UAE corporate tax changed the treatment of free zone companies from June 2023. Free zone businesses may still access a zero percent rate on certain income, but only if they meet the conditions of the Qualifying Free Zone Person regime and comply with substance, transfer pricing, and income classification rules.
Before 2023, the common assumption was that UAE free zone companies paid no corporate tax. Under the current regime, the position is more limited. UAE corporate tax applies at a standard rate of 9% on taxable income above AED 375,000. Small businesses earning below that threshold pay 0%.
These rates apply to mainland companies and to free zone businesses that either do not qualify for the free zone regime or choose not to claim it.
The Free Zone Carve-Out
The free zone exemption is technically known as the Qualifying Free Zone Person regime. It allows eligible free zone entities to apply a 0% corporate tax rate to their Qualifying Income.
The key limitation is that not all free zone income qualifies, and not every free zone company will satisfy the conditions required to be treated as a Qualifying Free Zone Person.
To qualify, a free zone entity must meet all of the following conditions:
- Maintain adequate substance in the UAE
- Carry out its core income-generating activities in a free zone or, in limited cases, outside the UAE
- Not elect to be subject to the standard 9% corporate tax rate
- Comply with transfer pricing rules and keep adequate documentation
- Keep non-qualifying income below the de minimis threshold: 5% of total revenue or AED 5 million, whichever is lower
Substance Requirements
The substance requirement is one of the most important conditions. A free zone trade licence alone is not enough.
A company must have genuine operational substance in the UAE, including:
- Real economic activity
- Appropriate assets
- Qualified employees
- Real operating expenditure in the UAE
- Employees genuinely involved in core income-generating activity
- Physical office space, rather than relying only on a flexi-desk in all cases
- Management decisions taken in the UAE
A free zone company that is only a post-box structure with no real UAE activity is unlikely to satisfy the Qualifying Free Zone Person conditions.
What Counts as Qualifying Income
Qualifying Income generally includes income from specified activities conducted with other free zone businesses or with parties outside the UAE.
It can include:
- Income from transactions with other free zone persons
- Income from ownership or exploitation of intellectual property
- Income from certain qualifying activities defined under the Corporate Tax Law
Income from transactions with UAE mainland businesses is generally not Qualifying Income and is usually subject to the standard 9% rate.
This is a major issue for free zone companies with mainland UAE clients or customers.
Excluded Activities
Some activities are excluded from the zero percent treatment even if the company would otherwise qualify.
Excluded Activities include:
- Transactions with natural persons, meaning individual consumers
- Banking activities
- Insurance activities
- Income from UAE immovable property
- Other excluded categories under the regime
Income from Excluded Activities is taxed at 9%. If Excluded Activity income is material, the company may lose its Qualifying Free Zone Person status entirely, causing all income to be taxed at 9%.
Transfer Pricing
UAE corporate tax introduced transfer pricing rules aligned with OECD guidelines.
Transactions between related parties must be conducted on arm’s length terms and documented. This includes transactions between a free zone company and its:
- Parent company
- Subsidiaries
- Associated companies
- Other related parties
Free zone companies that regularly transact with related parties should maintain a transfer pricing policy and supporting documentation.
The Federal Tax Authority can adjust transactions that are not conducted on arm’s length terms.
Practical Compliance Steps
Free zone businesses should review their position before filing tax returns.
Key steps include:
- Review income streams and classify them as Qualifying Income, Excluded Activity income, or non-qualifying mainland income.
- Assess whether the company has adequate substance in the UAE.
- Review related-party transactions and ensure they are documented on arm’s length terms.
- Register for UAE corporate tax if not already registered.
Corporate tax registration is mandatory for all UAE legal entities, even if the company ultimately has no tax to pay.
The main risk for UAE free zone businesses is assuming that a free zone licence automatically means zero corporate tax. Under the current regime, the zero percent rate depends on qualifying income, adequate UAE substance, transfer pricing compliance, and avoiding excessive non-qualifying or excluded income.
Source article: knightsbridge.ae
