Zero-Rated vs Exempt VAT in UAE: What’s the Difference?
February 24, 2025
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For years, free zone companies in the UAE have enjoyed 0% corporate tax, making them a preferred choice for entrepreneurs and foreign investors looking to set up businesses in a tax-friendly environment.
However, with the introduction of corporate tax in the UAE, many free zone businesses are now questioning whether they will need to pay tax, what conditions they must meet, and how their tax obligations compare to mainland companies.
The UAE government has confirmed that qualifying free zone businesses can still benefit from the 0% corporate tax rate on eligible income, but the rules surrounding tax exemptions are complex and highly specific.
If a free zone company does not meet the right conditions, it may be subject to the 9% corporate tax rate, just like mainland businesses.
The UAE’s has introduced new rules for free zone businesses, creating a clear distinction between companies that qualify for a 0% tax rate and those that must pay the 9% corporate tax on taxable profits.
While free zones remain attractive for foreign investors, startups, and international companies, the tax benefits are now conditional, requiring businesses to meet strict criteria set by the Federal Tax Authority (FTA).
Free zone companies that meet the FTA’s criteria for a “Qualifying Free Zone Person” (QFZP) can benefit from a 0% corporate tax rate on eligible income.
The primary condition for maintaining this tax benefit is that the company must only earn income from permitted activities within the free zone or from international business transactions.
Businesses that conduct transactions with UAE mainland companies may lose their tax exemption. If a free zone entity sells goods or provides services to mainland clients, that income may be subject to the 9% corporate tax rate, unless it qualifies for an exemption under the new regulations.
Maintaining free zone tax benefits also requires businesses to have a “substantial economic presence” in the free zone.
This means that the company must have a physical office, conduct active business operations, and meet the FTA’s substance requirements.
Shell companies or businesses that exist only on paper will not qualify for the 0% tax rate and may be taxed as mainland entities.
While some free zone businesses qualify for 0% corporate tax, others will be required to pay the standard 9% corporate tax on taxable profits exceeding AED 375,000.
Companies that fail to meet the FTA’s criteria or engage in taxable mainland transactions will not be able to maintain their tax-free status.
Free zone businesses that provide services to mainland clients, operate branch offices in the mainland, or have direct revenue sources within the UAE may be subject to corporate tax.
Even if a company is based in a free zone, its tax liability is determined by where it earns its income and how it conducts business.
Some free zone companies that conduct both qualifying and non-qualifying activities may be required to segregate taxable and non-taxable income in their financial records.
Failing to properly classify income can result in the entire business becoming subject to the 9% corporate tax, even if a portion of its revenue is eligible for a 0% tax rate.
Free zone businesses that want to retain their 0% corporate tax status must take a proactive approach to compliance.
Meeting the FTA’s requirements is not just about registration—it involves ensuring that business operations, revenue sources, and financial reporting align with UAE corporate tax laws.
Companies that fail to meet these conditions risk losing their tax-free status and being taxed at the standard 9% rate.
One of the most important factors in maintaining a 0% corporate tax rate is proving that the company has a substantial economic presence in the free zone.
This means that the business must be more than just a registered entity on paper. Companies that exist solely for tax advantages without real operations, employees, or a physical presence may not qualify as a “Qualifying Free Zone Person” (QFZP).
The FTA requires free zone businesses to have a real office, employees, and ongoing business activities within the free zone.
Companies that operate remotely or rely on offshore structures must ensure they meet these substance requirements to avoid being classified as taxable entities.
Businesses that fail to prove their economic presence may be taxed under standard corporate tax rules, even if they are based in a free zone.
Free zone companies must carefully structure their transactions to prevent their income from being classified as taxable under the 9% corporate tax system.
If a company earns revenue from mainland UAE clients, that portion of income may no longer qualify for the 0% tax rate.
Businesses that rely on direct sales, service contracts, or operational links to the mainland must consider restructuring their operations to protect their tax benefits.
Some businesses may choose to set up separate entities—one in the free zone and one in the mainland—to keep qualifying income separate from taxable income.
This approach allows companies to continue benefiting from tax-free income on international transactions while ensuring that mainland operations remain compliant with corporate tax rules.
Proper tax planning and structuring are essential for companies that want to optimize their tax position while maintaining compliance.
A key requirement for maintaining 0% corporate tax is ensuring that the company’s business activities align with FTA-approved categories.
Not all activities qualify for tax exemption, and businesses must verify that their operations fall under the approved list of qualifying activities.
Companies engaged in trading, manufacturing, logistics, and certain professional services are more likely to maintain tax benefits, provided they operate primarily within the free zone or conduct international transactions.
However, businesses that derive revenue from mainland UAE clients, non-qualifying services, or certain financial activities may become partially or fully taxable.
