ESR and the Adequacy conundrum

Deepak AgarwalDeepak Agarwal    25 August 2020
ESR and the Adequacy conundrum

The UAE introduced Economic Substance Regulations (“the Regulations”) to honour its commitment as a member of the OECD Inclusive Framework on BEPS, and in response to a review of the UAE tax framework by the EU which resulted in the UAE being included on the EU list of non-cooperative jurisdictions for tax purposes (“EU Blacklist”). The issuance of the Regulations on 30 April 2019, and the subsequent release of the Guidance on the application of the Regulations on 11 September 2019, was a requirement for the removal of the UAE from the EU Blacklist on 10 October 2019. Thus, the intent of Economic Substance Regulation (“ESR”) is to protect the reputation of offshore jurisdictions and those companies that operate from such jurisdictions by ensuring that revenue streams from certain activities are based on actual local activity to substantiate the use of low tax jurisdictions.

In the UAE, the Regulations apply to all businesses that undertake ‘Relevant Activities’ and which have income from such activities in any accounting period commending on or after 1 January 2019. The importance of compliance with the new substance regulations cannot be understated given the potential liability for penalties and cancellation of trade licenses.

The gorilla in the room – measuring substance:

Once it 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 Regulations do not provide an exhaustive list of tests that one can review and confirm compliance to the Authority. These tests would be driven by the nature of activity, the complexities of business and the scale of operations. Presently, the 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; and
  • There are sufficient employees and expenses (both operating and capital) incurred for running the business.

The evaluation of these substance tests is where the word ‘adequate’ repeatedly appears and brings ambiguity. The following are examples where the word ‘adequate’ could make an appearance:

  • The Board of Directors meet in the UAE at an adequate frequency given the level of decision making required. Quorum will be determined in accordance with Companies Law and the Company’s Articles. 
  • The board minutes adequately reflect the strategic decisions.
  • The Board of Directors have the necessary and adequate knowledge and expertise to discharge their duties as a board.
  • There are an adequate number of qualified employees to be able to conduct the relevant activity (not just the core income generating activities) during the accounting period. The qualifications that are adequate will depend on the relevant sector that the Company has activity in, and the duties performed by those employees. The qualifications could include academic qualifications, vocational qualifications, relevant industry technical qualifications and qualification by relevant experience.
  • There is adequate operating expenditure incurred by the Company in the UAE.
  • There are adequate physical assets in the UAE.
  • If core income generating activities are outsourced, the Company is able to demonstrate that it has adequate supervision and control of the outsourced activities.
  • In case of outsourcing of any core income generating activity: whether the activities, employees, expenditure, and premises are in the UAE; and whether these are adequate for carrying out the Relevant Activity being outsourced.
  • The Company maintains adequate and proper books and records, including accounting records that meet international financial reporting standards or generally accepted accounting principles, and keeps all books and records in the UAE.
  • The Company has in place an adequate set of internal policies and controls with respect to its operations, compliance, corporate governance, and risk management and these policies are reviewed regularly to ensure they remain appropriate and relevant.

The Regulations refers to the term ‘adequate’ at various places in the Law.  However, this term is not defined, therefore has its ordinary meaning. The dictionary definition of adequate is “enough or satisfactory for a particular purpose”.

The UAE acknowledges that businesses vary in size and nature, and what is adequate and appropriate will depend on the nature and level of activities carried out, and the level of income earned by a Company. As mentioned earlier, the Regulations and Guidance therefore do not provide a ‘minimum’ standard for what is considered ‘adequate’ or ‘appropriate’. The Regulatory Authorities are expected to take a pragmatic approach when assessing whether a Company has met the Economic Substance Test. It is believed that the Regulatory Authorities would also be cognizant of the fact that the type and level of activity of a Company may fluctuate during the course of a financial period and from year to year. Further, the Guidance indicates that the Regulation is not intended to impose requirements that businesses engage more employees or incur more expenditures than what is needed. Nevertheless, given the vagueness of these terms, it is recommended that Companies maintain sufficient records of resources used and expenditures incurred inside the UAE to ensure that they can demonstrate ‘adequacy’ and ‘appropriateness’.

Thus, meeting the adequacy test would be a challenge and may not be “adequate”. Amongst others, below are indicative areas that a Company may use to demonstrate economic substance in the UAE:

  • Historical trends around revenues, number of employees, assets, operating expenses, etc.
  • Documents/information submitted to other Regulatory Authorities.
  • Company gross profit margins relating to industry trends in normal circumstances.
  • Comparison of similar business operations outside the UAE.
  • Dealings are at arm's length, which demonstrates allocation of risks proportionate to the control.

The views expressed above are personal.

 

Disclaimer: Content posted is for informational & knowledge sharing purposes only and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/ interpretation of the publisher is based on the available Law, guidelines, and information. Each reader should take due professional care before you act after reading the contents of that article/ post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide and should not be relied on for tax or accounting advice.

You can access Law including Guidelines, Cabinet & FTA Decisions, Public Clarifications, Forms, Business Bulletins for all taxes (Vat, Excise, Customs, Corporate Tax, Transfer Pricing) for all GCC Countries in the Law Section of GCC FinTax. 

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