In order to align the entire region with global standards in the prevention of base erosion and profit/income shifting (BEPS), the UAE government introduced the Economic Substance Regulation (ESR). Economic Substance Regulations (ESR) have been enacted by the UAE and apply in all jurisdictions of the UAE, including financial free zones such as the DIFC.
What is Economic Substance Regulation?
In countries with low or no corporate taxes, ESRs have been introduced in order to comply with international initiatives to combat harmful tax practices, including illegal avoidance or evasion. In accordance with the Economic Substance Test, the ESR requires certain legal entities to demonstrate that they are carrying out substantial economic activities in these jurisdictions.
Applicability of the ESR
The ESR section applies to all-natural and legal persons engaged in relevant activities (RA) in the UAE, including the Free Zone and the Free Financial Zone. It is interpreted that offshore companies are included in the Free Zone companies, following the purpose behind the implementation of the ESR and implementing the legislation in its essence. The ESR shall not be subject to companies in which the Federal Government or the Government of any Emirate of the UAE, or any governmental authority or body of any of them, has at least 51% direct or indirect ownership of their shares.
UAE Economic Substance Regulations will apply to onshore and free zone companies engaging in any of the relevant activities listed below:
- Banking Businesses as licensed in the State, including Banking Businesses licensed in a Free Zone or a Financial Free Zone.
- Insurance Businesses as licensed in the State, including Insurance Businesses licensed in a Free Zone or a Financial Free Zone.
- Investment Fund Management Businesses as licensed in the State, including Investment Fund Management Businesses licensed in a Free Zone or a Financial Free Zone.
- Lease-Finance Businesses as licensed in the State, including Lease-Finance Businesses licensed in a Free Zone or a Financial Free Zone.
- Headquarters Businesses as licensed in the State, including Headquarters Businesses licensed in a Free Zone or a Financial Free Zone.
- Shipping Businesses as licensed in the State, including Shipping Businesses licensed in a Free Zone or a Financial Free Zone.
- Holding Company Businesses as licensed in the State, including Holding Businesses licensed in a Free Zone or a Financial Free Zone.
- Intellectual Property Businesses as licensed in the State, including Intellectual Property Businesses licensed in a Free Zone or a Financial Free Zone.
- Distribution and Service Centers Businesses as licensed in the State, including Distribution and Service Centres Businesses licensed in a Free Zone or a Free Zone.
The Economic Substance Regulations (ESR) of the UAE listed a number of institutions that are excluded from the requirements to file an ESR report and to comply with the Economic Substance Test, even though they remain subject to a notification duty. A number of exempted licensees are shown below:
- UAE companies that are tax resident outside of the UAE;
- Investment Funds and their underlying SPVs/investment holding entities;
- A Licensee wholly owned by UAE residents that is not part of a multinational group and that only carries out activities in the UAE;
- UAE branches of a foreign company if the Relevant Income of the branch is subject to tax in the foreign jurisdiction.
In order to assert an exception on each of the grounds alluded to above, the licensee must submit a notification and offer adequate photographic documentation to establish that it complies with the provisions of the application form of exemption in any of the financial years in which it seeks to be excluded. UAE firms that are majority-owned by the UAE government (51% or more) are no longer excluded from the UAE ESR.
Notification and Reporting
All UAE authorized undertakings, including partnerships, free zone undertakings, and subsidiaries, shall provide notice to the competent authorities about the following issues:
- Date and end of the company’s financial year
- Whether or not a part or all of the business’s gross income related to any Relevant Activity has been subjected to taxation in any jurisdiction outside the UAE
- Whether or not the business carries any Relevant Activity
In addition to the notification provision, an undertaking that derives revenue annually from a relevant activity in the UAE must demonstrate that it has an adequate degree of economic substance to permit it to carry out a relevant activity. Both eligible licensees shall prepare and send a report to the competent Regulatory Authorities containing the following material, as set out below:
- Type of the Relevant Activity that the business conducts.
- Type and amount of relevant income with respect to every Relevant Activity.
- Place or location of the business.
- Type and amount of operating expense with respect to every Relevant Activity.
- The number of employees working full time.
- Details regarding the Core Income/Profit Generating Activities (CIGAs) conducted by the business.
- Detailed information regarding the activities that are outsourced by the business.
- Declaration of whether or not a business licensed in UAE satisfies the UAE Economic Substance Test.
What is the Economic Substance Test?
All licensees carrying out and deriving revenue from a particular operation within the financial year are expected to ensure that, for each relevant activity, they satisfy the content and reporting criteria set out in the ESR. In order for the licensee to show that its operations in the UAE are reasonably substantive, it must comply with the following requirements:
- Directed and Managed Test
The regulations contain specific requirements on how a company has to be directed and managed in the UAE.
- Core Income Generating Activities’ Test
The company has to establish these activities that are undertaken in the jurisdiction and in relation to the level of income derived from the relevant activity.
- Adequate Test
Have an adequate number of qualified full-time employees in the UAE; incur an adequate amount of operating expenditure in the UAE; and hold adequate physical assets here.
Penalty for Non-Compliance
In case that the corporate company has not obtained any revenue from the above-related operations in the financial year, it is not necessary to submit a statement of economic substance. If the business enterprise follows the specifications stated but fails to comply with the legislation, then a liability varying from AED 10,000-50,000 would have to be charged. If the regulatory authority finds that an individual consistently fails to comply with the Economic Content Examination, a liability of AED 50,000-300,000 can be levied. The authority can even cancel, withdraw or refuse the company’s license renewal.
How Riz and Mona Consultancy Can Help You?
Our skilled professionals, at Riz and Mona Consultancy, will help you decide whether you are within the rules and advise you as to what steps are required to ensure maximum compliance. We are here to help you build the ESR notification before the final report is generated. For any advice relevant to Economic Substance Regulations, contact us.