The United Arab Emirates ('UAE') introduced Economic Substance ('ES') Regulations ('ESR') with effect from 1 January 2019. The ESR is a milestone for the UAE's tax policy and an important step towards its alignment with initiatives set out in the Organization for Economic Co-operation and Development's ('OECD') Base Erosion and Profit Shifting ('BEPS') Action Plan.
The ESR is applicable to broadly all UAE onshore and free zone legal entities that conduct one or more relevant activity ('RA') during a financial period ('Licensees'). Licensees, irrespective of whether exempt or income was earned from the RA during a financial period, are required to file a notification within six months from the end of the relevant financial period. Licensees that earned income from a RA during the financial period and that are not exempt from the ESR are also required to file a detailed ES report within twelve months from the end of the relevant financial period demonstrating ES in the UAE.
With many Licensees having now filed notifications and reports for the first applicable period on the Ministry of Finance's ('MoF') filing portal, we look at some of the difficulties experienced by entities when assessing the applicability of certain RAs and during the preparation of ES reports.
RAs and associated complexities
In this section, we discuss certain technical points commonly encountered by businesses assessing whether or not their activities may fall within scope of the Holding Company Business and Service Centre Business RAs.
Holding Company Business
The ESR provide a narrow definition of a Holding Company Businesses ('HCBs'). HCBs are businesses whose sole function is to acquire and hold shares or equitable interests in other companies and only earn dividends and/or capital gains. As such and in theory, it should be fairly straight forward to identify whether or not a business is conducting an HCB during a particular period.
However, in practice it is common for holding companies to also hold other assets, such as bonds, various types of debt investments, fixed deposits, etc. In such instances, the RA qualification becomes more complex. For example, should a company holding equity investments as well as fixed deposits be considered as falling outside the definition of an HCB? Based on a strict reading of the law and in the absence of further guidance, the answer is potentially 'yes' , however this may create a scenario which motivates potential HCBs to acquire non-equity assets in order to move outside the scope of a HCB and as a result, the scope of ESR if not conducting another RA.
For the moment, the ESR guidance issued by the UAE only clarifies that the holding of real estate assets that are solely used for purposes of its HCB will not prevent such an entity from being considered as carrying on a HCB. It is unclear whether the UAE will issue any clarifications on implications of holding other assets in the context of falling in scope of the HCB RA. It is noted, based on a review of guidance issued in certain other jurisdictions which have recently introduced similar ES rules, that a company will still be regarded as conducting a HCB and subject to ES requirements in situations where it is placing dividend monies received on deposit or using them to acquire and passively hold other securities.
As such and in relation to the position for UAE entities, a reasonable approach may be to consider and verify the length of time for which the non-equity instruments were held, and perhaps to also consider the ratio between equity and non-equity investments. The higher the proportion of the non-equity investments, the stronger the case for a holding company to argue it should not fall within the definition of an HCB.
Service Centre Business
In contrast to the HCB, the definition of a Service Centre Business ('SCB') is very broad and in principle, encompasses all entities engaged in the provision of services to their Foreign Connected Person(s) ('FCP'). As there is no clear definition of the nature of services falling under the definition of SCB, technically, the provision of any type of services to FCPs qualifies an entity as falling under the SCB definition.
The ESR guidance only specifies that transactions that are outside the normal course of business (i.e.,one-off transactions) and re-charged at cost or less should not be considered for the RA of SCB. Other than this, no additional guidance has been provided on what should be considered as 'outside the normal course of business' , and which 'costs' should be taken into consideration.
For example, if a trading company partially allocates or recharges its marketing team's costs to an FCP (whether fully or partially), should that be considered as 'outside the normal course' of its trading business? Whilst marketing is not regarded as the core activity of a trading company, it is nonetheless critical to the success of the business, and hence in the 'normal course' of business. The UAE guidance provides 'one-off transactions' as an example of transactions outside the normal course of business, which is a very narrow criterion. ES guidance issued in similar jurisdictions make reference to 'occasional transactions' - a phrase which allows for relatively greater flexibility. In this scenario, one could take the reasonable view that the trading company should likely qualify as an SCB even if its marketing team's activities do not form part of its main business activities, provided that the marketing costs are recharged on a recurring basis.
Moreover, the UAE ESR do not clarify the 'costs' that should be taken into consideration in order to determine whether a Licensee's services to its FCP have been rendered at cost or less. For instance, should the Licensee rely only on actual salary costs, or can apportioned overheads be considered for this purpose as well? It is a reasonable view to consider that overheads should be considered so long as the basis of their allocation is proportionate to the service and can be justified.
It is not uncommon for UAE-based companies to have smaller-value transactions with their foreign related parties that qualify as FCPs. Owing to the broad definition of SCB, a very large number of companies would therefore be covered by the ESR compliance requirements, even if their main business does not consist of providing such services to FCPs. This begs the question: was this the intention of the ESR? The wide net that the broad definition of SCB casts at present appears to be excessive. Perhaps it would have been helpful if there were a wider exclusion criterion in the form of a transaction value threshold. This could provide relief to certain businesses from compliance requirements, akin to safe harbor rules/thresholds under the TP legislation in some countries.
Another contentious area under the ESR is the treatment of branches that operate as cost-centers or perform marketing activities on behalf of their parent entity or head office. Such entities, in substance, provide services to their parent entity or head office that would qualify under the definition of an SCB. These entities are typically eligible to apply for branch exemptions. Providing satisfactory evidence in order to claim the exemption, however, might be challenging as they would need to evidence that the branch operations are part of the consolidated accounts which form part of the parent entity or head office's tax returns.
