Economic Substance Regulation (ESR) was introduced by the UAE government in order to align the entire region with global standards in the prevention of Base Erosion and Profit/Income Shifting (BEPS). The UAE has enacted Economic Substance Regulations (ESR) that applies in all UAE jurisdictions, including financial free zones such as the DIFC.
What is the Economic Substance Regulation?
ESR has been introduced in countries with low or no corporate taxes, in order to comply with international initiatives to combat harmful tax practices including unlawful avoidance or evasion. ESR requires certain legal entities to demonstrate that they carry out substantial economic activities in these jurisdictions, in accordance with the Economic Substance Test.
Applicability of the ESR
The ESR is applicable to all-natural and juridical persons carrying out Relevant Activities (RA) in the UAE including Free Zone and Financial Free Zone. Following the intention behind introducing the ESR and following the law in its spirit, it is interpreted that Offshore companies are included in the Free Zone companies. 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 in its shareholding are not subject to the ESR.
Economic substance regulations UAE will be applicable to onshore and free zone companies that engage in any of the below mentioned Relevant Activities;
- 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 UAE Economic Substance Regulations (ESR) provide for a list of entities that are exempt from the requirements to file an ESR Report and meet the Economic Substance Test, albeit they remain under an obligation to submit a notification. The following is a list of Exempted Licensees:
- 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.
To claim an exemption under any of the aforementioned grounds, the Licensee must file a Notification and provide sufficient documentary evidence to show that it meets the requirements of the relevant exemption category in each Financial Year in which it claims to be exempt. UAE companies that are the majority (51% or more) owned by the UAE government are no longer exempt from the UAE ESR.
Notification and Reporting
All businesses that are UAE licensees, including partnerships, free zone companies, and branches, have to provide competent authorities notification regarding matters listed below:
- Date and end of the company’s financial year
- Whether or not a part or all of the business’ 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
Apart from the notification requirement, a business that derives income from a Relevant Activity in UAE every year has to demonstrate that it has a sufficient level of economic substance that allows it in carrying out a Relevant Activity. All qualified licensees have to prepare a report and submit it to relevant Regulating Authorities which include the following information listed 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 income from a Relevant Activity during the Financial Year are required to endure that they meet the substance and reporting requirements set out under the ESR for each Relevant Activity. In order for a licensee to demonstrate that its activities in the UAE have adequate substance, it must meet the following:
- 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 the business entity has not earned any income from the mentioned relevant activities in the financial period, it does not have to file for any economic substance declaration. If the business entity meets the specified requirements but fails to comply with the regulations, then they will have to pay a penalty ranging from AED 10,000-50,000. If the regulatory authority determines that an entity is not meeting the Economic Substance Test repeatedly, a penalty between AED 50,000-300,000 may be imposed. The authority may also suspend, revoke, or deny the renewal of the company’s license.
How Riz and Mona Consultancy Can Help You?
Our experienced team will assist you to determine whether you are within the rules and guide you as to what actions are required to ensure full compliance. We are here to help you with creating ESR Notification until generating the final report. Contact us for any guidance related to Economic Substance Regulation