Although most countries globally have full-fledged tax authorities, tax profiles, and tax treaties, millions of dollars of annual tax revenues continue to leak through loopholes, or what could be described as ‘creative’ tax planning.
The Organization for Economic Co-operation and Development (OECD) took joint action with G20 countries to develop “15 Action Points” to tackle tax avoidance caused by Base Erosion and Profit Shifting.
Being a member of the OECD Inclusive Framework, and in response to the European Union Code of Conduct Group on Business Taxation’s assessment of its tax framework, the UAE introduced its own Regulations on Economic Substance Requirements (ESR) in 2019.
Economic Substance Regulations, or ESR: What is it?
According to the UAE’s Ministry of Economy, the UAE applies Economic Substance Regulations (ESR) to companies located in the country, including businesses in free zones and those engaged in any of the defined ‘relevant activities.’
Regulations require these companies to maintain and demonstrate an adequate "economic presence" in the UAE relative to the activities they undertake.
In simple terms, if an entity wanted to declare their revenue in a country, they need to demonstrate sufficient “substance,” i.e. business actions that fit ESR’s relevant activities, taking place in the country.
Entities can no longer book any revenue in any jurisdiction for tax benefits, when there is no real activity taking place in that jurisdiction.
To rightfully book revenues and demonstrate substance, a company should have the infrastructure, required, corresponding number of employees, incur an appropriate amount of expenses, and generate the bulk of its income from its Core Income Generating Activity, all in the right jurisdiction.
The Economic Substance Regulation is not restricted to entities that belong to a foreign multinational group. The regulations impose economic substance on any UAE entity that carries out the relevant activity.
There are also no specific exemptions for offshore companies, and ESR is applicable to any offshore company undertaking a relevant activity.
The assessment and determination on whether a Licensee has economic substance in the UAE is made by the Federal Tax Authority, in its capacity as the “National Assessing Authority" under the Regulations.
So, which business activities fall under ESR regulations in the UAE?
Relevant activities listed in the economic substance regulations include:
Let’s look at a few examples: UAE entity ‘X’ is considered engaged in a Holding Company Business, which is a relevant activity under ESR if X holds equity interest and earns dividend and capital gains from its equity interest.
UAE entity ‘Y’ is considered engaged in a Distribution Business which is a relevant activity, if it purchases goods from a Foreign Connected Person and distributes those goods inside or outside the UAE.
Hence, to determine whether your business falls under the scope of an ESR, it is crucial to properly understand and interpret the definition of the relevant activity described by the law.
What does it mean to be subject to these regulations?
Additionally, businesses earning income from Relevant Activities are also required to file an Economic Substance Report within 12 months from the end of the relevant financial period.
Timing overview for ESR filings
How is an entity required to demonstrate substance?
For each financial period in which a Licensee earns income from a Relevant Activity, it will need to meet an Economic Substance Test in relation to that activity. You can view a full directory of documents that can provide you with further information here.
In general, the Economic Substance requirements will be met:
- If Core Income Generating Activities (“CIGA”) are conducted in the UAE;
- If the activities are directed and managed in the UAE;
- If there is an adequate level of qualified full-time employees in the UAE,
- If there is an adequate amount of operating expenditure in the UAE,
- If there are adequate physical assets in the UAE.
Key points to note:
1. SUBSTANCE OVER FORM: Activities listed on the commercial license do not determine whether a licensee in fact undertakes a relevant activity. A “substance over form” approach is to be used. This, in simple terms, necessitates the business to look beyond what is stated in the trade/ commercial license.
2. ESR ASSESSMENT: The assessment to determine if your entity undertakes a Relevant Activity is not a one-time process: it has to be done for each financial period. It is imperative to note that the assessment should consider the activities undertaken by the Licensee at any time throughout the relevant financial period.
3. EXEMPTIONS: The regulation has exempted certain categories of entities from filing ESR Reports. However, sufficient evidence must be submitted along with the Notification form to claim the exemptions.
- A Licensee that is a tax resident outside the UAE;
- An investment fund and its underlying SPVs/investment holding entities;
- A wholly UAE resident-owned business that is not part of a multinational group and that only engages in business in the UAE;
- A branch of a foreign entity that is subject to tax on all of its Relevant Income in a foreign jurisdiction.
4. FILING OBLIGATIONS: The ESR Notification filing obligation is irrespective of whether a business earned income from that Relevant Activity or not. That is, if the business conducts a relevant activity, a notification must be filed.
5. PENALTIES: The regulation has defined penalties for failure to submit a notification, failure to submit an economic substance report, and failure to provide accurate or complete information. There is also a separate penalty in case of failure to demonstrate sufficient economic substance.
Final word of advice
Businesses are responsible for self-assessing whether they undertake a Relevant Activity and ensuring they have a filing requirement under the Economic Substance Regulations. Hence, all businesses should examine their business activities and assess whether they are subject to UAE Economic Substance Regulations (ESR) based on available Regulations and Guidance. Those subject to the Regulations should start initiating steps to ensure compliance with them.