Understanding Free Zones in the UAE

The UAE has long been an attractive destination for businesses worldwide due to its strategic location, advanced infrastructure, and investor-friendly policies. Free zones play a pivotal role in this ecosystem, offering businesses the opportunity to operate with several key incentives. These zones are specialized areas within the UAE that provide benefits such as 100% foreign ownership, exemption from import and export duties, and a 0% corporate tax rate on qualifying income. The UAE is home to over 45 free zones, which are tailored to cater to various industries such as technology, finance, logistics, and manufacturing.

These free zones have been central to attracting foreign investment and fostering economic growth in the country. However, as of June 1, 2023, with the introduction of the Federal Decree-Law No. 47 of 2022, a Corporate Tax regime was implemented. While free zones still retain certain tax advantages, not all activities or entities are automatically eligible for the 0% corporate tax rate. Understanding which entities and activities qualify is critical for businesses operating in these zones.

Background of Corporate Tax in the UAE

The UAE's shift from a tax-free environment to a Corporate Tax system marks a significant change in its economic landscape. The introduction of corporate taxation aims to diversify the country's revenue sources, align with international standards, and support long-term economic growth. While the standard corporate tax rate in the UAE is set at 9%, the government has implemented a special regime for free zone entities, allowing them to benefit from a 0% tax rate on qualifying income, provided they meet specific conditions.

The introduction of corporate tax is part of broader global initiatives such as the OECD's Base Erosion and Profit Shifting (BEPS) project. This ensures that businesses pay tax where their economic activities occur and value is created.

Understanding the Context of 'Person' in the UAE Tax Law

The concept of "Person" under UAE tax law is crucial to determining tax obligations. The UAE Corporate Tax law distinguishes between two types of persons: Natural Persons and Juridical Persons.

• Natural Persons include individuals who own businesses, such as freelancers or sole proprietors. These individuals do not qualify for the 0% corporate tax rate under the Free Zone Corporate Tax regime, even if they operate within a free zone.
  
  
• Juridical Persons, on the other hand, consist of corporate entities, including FZE or FZ LLC  established in a free zone. Only these juridical persons can benefit from the 0% corporate tax rate, provided they meet the conditions for being classified as a Qualifying Free Zone Person (QFZP).

What is a Qualifying Free Zone Person (QFZP)?

A Qualifying Free Zone Person (QFZP) refers to a juridical person that is incorporated or registered in a UAE free zone and meets specific criteria outlined in the Corporate Tax law. To maintain their eligibility for the 0% corporate tax rate, QFZPs must adhere to the following requirements:

1. Adequate Substance: The entity must have substantial operations within the free zone, demonstrated by adequate staff, assets, and operational expenses.
2. Qualifying Income: The entity must derive income from qualifying activities (as specified by the Cabinet).
3. Opt-Out from Standard Rate: The entity must not have elected to be subject to the standard 9% corporate tax rate.
4. Transfer Pricing Compliance: The entity must comply with the arm’s length principle for transactions with related parties and maintain transfer pricing documentation​

What is a Qualifying Activity?

Qualifying activities are key to determining whether a business can benefit from the 0% corporate tax rate. These activities are explicitly defined in Cabinet Decision No. 55 of 2023 and include:

• Manufacturing and processing of goods.
• Holding of shares or securities.
• Management and operation of ships.
• Reinsurance and fund management services.
• Headquarters services provided to related parties.
• Treasury, financing, and leasing of aircraft to related parties.
• Logistics and distribution activities within a designated zone.

It is crucial to note that not all business activities conducted in free zones qualify for the 0% corporate tax rate. Transactions with non-Free Zone Persons or activities categorized as "excluded" do not qualify for the tax exemption​.

What is Qualifying Income?

Qualifying Income refers to the revenue generated from activities that align with the criteria for the 0% corporate tax rate. Qualifying income generally includes:

• Revenue from transactions with other free zone entities, excluding income from excluded activities. (excluded activities mentioned below)
• Revenue from specific qualifying activities, whether sourced from within the free zone, the mainland UAE, or internationally.