To safeguard tax benefits, companies should regularly assess their revenue sources, evaluate customer relationships, and restructure contracts if necessary.
If a business is engaging in activities that might make it ineligible for tax exemption, it should consider restructuring its operations to ensure compliance.
This may involve establishing separate entities for taxable and non-taxable transactions or adjusting business models to focus on qualifying activities.
The way a free zone company handles transactions with UAE mainland businesses can determine whether it retains tax benefits or becomes subject to the 9% corporate tax rate.
Even if a business is based in a free zone, earning income from mainland UAE clients may trigger tax obligations, unless carefully structured.
A free zone company that sells physical goods to mainland customers can retain tax benefits if the sale is conducted through a distributor or agent licensed in the mainland.
However, if the company directly sells to mainland businesses or provides services to UAE-based clients, that portion of income may become taxable.
For businesses offering consulting, IT, legal, or other professional services, structuring operations correctly is crucial.
Companies may consider setting up a separate mainland entity to handle taxable transactions while keeping their free zone company focused on qualifying international business activities.
Implementing clear service agreements, distinct revenue channels, and separate financial reporting ensures that taxable and non-taxable income is properly classified.
A business cannot qualify for 0% corporate tax if it exists only on paper without real operations in the free zone.
The UAE’s Economic Substance Regulations (ESR) require companies to demonstrate actual business activity within the free zone, meaning that a company must have a physical office, employees, and ongoing commercial operations.
Some businesses mistakenly assume that maintaining a virtual office or shared workspace is enough to comply with ESR rules.
However, the FTA evaluates whether a company has a genuine operational presence, decision-making authority within the UAE, and sufficient staff to manage its core activities.
Companies that fail to meet these criteria may be deemed non-compliant and lose their tax exemption status.
Even if a free zone company qualifies for 0% corporate tax, it is still required to comply with the Federal Tax Authority’s (FTA) reporting and documentation requirements.
Many businesses assume that being tax-exempt means they do not need to submit tax returns, but failing to meet compliance obligations can lead to penalties, fines, and potential loss of tax benefits.
Every free zone company must file an annual corporate tax return, even if it qualifies for a 0% tax rate. This return serves as a formal declaration to the FTA that the company meets the conditions for tax exemption.
Businesses that do not submit their tax returns on time or fail to provide accurate financial records may be subject to tax audits, financial penalties, or even reclassification as a taxable entity.
Companies must ensure that their financial statements are properly maintained, revenue sources are clearly documented, and transactions are accurately classified.
The FTA may request supporting evidence to confirm that the company is conducting qualifying activities and complying with free zone regulations.
Businesses that cannot provide sufficient documentation may lose their tax-free status and be required to pay corporate tax on all income.
For free zone businesses that engage in intercompany transactions, compliance with transfer pricing regulations is critical. The UAE follows OECD transfer pricing guidelines, which require businesses to price transactions between related parties at fair market value.
Many free zone companies operate as part of a multinational group or have subsidiaries in different jurisdictions, making it essential to document and justify their pricing structures.
If a free zone business provides services, loans, or intellectual property to related entities at prices that do not reflect market conditions, the FTA may consider this an attempt to shift profits and reduce taxable income artificially.
Companies must maintain detailed transfer pricing reports, benchmarking studies, and intercompany agreements to prove that their transactions comply with tax regulations.
Failing to comply with corporate tax regulations can have serious financial and operational consequences for free zone businesses.
While qualifying companies can enjoy a 0% tax rate, they must ensure they meet the conditions set by the Federal Tax Authority (FTA). Any non-compliance, even unintentional, can lead to penalties, backdated tax liabilities, or even loss of tax-free status.
A free zone company that does not meet the qualifying criteria may lose its 0% corporate tax rate and be reclassified as a fully taxable entity under the 9% corporate tax system.
If a business unknowingly earns taxable income—such as revenue from mainland clients—or fails to meet the economic substance requirements, it may no longer qualify for tax-free status.
Losing tax benefits not only increases a company’s financial burden but can also impact its long-term profitability and operational costs.
Businesses that fail to plan for these risks may face unexpected tax liabilities that disrupt their cash flow and business strategy.
The FTA actively monitors free zone companies to ensure they comply with tax regulations. If discrepancies are found in tax filings, financial statements, or transfer pricing reports, the FTA may conduct a corporate tax audit.
Businesses that cannot justify their tax position or fail to provide supporting documentation may be subject to financial penalties, additional tax assessments, and reputational damage.
Penalties for non-compliance can range from fixed fines for late tax filings to significant financial penalties for misreporting taxable income.
