How UAE Corporate Tax Applies To Free Zone Companies

Free zones remain one of the UAE’s most attractive business locations for foreign investors. With the introduction of UAE Corporate Tax, free zone companies are now subject to a clearer tax framework, under which qualifying entities may benefit from a 0% rate on qualifying income, subject to specific conditions.

Benefits of Free Zones for Foreign Investors:

• 100% foreign ownership
• Favorable regime for UAE VAT
• 100% exemption from customs duty
• Modern, sophisticated infrastructure
• Simplified procedures for set-up
• Better global market access
• 100% repatriation of capital and profit

How UAE Corporate Tax Applies To Free Zone Companies

Public Consultation Position

When UAE Corporate Tax was announced, the Public Consultation Document indicated that free zone entities would fall within the scope of the regime and would need to register and file returns. They would, however, remain eligible for a 0% rate on specified income, subject to substance and free zone compliance requirements.

As per the said document, the following income of Free Zone persons would be subject to 0% Corporate Tax:

• Income from outside UAE or from other Free Zones
• Passive income from mainland companies (royalties, interest, etc.)
• Income from group companies in the mainland is subject to a disallowance of expenses in the hands of mainland companies.

The document also specified that Free Zone persons not fulfilling requisite conditions or earning any other income from the mainland would result in losing out on exemption, and entire income would become subject to CT. The taxation of entire income in case of violation of the condition appeared to be harsh for companies having income from the mainland.

Provisions for a Free Zone person under the final Corporate Tax law

Finally, on 9 December 2022, the UAE MoF released the final version of the CT law. Under the final CT law, a Free Zone person is included in the definition of taxable persons. Furthermore, the beneficial tax regime would apply only to a qualifying Free Zone person earning qualifying income.

As per Article 18 of the final law, a qualifying Free Zone person means an entity in the Free Zone that:

• Maintains adequate substance.
• Derives qualifying income as may be specified.
• Complies with transfer pricing provisions of the law.
• Has not elected to be subject to CT, and
• Meets such other conditions as may be prescribed.

A Free Zone person that fails to meet the aforesaid conditions at any time during a tax period shall cease to be a qualifying Free Zone person from the beginning of that tax period. Furthermore, a Free Zone person shall be taxed at 0% on its qualifying income and at 9% on all income other than qualifying income. It appears that the income threshold of AED 3,75,000 may not be available to Free Zone persons. A qualifying Free Zone person can make an application to be subject to CT at rates applicable to other taxable persons.

In practical terms, qualifying income generally refers to income that remains eligible for the 0% tax rate under the UAE Corporate Tax framework, subject to the final rules and notifications.

Key Compliance Points for Free Zone Companies

• A Free Zone person has the option to elect to be taxed as per the normal provisions.
• Free Zone persons would be required to adhere to the arm’s length principle and maintain adequate transfer pricing documentation providing disclosure of transactions with related parties and connected persons
• However, Free Zone persons cannot be a part of tax groups and they are also not eligible for tax relief on intra-group transfers and restructuring. Also, the transfer of tax loss to or from a Free Zone person is also not permissible.
• Free Zone companies, especially ones that are part of large groups, would have to carefully evaluate the pros and cons of opting out of the exemption, as it’s a one-time option.
• Given that Free Zone Companies' income would be classified in Qualified Income and other income, it would become imperative for companies to have appropriate break-up/allocation of expenses incurred for earning qualifying income and other income.
• Furthermore, the FAQs released by the MoF have also clarified that qualifying Free Zone entities that are part of a large multinational group are anticipated to be subject to a different CT rate once the Pillar Two rules are embedded into the UAE CT regime.

Open Questions on Free Zone Taxation:

• Whether Free Zone Companies complying with the Economic Substance Regulations in UAE could be said to have maintained adequate substance, or they may have to provide proof of substance in any other manner?
• Whether the transactions eligible for 0% CT rate, as specified in the Public Consultation Document would continue to appear in the cabinet decision?
• Whether certain specified Free Zone person would be mandated to get their books audited?
• Whether any further relaxations are expected for Free Zone Companies liable to tax on qualifying income?