Qualified Free Zone Income Under UAE Corporate Tax: A General Overview

With the introduction of Corporate Tax (CT) in the UAE, beginning on June 1, 2023, businesses within the UAE free zones must assess their income taxation under the new regime. Historically, the UAE has been an attractive jurisdiction for companies because of its tax-free environment. Free zones, in particular, offer various incentives, including exemptions from corporate tax for certain activities.

The new UAE Corporate Tax Law introduces the concept of Qualified Free Zone Income (QFZI), determining whether free zone businesses can benefit from a 0% corporate tax rate or face a standard 9% tax rate. In this guide, we will explore the definition of QFZI, the conditions that businesses must meet to qualify, and the compliance steps.

What is Qualified Free Zone Income (QFZI)?

Qualified Free Zone Income (QFZI) refers to income earned by a Free Zone Person—a business entity registered and operating within a designated free zone in the UAE—that qualifies for preferential tax treatment under the UAE’s Corporate Tax Law. This income is eligible for a 0% corporate tax rate, provided certain conditions are met. The introduction of QFZI is designed to maintain the UAE’s status as an attractive destination for international businesses while ensuring tax compliance and transparency.

The Purpose of QFZI in UAE Corporate Tax Law

The UAE Corporate Tax Law recognizes the importance of free zones in attracting foreign direct investment (FDI) and fostering business growth. Free zones contribute significantly to the UAE’s economy by offering a range of incentives to companies, including the ability to repatriate profits, 100% foreign ownership, and exemptions from certain import/export duties. The law prevents misuse and compliance issues, ensuring meaningful economic contribution while maintaining global market competitiveness.

Eligibility Criteria for QFZI

For income to be considered Qualified Free Zone Income, businesses operating in free zones must meet a series of stringent conditions. Failing to meet any of these requirements could result in the business being taxed at the standard rate of 9% on all of its taxable income. Here, we break down the main criteria that define QFZI:

1. Free Zone Person Status
   To qualify for the QFZI regime, a business must be a Free Zone Person, a registered entity in a UAE free zone with a valid license, operating within the designated zone and adhering to its rules. It can include entities involved in various sectors such as manufacturing, trading, logistics, and financial services.
   
2. Substantial Economic Presence and Economic Substance Regulations (ESR)
   QFZI requires a substantial economic presence in the UAE, demonstrating core income-generating activities (CIGAs) for 0% tax rate income, in line with Economic Substance Regulations. This ensures companies claiming tax advantages have sufficient substance and are not simply “shell” companies.Examples of Core Income-Generating Activities (CIGAs) include:
   
   Manufacturing or assembling goods within the free zone.
   Providing services to other free zone entities or foreign businesses.
   Warehousing, logistics, and distribution activities.
   Research and development conducted within the free zone.
   
3. A free zone business must meet the ESR reporting requirements annually to prove that it has sufficient staff, premises, and business activities in the UAE that align with its declared income.
4. Eligible Activities for QFZI
   Only income derived from eligible activities will qualify as QFZI. According to the UAE Corporate Tax Law, the following activities are generally considered eligible for the 0% corporate tax rate:
   
   Manufacturing: Income generated from manufacturing and processing goods within the free zone.
   Trading: Sale and purchase of goods within the free zone or internationally, as long as it does not involve the UAE mainland.
   Service Provision to Free Zone and Foreign Entities: Services rendered to businesses located within the same or other UAE free zones, as well as to foreign entities.
   Passive Income: Interest, dividends, royalties, and capital gains earned from foreign sources or from other free zone entities.
   
5. Activities that involve direct business with UAE mainland entities are not eligible for QFZI unless they are related to passive income, such as interest or royalties. Mainland-sourced active income will generally be subject to the 9% corporate tax.

Transfer Pricing Rules and Arm’s Length Principle

• Transfer pricing rules ensure transactions between related parties are conducted at arm's length or at market value.
• Free zone businesses must document and report all transactions with related parties – loan, sale of goods, provision of services.
• Non-arm's length transactions may be recharacterized by tax authorities, leading to additional tax liabilities.
• Businesses should prepare transfer pricing documentation supporting related-party transaction pricing.
• Comparability analysis using third-party data is required to align transaction terms with market practices.

Mainland Income and its Impact on QFZI

A key distinction in the UAE Corporate Tax Law is the treatment of mainland income for free zone businesses. As mentioned, income from mainland activities is generally excluded from QFZI unless it is categorized as passive income.
Mainland activities that could disqualify income from being considered QFZI include:

• Selling goods or providing services to mainland businesses or consumers.
• Operating branches or offices on the mainland.

Free zone businesses that engage in mainland activities must carefully structure their operations to ensure that only eligible income qualifies for the 0% tax rate. Otherwise, income from the mainland will be subject to the 9% corporate tax rate once it exceeds the AED 375,000 threshold for taxable income.

Tax Rates for Free Zone Businesses

Under the new UAE Corporate Tax framework, free zone businesses are subject to two possible tax rates depending on the nature of their income:

0% Tax Rate on Qualified Free Zone Income: This applies to income that meets all the requirements outlined in the Corporate Tax Law, including eligible activities, compliance with transfer pricing rules, and maintaining substantial economic presence.

9% Tax Rate on Taxable Income: Free zone businesses that generate non-qualifying income, such as mainland-sourced income or income from non-eligible activities, will be taxed at the standard 9% corporate tax rate on the portion of their income that exceeds AED 375,000.

This dual tax rate system ensures that free zone businesses can still benefit from a favorable tax environment while maintaining compliance with the UAE’s broader tax regulations.

Compliance Requirements for Free Zone Businesses

To claim the 0% corporate tax rate on QFZI, free zone businesses must ensure that they meet a number of compliance requirements. Failure to comply with these requirements could result in the business being disqualified from the 0% tax rate and subject to the standard 9% rate on all taxable income.

Filing Corporate Tax Returns
All free zone businesses, regardless of 0% tax rate eligibility, must file annual corporate tax returns with the UAE's Federal Tax Authority, including detailed financial statements and QFZI claims.

Economic Substance Reporting
As previously mentioned, free zone businesses must meet the Economic Substance Regulations (ESR) reporting requirements and submit an ESR report demonstrating sufficient economic substance, including CIGAs, staff, and premises, to regulatory authorities to prove that the business is genuinely operating in the UAE.

Transfer Pricing Documentation
Businesses involved in related-party transactions must submit transfer pricing documentation to tax authorities, detailing transaction records, arm's length nature, and a transfer pricing analysis.

Audited Financial Statements
To ensure transparency and accuracy in their corporate tax filings, free zone businesses may be required to submit audited financial statements. The UAE’s Corporate Tax Law requires certain businesses to maintain audited accounts, and free zone entities claiming QFZI are likely to fall into this category.

Conclusion

In summary, the introduction of Corporate Tax in the UAE marks a significant change for businesses, particularly those operating in free zones. Understanding the intricacies of Qualified Free Zone Income (QFZI) is crucial for maintaining eligibility for the 0% corporate tax rate. Businesses must adhere to specific criteria, including maintaining a substantial economic presence and complying with UAE TP regulations. Failure to meet these conditions could result in a higher tax liability. Therefore, engaging with Corporate Tax Advisors in UAE is highly recommended to navigate the complexities of compliance, transfer pricing rules, and to ensure that businesses maximize their benefits under the new UAE Corporate Tax framework. By staying informed and compliant, free zone entities can continue to thrive in this evolving tax landscape.

Authored by
CA Vivek Anand
Audit Associate