If a free zone business is found to be intentionally avoiding corporate tax, it could face even more severe consequences, including legal action or restrictions on future business activities.
Free zone businesses that want to retain their 0% corporate tax benefits while remaining compliant with UAE tax laws must implement effective tax planning strategies.
A well-structured approach ensures that companies can minimize tax liabilities, optimize financial efficiency, and protect their tax-exempt status.
One of the most effective ways to maintain free zone tax benefits is by ensuring that income from qualifying and non-qualifying activities is clearly separated.
Businesses that engage in both tax-exempt and taxable activities must structure their financial records in a way that ensures only eligible income benefits from the 0% corporate tax rate.
Companies should establish clear accounting procedures, ensuring that taxable and non-taxable revenue is documented separately.
If the FTA finds that a business has blended taxable and non-taxable income, it may revoke its tax exemption entirely, making the company liable for the 9% corporate tax on all profits.
Many free zone companies operate as part of a larger corporate structure, with subsidiaries or related entities conducting business across multiple jurisdictions.
Properly structuring a holding company can help businesses optimize their tax position, manage profits efficiently, and ensure compliance with UAE tax laws.
A well-planned corporate structure can allow businesses to legally manage intercompany transactions, retain free zone tax advantages, and align with international tax treaties.
However, businesses must ensure that their corporate structures are transparent and do not engage in artificial profit shifting, which could trigger FTA audits and transfer pricing scrutiny.
As the UAE’s tax landscape continues to evolve, free zone companies must continuously reassess their business models to ensure they remain compliant.
Businesses that rely heavily on mainland transactions may find that their current free zone structure is no longer the most tax-efficient option.
Some companies may benefit from restructuring their operations, adjusting revenue models, or establishing a separate mainland entity for taxable income while keeping their free zone business focused on tax-exempt activities.
Working with experienced tax advisors can help businesses determine the most effective structure to maximize tax efficiency while remaining within the law.
The UAE corporate tax system is still evolving, and free zone companies must stay informed about potential regulatory changes that could impact their tax status.
While the 0% corporate tax rate remains a strong incentive for businesses to operate in free zones, the government continues to refine tax policies to align with international tax standards and economic goals.
As the UAE strengthens its corporate tax framework, additional conditions or restrictions may be introduced for free zone companies to qualify for tax exemptions.
The Federal Tax Authority (FTA) may tighten compliance rules, adjust qualifying income categories, or introduce new reporting requirements to ensure businesses are operating transparently and contributing to the economy.
Companies that rely heavily on free zone tax incentives must prepare for the possibility that tax benefits could be modified or phased out for certain industries.
Businesses should monitor FTA announcements, industry updates, and economic trends to adapt their tax strategies accordingly.
The UAE has committed to international tax cooperation, including the OECD’s global minimum tax framework, which aims to ensure that large multinational corporations pay at least 15% tax on profits.
While this currently applies to large global businesses, there is growing speculation about how such reforms may influence free zone tax policies in the future.
Free zone companies that operate as part of multinational groups or engage in cross-border transactions should evaluate how international tax agreements might affect their UAE corporate tax obligations.
Businesses that proactively assess global tax risks, maintain transparent financial records, and align with evolving tax regulations will be better prepared for any future tax changes.
Free zone companies that focus on compliance, structured tax planning, and transparent financial reporting will be in the strongest position to retain tax benefits and adapt to regulatory changes.
Rather than waiting for new tax laws to be enforced, businesses should take a proactive approach by regularly reviewing their tax status, seeking expert advice, and ensuring full alignment with UAE tax laws.
A well-prepared business will not only avoid penalties and tax disputes but also gain a competitive edge in the market, ensuring sustainable growth while maximizing tax efficiency.
The UAE remains one of the most business-friendly tax environments in the world, and free zone companies can still enjoy the 0% corporate tax rate, provided they meet the necessary conditions.
However, tax exemptions are no longer automatic, and businesses must ensure they are structuring their operations correctly, maintaining compliance with FTA regulations, and staying informed about potential policy changes.
Companies that fail to segregate taxable and non-taxable income, comply with transfer pricing rules, or meet economic substance requirements risk losing their tax-free status and being subject to the 9% corporate tax rate.
By implementing smart tax planning strategies, keeping financial records transparent, and continuously adapting to regulatory updates, free zone businesses can legally optimize their tax position while avoiding financial penalties.
For businesses looking to protect their tax benefits, ensure compliance, and develop a sustainable tax strategy, expert guidance is essential.
Protax Advisors specializes in corporate tax planning, free zone compliance, and FTA regulatory advisory, ensuring that businesses stay ahead of tax risks and maintain the most efficient tax structures possible.
Schedule a consultation call and learn how our expertise in accounting and tax services can benefit your business.