Income that does not meet the "qualifying" definition is subject to the standard 9% corporate tax rate. Furthermore, the UAE tax law includes a de minimis rule, allowing companies to maintain their 0% tax status if non-qualifying income does not exceed a certain threshold​.

Related Guide: Corporate Tax in UAE Free Zones

Excluded Activities

The "excluded activities" in the context of qualifying income for free zones in the UAE generally refer to activities that, if engaged in, disqualify that income from benefiting from the 0% corporate tax rate. These activities are outlined in the relevant Cabinet and Ministerial Decisions, such as Cabinet Decision No. 55 of 2023 and Ministerial Decision No. 139 of 2023.

Here are common examples of excluded activities:

1. Transactions with Mainland UAE: Income derived from the sale of goods or services to entities located in the UAE mainland does not qualify for the 0% tax rate.
2. Banking and Insurance Services: Financial institutions and insurance providers are often excluded from qualifying activities, making their income subject to the 9% tax rate.
3. Immovable Property Transactions: Income from the ownership, sale, or lease of residential property in free zones is typically excluded, except in the case of commercial property transactions between free zone entities.
4. Professional Services to Non-Free Zone Persons: Services provided by free zone entities to individuals or businesses outside the free zone (especially in the mainland UAE) are not considered qualifying activities.
5. Any Activity Related to Natural Persons: Income from transactions with natural persons (individuals) is typically excluded, except in limited cases related to qualifying activities like the operation of ships, wealth management, etc.
6. Activities Related to Intellectual Property: In certain cases, income from the exploitation or ownership of intellectual property may be excluded unless it falls within specific qualifying income guidelines.

Understanding De Minimis Tax Rule

The de minimis rule is designed to allow free zone companies some flexibility. It permits a small amount of non-qualifying income without disqualifying the company from the 0% corporate tax rate. Specifically, if non-qualifying income does not exceed the lower of AED 5 million or 5% of the total revenue, the company can still retain its QFZP status and continue benefiting from the 0% corporate tax rate. This is an essential consideration for businesses that may occasionally engage in non-qualifying activities.

Corporate Tax Rates for Free Zones

Free zones in the UAE are subject to a two-tier corporate tax system:

1. 0% Corporate Tax: Applied to income derived from qualifying activities and transactions with other free zone entities. This rate is also applicable to qualifying income earned from foreign sources.
2. 9% Corporate Tax: Applied to income from non-qualifying activities, including transactions with non-free zone entities or excluded activities such as the sale of goods or services within the mainland UAE.
   
   Related Guide:  How to Calculate Corporate Tax Payable in UAE
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The Importance of Maintaining Substance and Compliance

To maintain eligibility for the 0% tax rate, free zone companies must demonstrate "adequate substance." This means they must have sufficient staff, assets, and operational expenses proportional to the income they generate. Moreover, they must comply with the UAE’s transfer pricing rules, including maintaining proper documentation for all related-party transactions.

Failure to meet these requirements could result in disqualification from the 0% tax rate for up to five tax periods. During this period, the company would be subject to the standard 9% corporate tax rate.

Limitations and Exclusions

While free zones offer significant tax benefits, not all activities or transactions qualify for the 0% tax rate. Limitations include:

• Excluded Activities: Certain activities, such as providing services to mainland UAE entities, fall outside the scope of qualifying income and are taxed at 9%.
• Immovable Property Transactions: Income from residential property transactions is excluded from the 0% tax rate, except for commercial property transactions within free zones.

Conclusion

In conclusion, while the UAE's free zones offer a range of tax incentives, not all businesses or activities are eligible for the 0% corporate tax rate. Companies operating within free zones must carefully navigate the corporate tax landscape, ensuring they meet the criteria for being a Qualifying Free Zone Person, engage in qualifying activities, and comply with the required substance and documentation rules. Understanding the limitations and maintaining compliance is key to fully leveraging the tax benefits available in UAE free zones​