UAE Free Zone Tax Regime: economic substance tested in tax audits and impact geopolitical developments

Background

The UAE has introduced Corporate Tax at a standard rate of 9% as from June 2023. Companies established in one of the UAE’s Free Zones may, however, benefit from a 0% tax rate, provided that several conditions are met.

 

Free Zone Tax Regime

The Free Zone Tax Regime offers a significant tax incentive to businesses established in a Qualifying Free Zone, to the extent that they perform Qualifying Activities. While the list of Qualifying Activities is broad, it is not exhaustive, and Free Zone companies should closely review all the activities they perform to determine whether the 0% rate can be claimed.

Further conditions apply, including that a Free Zone company must transact on an arm’s-length basis, and it must not exceed the threshold for non-Qualifying Income (the de minimis requirement). Finally, and increasingly the focus of the Federal Tax Authority (FTA), the company must maintain sufficient economic substance in the Free Zone for the activities it performs.

 

Economic substance and increased enforcement review

The economic substance requirement obliges a Qualifying Free Zone Person to carry out its core income-generating activities within a Free Zone, and to maintain substance there that is commensurate with the level of those activities. In assessing this, factors such as adequate office space, number of qualified employees, operational expenditure, and the location of key management and decision-making functions are all relevant. The required level of substance is not uniform: a holding company carrying out passive activities may legitimately operate with relatively limited substance, whereas a company performing active trading, manufacturing or distribution functions will be expected to demonstrate considerably more.

Although the concept is not new to the market – formal Economic Substance Regulations were introduced in 2019 – its role within the Corporate Tax framework warrants fresh and careful consideration, because the consequences now directly affect a Free Zone company’s tax position. Economic substance has recently become an area of focus for the FTA in its review of Corporate Tax returns filed for Tax Year 2024, where the audit questions specifically address whether Free Zone companies genuinely have economic substance, within the Free Zone, aligned with their 0% taxable activities. This issue has come up in tax audits (for 2024) of several businesses that we support.

Free Zone companies should therefore anticipate an increased level of scrutiny from the FTA and they should be ready to appropriately demonstrate that their economic and operational footprint matches the Qualifying Activities they perform in the Free Zone.

 

Distribution Activities and the Strait of Hormuz Closure:

A more immediate challenge has emerged for Free Zone companies carrying out Qualifying Distribution Activities under the Free Zone Tax Regime. To qualify, goods destined for the UAE mainland must be distributed from, or through, a Designated Zone.

In practice, many businesses in the sector rely on the Jebel Ali Free Zone, which has historically served as the region’s primary maritime gateway. If this condition is not met, distribution income relating to mainland-bound goods may not qualify. As a result, access to the Free Zone Tax Regime’s 0% rate may be at risk.

The prolonged disruption of the Strait of Hormuz in recent months has put this requirement under pressure. With transit through the waterway affected, businesses have had to reroute shipments and seek alternatives. This, in turn, creates tension with the “de minimis threshold”. Temporary routing changes may increase non-Qualifying Income, potentially exceeding the permitted threshold during the tax year.

Based on our recent client work, this is already a live issue for many trading and distribution businesses. Companies should closely reassess the conditions for Qualifying Distribution Activities. In particular, they should evaluate how alternative shipping routes may affect their Qualifying Free Zone Company status.

 

Conclusion / Key takeaway

Increased audit activity around economic substance, combined with external disruptions affecting distribution models, means that businesses benefiting from the Free Zone Tax Regime must continuously ensure alignment between their activities, structure, and operations—and be able to evidence this clearly.