out the details of qualifying income and activities.

Cabinet Decision 100 of 2023, issued under Article 18 of the Corporate Tax Law, defines “Qualifying Income” for a Qualifying Free Zone Person. This is a critical piece of the puzzle, as only income falling within these categories is eligible for the 0% tax rate. According to Article 3 of this Decision, Qualifying Income of a QFZP encompasses the following broad categories:

• Income from transactions with other Free Zone Persons, except income from any Excluded Activities (excluded activities are defined separately in the Ministerial Decision). In other words, trading or service income earned within the Free Zone community (business with other companies in any Free Zone) is generally qualifying, unless the nature of the activity is disqualified.
  
  
• Income from transactions with Non-Free Zone Persons (e.g. mainland UAE or foreign parties), but only if derived from Qualifying Activities that are not excluded. This clause allows certain income earned from customers or businesses outside the Free Zone (including UAE mainland or overseas) to still enjoy 0% tax, provided the income is attributable to an approved Qualifying Activity (for example, manufacturing or logistics, as defined) conducted by the Free Zone company. If the income stems from an activity that is not on the qualifying list or is specifically excluded, it will not be treated as Qualifying Income.
  
  
• Income from the ownership or exploitation of Qualifying Intellectual Property (IP), subject to additional conditions. Qualifying IP generally refers to patents and copyrighted software (excluding marketing intangibles). The decision lays out detailed nexus requirements (R&D expenditure in the UAE, etc.) to prevent abuse of the 0% rate for IP income, aligning with OECD nexus approach. Free Zone companies deriving royalties or IP income must ensure they meet these tests to count such income as qualifying.
  
  
• Any other income, provided that the de minimis requirement is satisfied. This catch-all allows a QFZP to earn a small amount of non-qualifying revenue without losing its status, as long as such non-qualifying revenue does not exceed the threshold set by the Minister. Essentially, if the Free Zone company’s “other” income (which is not in the above categories) is below a certain limit, it can still be disregarded and the company retains the 0% on its qualifying portion.

Crucially, Cabinet Decision 100 also clarifies that income will be considered as derived from a Free Zone Person only if the recipient is the “Beneficial Recipient” of the goods or services. This is an anti-avoidance measure to ensure that a transaction truly occurs with a Free Zone business as the end-beneficiary, rather than using an intermediary conduit. Additionally, the decision adapts the definition of a “Domestic Permanent Establishment” for QFZPs (Qualifying Free Zone Person(s)): if a QFZP has a place of business in mainland UAE (outside the Free Zone), income attributable to that domestic PE is carved out from Qualifying Income. Free Zone companies must therefore be careful about establishing branches or offices in the mainland, as profits of such branches would generally be taxed at 9%.

Ministerial Decision 265 of 2023 complements the Cabinet Decision by enumerating which activities are “Qualifying Activities” and which are “Excluded Activities” for Free Zone Persons. This decision provides a granular list that businesses can use to determine if their operations in the Free Zone fall within the scope of the tax-free regime or not.

Qualifying Activities (conducted by a QFZP) that can generate Qualifying Income include a range of business activities traditionally encouraged in Free Zones

• Manufacturing of goods or materials – the production or assembly of products.
  
  
• Processing of goods or materials – treatment or refinement of raw materials.
  
  
• Trading of Qualifying Commodities – physical and derivative trading of specific exchange-traded commodities (metals, minerals, energy, agriculture).
  
  
• Holding of shares and other securities for investment purposes – i.e. a holding company for equity interests (with a condition that shares are held for at least 12 months).
  
  
• Ownership, management and operation of ships – focusing on international shipping activities (excluding local transport or leisure use).
  
  
• Reinsurance services.
  
  
• Fund management services – managing investment funds under regulatory oversight.
  
  
• Wealth and investment management services – managing portfolios for investors (discretionary or advisory).
  
  
• Headquarters services to Related Parties – providing support services (e.g. management, coordination) to group companies.
  
  
• Treasury and financing services to Related Parties – intra-group financing and treasury operations.
  
  
• Financing and leasing of aircraft (including engines and rotable components)
  
  
• Distribution of goods or materials in or from a Designated Zone – trading or logistics operations where goods are stored/distributed within a Designated Zone.
  
  
• Logistics services – freight, warehousing, and distribution services.
  
  
• Ancillary activities – any activities ancillary to the above qualifying activities.

On the other hand, the decision lists Excluded Activities which, if conducted by a Free Zone company, produce non-qualifying income (and potentially disqualify the entity if thresholds are exceeded). These include:

• Transactions with natural persons (individual customers), except when the transactions are in the context of certain allowed activities (specifically, the decision permits dealings with individuals only for the activities of owning/operating ships, fund management, wealth management, and aircraft leasing, as these are primarily B2C in nature by industry). All other direct consumer-facing transactions (e.g. retail or personal services) are excluded. For example, a Free Zone retail shop or a service firm directly serving individual clients would be undertaking excluded activities, jeopardizing its 0% tax status.
  
  
• Banking activities – any conventional banking business is excluded. Banks in Free Zones, such as those in the DIFC, will thus not qualify for the 0% regime and will be taxed at 9% like other mainland banks.
  
  
• Insurance activities – insurance is excluded except reinsurance (reinsurance was listed as qualifying). So, insurers writing primary insurance policies do not qualify, whereas reinsurance companies can.
  
  
• Financing and leasing activities – this refers to providing finance or leasing as a business, except those to related parties or involving aircraft/ships which are qualifying. For instance, a leasing company in a Free Zone that leases equipment to third parties would be an excluded activity (unless it’s aircraft leasing, which is explicitly qualifying).
  
  
• Ownership or exploitation of immovable property – income from real estate is excluded except if it is from commercial property located in a Free Zone and the transaction is with a Free Zone Person. In simple terms, Free Zone companies cannot use the 0% regime to shelter income from UAE real estate (especially residential or mainland property). Only if the property is within a Free Zone (and not used as a residence) and the tenant/buyer is also a Free Zone entity, can that income remain qualifying. All other real estate income (e.g. renting warehouses to mainland companies, or any residential rentals) is non-qualifying.
  
  
• Any ancillary activities to the above excluded categories. This catch, ensures that supporting activities related to excluded items are also treated as excluded.

Ministerial Decision 265 also introduced two additional critical conditions for QFZPs (Qualifying Free Zone Person(s)):

(a)   a de minimis rule and

(b)   an audit requirement.

It specifies the de minimis threshold referenced by the Cabinet Decision: a Qualifying Free Zone Person’s non-qualifying revenue must not exceed 5% of its total revenue or AED 5,000,000 (whichever is lower) in the tax period.

In the event non qualifying income exceeds the threshold, the company loses its QFZP status entirely for that year (and the four subsequent years), meaning its entire income becomes taxable at 9%.

This high-stakes outcome makes compliance with the threshold essential for Free Zone businesses that have even a minor share of non-qualifying activities. Second, every QFZP must prepare audited financial statements in accordance with the applicable Ministerial decision on audit requirements. Maintaining audited books is now not just a Companies Law obligation but a condition for enjoying the tax benefit, a new compliance cost especially for smaller firms.

Disclaimer: Content posted is for informational and knowledge sharing purposes only, and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/interpretation of the publisher is based on the available Law, guidelines and information. Each reader should take due professional care before you act after reading the contents of that article/post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide, and should not be relied on for tax or accounting advice.

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