Free Zone vs. Mainland: Corporate Tax Implications in the UAE

Free Zone vs. Mainland: The United Arab Emirates has long been a magnet for international business, renowned for its business-friendly environment and attractive tax landscape. The recent introduction of a federal Corporate Tax (CT) regime, effective for financial years starting on or after June 1, 2023, has brought a new dimension to this landscape, particularly concerning the distinct tax treatments of mainland and Free Zone entities. Understanding these differences is crucial for businesses operating in, or considering establishing a presence in, the UAE.

The Fundamental Distinction

At its core, the primary difference in corporate tax implications between mainland and Free Zone companies lies in the applicable tax rates and the conditions for benefiting from preferential rates.

• Mainland Businesses: Companies registered on the UAE mainland are subject to the standard corporate tax rates: 0% on taxable income up to AED 375,000 and 9% on taxable income exceeding AED 375,000. This tiered approach aims to support small and medium-sized enterprises (SMEs) while ensuring larger businesses contribute to the national revenue. Mainland entities generally have unrestricted access to the wider UAE market, allowing them to trade and offer services directly to customers across all Emirates.
• Free Zone Businesses: Historically, Free Zones offered a 0% tax rate on all income. While the new CT law mandates that all Free Zone entities register for corporate tax, a preferential 0% corporate tax rate remains available for “Qualifying Free Zone Persons” (QFZPs) on their “Qualifying Income.” This distinction is critical and carries specific conditions. Any income that does not meet the “Qualifying Income” criteria will be subject to the standard 9% corporate tax rate, similar to mainland businesses. Free Zone entities are generally restricted in their direct dealings with the mainland market, often requiring a separate mainland entity or a local distributor for such operations.

Qualifying Free Zone Person (QFZP) Status and Qualifying Income

For a Free Zone entity to benefit from the 0% corporate tax rate, it must meet the stringent conditions to be classified as a QFZP. These conditions include:

1. Maintaining Adequate Substance: The Free Zone entity must demonstrate a genuine economic presence within the Free Zone. This involves having sufficient physical assets, qualified employees, and incurring adequate operating expenditures within the Free Zone, commensurate with the nature and scale of its activities. This requirement aims to prevent shell companies and ensure real economic activity.
2. Earning Qualifying Income: This is arguably the most complex aspect. “Qualifying Income” primarily refers to income derived from specific “Qualifying Activities” and transactions with other Free Zone persons. Examples of Qualifying Activities include:
   • Manufacturing and processing of goods or materials.
   • Holding of shares and other securities.
   • Ownership, management, and operation of ships.
   • Distribution of goods in or from a Designated Zone (certain Free Zones with specific customs rules).
   • Logistics services.
   • Ancillary activities that are incidental to or support a Qualifying Activity.
   Income from transactions with non-Free Zone persons (e.g., mainland UAE clients or international clients) can also qualify, but only if it relates to a Qualifying Activity and is not considered an “Excluded Activity.””Excluded Activities” generally include:
   • Transactions with natural persons (with some exceptions).
   • Activities in regulated financial services (banking, insurance, finance, and leasing).
   • Ownership or exploitation of immovable property (other than commercial property in a Free Zone used by other Free Zone persons).
   • Ownership or exploitation of intellectual property assets (unless it meets specific criteria under the “nexus approach”).
3. De Minimis Requirement: A Free Zone entity can still be a QFZP even if it earns some non-qualifying income, provided this “non-qualifying revenue” does not exceed certain thresholds. This “de minimis” rule states that non-qualifying revenue must be either less than 5% of the entity’s total revenue for that tax period, or AED 5 million, whichever is lower. Exceeding this threshold will result in the entity losing its QFZP status for that tax period and the subsequent four tax periods, making all its income subject to the 9% corporate tax rate.
4. Compliance with Transfer Pricing Rules: QFZPs must adhere to the UAE’s transfer pricing regulations, ensuring that transactions with related parties are conducted at arm’s length.
5. Not Electing for Standard Taxation: The Free Zone entity must not have elected to be subject to the standard 9% corporate tax rate.

Compliance and Operational Considerations

The differences in tax implications translate into distinct compliance and operational considerations for businesses:

• Registration: All businesses, whether mainland or Free Zone, must register for corporate tax with the Federal Tax Authority (FTA) and obtain a Corporate Tax Registration Number (TRN).
• Financial Record Keeping and Auditing: Both mainland and Free Zone entities are required to maintain accurate financial records for at least seven years and prepare financial statements in accordance with International Financial Reporting Standards (IFRS). While annual audits are mandatory for most mainland companies, the requirement for Free Zone entities can vary depending on the specific Free Zone authority and the nature of their business. However, for QFZPs, maintaining audited financial statements is a crucial condition for qualifying for the 0% tax rate.
• Tax Return Filing: All taxable persons, including QFZPs with 0% taxable income, must file an annual corporate tax return with the FTA within nine months after the end of their financial year.
• Market Access: Mainland companies enjoy unrestricted access to the entire UAE market. Free Zone companies, while benefiting from the 0% tax on qualifying income, face restrictions on direct business with the mainland. For Free Zone entities wishing to serve mainland clients, common strategies include:
  • Establishing a mainland branch or subsidiary, which would then be subject to mainland corporate tax rules on its mainland-sourced income.
  • Utilizing authorized distributors or agents on the mainland.
  • Ensuring the income falls within specific “qualifying income” criteria for transactions with non-Free Zone persons.
• Setup Costs and Procedures: While not directly a tax implication, the cost and ease of setting up a business can also differ. Free Zones often offer more streamlined setup processes and more flexible office solutions, including co-working spaces, which can be attractive for startups and smaller businesses. Mainland setups might involve more extensive licensing procedures with the Department of Economic Development (DED) and typically require a physical office space.
• Foreign Ownership: Recent reforms have largely removed the requirement for a local sponsor for many mainland business activities, allowing 100% foreign ownership. Free Zones have historically offered 100% foreign ownership.

Strategic Decisions

The choice between a Free Zone and a mainland setup is no longer solely about avoiding tax. It now involves a strategic assessment of:

• Target Market: Is the primary focus on the UAE mainland, international clients, or other Free Zone entities?
• Nature of Business Activities: Do the core activities fall within the “Qualifying Activities” list for Free Zones? Are there any “Excluded Activities” involved?
• Substance Requirements: Can the business genuinely meet the economic substance requirements in a Free Zone?
• Operational Flexibility: What are the long-term expansion plans? Will a mainland presence eventually be required?
• Compliance Burden: The ongoing compliance requirements for QFZPs, particularly around income segregation and substance, can be intricate.

CONCLUSION

In essence, while Free Zones continue to offer significant advantages, especially for businesses with an international focus and those engaged in specific qualifying activities, they now come with a heightened need for careful tax planning and strict adherence to the new regulations. Mainland companies, benefiting from direct access to the lucrative local market, operate under a clear 9% tax regime above a generous threshold. Businesses must conduct a thorough impact assessment, ideally with professional tax advice, to determine the most suitable structure that aligns with their operational model, strategic objectives, and long-term growth aspirations in the evolving UAE tax landscape.

WATCH MORE HERE: https://www.youtube.com/watch?v=mkFLhCV2hK4

READ MORE HERE: UAE Corporate Tax 2025: What Every Business Needs to Know Now