The ES Test
Licensees carrying out an RA need to demonstrate a sufficient level of substance in relation to their RA in the UAE. This can be demonstrated once the Licensee satisfies the following tests:
Directed and Managed test
We have seen several UAE Licensees struggling to meet the Directed and Managed test. This test requires Licensees to physically hold board meetings in the UAE, with the quorum of directors physically present in the UAE when taking strategic decisions in respect of the RA carried out by the Licensee.
We have observed that some companies did not hold physical board meetings in the UAE. Instead, the minutes of the meetings were often circulated as written resolutions, or the board meetings were held in the form of conference calls, where directors had the option to dial-in while situated outside the UAE. Additionally, the company laws of certain UAE free zones generally do not prescribe mandatory board meetings in the UAE as a result of which the practice of having physical board meetings in the UAE has not been followed.
While for FY20 exceptions have been granted on account of travel restrictions associated with the Covid-19 pandemic, going forward, the ESR is likely to prompt many companies to review their existing governance approach in order to ensure they are compliant.
Interestingly, we note that the UAE ESR provides a special provision (Article 6(4)), which states that for Licensees managed by a shareholder, a partner, or by one or more managers, the requirements related to the board meetings shall apply to any such persons as if they were directors. Prima facie, this provision may serve as a rescue for several companies, however, its full scope and intent of application remains somewhat unclear. For instance, where a company has three directors, two of whom are non-UAE residents and are not involved in the direction and management of the company, would it be possible for it to rely on Art.6 Para.4 by stating that the directed and managed function is performed by its UAE resident director only? Whilst this approach may be possible for FY19, it is recommended that Licensees abide by the standard requirement of physical board meetings in the UAE.
Additionally, we observed that companies faced issues in preparing their ES Reportsgiven that the fields ' umber of board meetings held during the Reportable Period' and 'Number of board meetings held in the UAE during the Reportable Period' only allowed numeric entries. What number should be indicated by a Licensee that did not have board meetings in the UAE, but was managed by a manager (e.g. a branch manager) who was physically present in the UAE? In such scenarios, it should be considered whether there have been management meetings which can be included in this field.
In any case, it is prudent to provide additional clarification in the declaration section of the ES report; setting out the facts, making reference to Art.6 Para.4,stating that the directed & managed function is assumed by the manager on behalf of the Licensee, and that the questions regarding the directed and managed test have been responded to accordingly. On this basis any red-flags are sufficiently explained.
As the ESR only provides indicative examples, CIGA should be assessed on a case-by-case basis. What is clear is that the CIGA must be performed within the UAE.
This creates issues in situations where some of the CIGA are carried out overseas. Take for instance a UAE based company that has a shared service center ('SSC') which is a related party in another jurisdiction.The SSC provides business development activities, primarily by facilitating UAE based customers in establishing business relationships. The SSC is remunerated at arm's length. Should these activities be considered as CIGA? There could be valid arguments to conclude that such business development activities are critical to generate income and, therefore, qualify as CIGA. Based on a strict reading of the law, such activities would have to be performed from the UAE. This is undoubtedly a strange outcome, given that the arrangement as such is in line with the core of BEPS. Here, the UAE ESR seem to go beyond the core of BEPS and effectively limit the way businesses prefer to structure their operations.
One of the areas where there is still a lack of guidance is pure equity holding companies and what they would need to do to satisfy the test. The ESR talks about a reduced test which includes statutory filing requirements as well as adequate employees and premises for managing investments. If a company has only one or two investments for long-term investment purposes (i.e.,not for the purpose of buying and selling investments) one may conclude that there is no need to have adequate employees, but does that mean that some of the decisions to divest or acquire would still have to be made in the UAE through a board of directors meeting? It would be helpful to understand exactly what would need to be performed in such cases.
Enforcement of the law and issuance of penalties – outlook
With the conclusion of the first ES compliance season, the UAE has begun enforcing ES penalties to Licensees who did not submit their ES notification, or ES report where they were required to. Based on the law, the Federal Tax Authority ('FTA') is in charge of assessing whether Licensees met the applicable ES Tests, imposing administrative penalties, hearing and deciding on appeals. The regulatory authorities (e.g.,free zone authorities) have a supporting role in assessing whether the notifications/reports were completed and collecting additional information where required.
We are already seeing the regulatory authorities requesting additional for information post-submission of the ES reports. However, we are seeing different approaches taken by different regulatory authorities; some requests are (unhelpfully) quite vague, while some are requesting for very specific additional documents/information (e.g., information on how certain information ties back to the financial statements, copies of outsourcing contracts etc.). Furthermore, certain communications from the authorities show technical glitches in the system (e.g., issuance of penalty for late submission where the ES report was in fact submitted on time).
Licensees who receive a penalty have the right to appeal if:
(i) they did not commit the violation attributed to it;
(ii) the administrative penalty imposed is not proportionate to the violation; or
(iii) the penalty exceeds the limit imposed under the law.
However, no resolution has been issued yet to set out the procedures for the appeal. In the absence of specific formal requirements, we recommend to abide by general principals including setting out the facts, technical analysis and putting forward a clear request.
We have supported clients in submitting appeals and have seen that the authorities are have been responding to appeals on a timely basis.
Based on the response it is clear that the FTA/regulatory authorities are thoroughly reviewing the ES reports. Authorities are putting in place teams and resourcing that will focus on the enforcement of these rules. Licensees are advised to properly assess their RA position and take appropriate actions. Also, given the increased penalty exposure in case of consecutive non-compliance, Licensee should investigate the basis of a penalty and consider an appeal. Such an appeal can also be an opportunity to engage with the authority and seek clarification on a specific area/fact pattern.
Authored by Jan Van Abbe / Chiara Furfari
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