Economic Substance Regulations
UAE has always been at the forefront of implementing a business friendly environment and ensuring necessary legal and regulatory framework in alignment to international economic regulations. To fulfill its commitment as a member of OECD Inclusive Framework on BEPS, the intent of Economic Substance Regulations is to protect the reputation of offshore jurisdictions and those companies, that operate from such jurisdictions, by ensuring that the revenue streams from certain activities are real and based on local business activities to substantiate the use of low tax jurisdiction.
On 10 August 2020, the UAE Cabinet of Ministers issued Cabinet Resolution No. 57 (2020) which supersedes Cabinet Resolution No. 31 (2019). This elaborate guidance provides clear directions to the Licensees operating in the UAE and guide them about regulations relevant for their businesses carrying out one or more relevant activities. The initial regulations were more generic and covered “a natural or juridical person licensed by the competent licensing authority to carry out a ‘Relevant Activity’ in the State, including a Free Zone and a Financial Free Zone”. Key amendments in the ESR now covers juridical persons or unincorporated partnerships, while ‘natural persons’ possibly including sole proprietors, trusts and foundations are now excluded from filing notification as well as meeting the Economic Substance test. Exemptions include the following (subject to filing of notification and documentary evidence):
- Entities that are tax resident outside the UAE
- Investment Funds,
- Entities wholly owned by UAE residents and are not part of an MNC group and only have business in the UAE
- UAE branches of foreign parent whose income is subject to tax in the home country
It is pertinent to note that earlier exemption for entities directly/indirectly owned at least 51% by the UAE Government stands withdrawn under the new regulations unless they fall under the above mentioned newly introduced regulations. However, any entity which claims to be an Exempted Licensee must submit to the relevant Regulatory Authority, along with a Notification, sufficient evidence substantiating its status as an Exempted Licensee for each Financial Year. The UAE Federal Tax Authority is now responsible for assessing and enforcing compliance with the Economic Substance test.
Branches registered in UAE are regarded to be an extension of their parent/head office and hence not considered to have separate legal personality, therefore not considered as Licensees. A branch of a foreign entity registered in the UAE that carries out a Relevant Activity, is required to comply with the Amended ESR unless the Relevant Income of such branch is subject to tax in a jurisdiction outside the UAE. Once it is clearly established that a business is carrying out a relevant activity and has income, the business is required to satisfy the substance tests and submit a Report to the Authority.
The ESR Regulations provide the following broad parameters around which the substance needs to be demonstrated:
- The core income generating activity (“CIGA”) is performed in the UAE
- The management and direction of the Company is from within the UAE
- There are sufficient employees and expenses (both operating and capital) incurred for running the business
The Regulations refer to the term ‘adequate’ at various places in the Law, however, as this term is not unambiguously defined, therefore has its ordinary meaning “enough or satisfactory for a particular purpose” is considered. Every Licensee and Exempted Licensee is required to submit a notification to their respective Regulatory Authorities setting out the following, for each relevant Financial Year:
- The nature of “Relevant Activity” being carried out
- Whether it generates Relevant Income
- The date of end of its Financial Year
- Any other information as may be requested by Regulatory Authority
All the Licensee and Exempted Licensee needs to Electronically Submit the ES Notification within Six Months from the end of Financial Year. Also, the Licensee who has filed ES Notification to their respective authority, needs to re-submit the same electronically on the MOF Portal once live. Other changes in the regulation include a change in definition of Distribution and Service Center Business. The Penalties for non-compliance have been revised upwards ranging from AED 20,000 to AED 400,000 which was earlier limited to AED 300,000 maximum.
With the new amendments, it is of paramount importance that businesses re-evaluate their initial position taken and their earlier submissions in June 2020, and take corrective measures. The Entity assessment should include sufficient consideration of the Local federal laws, Tax laws, transfer pricing and other international laws, DTAA Agreements, Internal Controls and its implementation, SOPs, internal policies, and its practice. Licensee needs to resubmit the ES Notification, thus availing the opportunity to rectify the errors, if any, made in the old Notification. Companies should now give sufficient importance to documentation kept by the entity. Evidence needs to be submitted to prove the exemption which may include Tax details, return filed, etc.
UAE acknowledges that businesses vary in size and nature, and what is adequate and appropriate as part of ESR reporting, will actually depend on the nature and level of activities carried out, and the level of income earned by a company. The Regulatory Authorities are expected to take a pragmatic approach when assessing whether a Company has met the Economic Substance Test. However, the revised provisions in new Economic Substance Regulations have substantially reduced the scope of errors in interpretation.
Quantum Auditing offers support to the business community in the UAE in ensuring compliance with Economic Substance Regulations. We are well placed to assess the impact of the Rules on your organisation and assist you to complete and submit the required ESR Notification and Annual Return.