UAE Economic Substance Regulations: Explained

Pursuant to a resolution passed by the Ministry of Finance, UAE introduced the Economic Substance Regulations (ESR) in the state, on 30 April 2019. A year later, in August 2020, a revised cabinet resolution was passed to replace the former, with several key amendments.

With the introduction of ESR, UAE is joining hands with other nations to build the framework for a coherent international tax structure. The first step in this direction being to comply with the BEPS (Base Erosion and Profit Shifting) minimum standards formulated by OECD. And the ultimate goal being to curb harmful tax practices by promoting transparency and timely exchange of information between jurisdictions. Large multi- national entities have been notoriously known for exploiting gaps in local tax systems and reporting profits in countries where they do no have significant economic activities. These guidelines and reporting requirements will serve as one additional check to ensure that entities operating in the UAE have an economic presence in the state and are not merely incorporated to take advantage of a lenient tax system.

Applicability & filing deadlines

As per the ESR regulations, UAE onshore and free zone entities (referred to as ‘licensees’) that carry out any of the specified relevant activities need to demonstrate adequate economic presence in the state with respect to those activities. In other words, those entities must be subjected to an economic substance test annually.

Applicable to financial years commencing from 1 January 2019, the regulations require the filing of the following to the relevant Regulatory Authority:

1. Notification (to be filed within 6 months from the end of the relevant financial year)
2. Economic substance report (to be filed within 12 months from the end of the relevant financial year)

The relevant deadlines for the financial year commencing from 1 January 2019 are therefore 30 June 2020 and 31 December 2020 respectively.

The portal is set to be launched in the first week of December.

For the purpose of the regulations, the following are considered relevant activities:

1. Banking business
2. Insurance business
3. Investment fund management business
4. Lease finance business
5. Headquarters business
6. Shipping business
7. Holding company business
8. Intellectual property business
9. Distribution and service centre business

For each of these relevant activities, the regulations also define some core income generating activities (CIGA). The Regulatory Authority assigned the responsibility of regulating activities, collecting notifications, reports and all connected documents, differ from one activity to the other.

Economic Substance Test

A licensee (other than exempted licensee) must satisfy the below criteria to pass the Economic Substance Test in relation to every relevant activity carried on by it:

Criteria 1: The licensee conducts a CIGA (core income generating activity) in the state

The regulations provide an inclusive definition for what constitutes a CIGA. The licensee may either carry out the CIGA on its own or may outsource the same to an outsourcing service provider. In case of the latter, the following conditions must be met:

• The licensee must be able to monitor, control and demonstrate adequate supervision over the activity
• The employees, operating expenditure and physical assets of the outsourcing provider must be adequate
• The activity must be carried on by the outsourcing provider in the state
• The employees, operating expenditure and physical assets of the outsourcing provider must not be

counted multiple times by multiple licensees when providing evidence for meeting economic substance test

Criteria 2: The relevant activity is directed and managed in the state

The relevant activity can be said to be directed and managed in the state if:

• The Board of Directors of the licensee meets in the state at an adequate frequency, considering the level of decision making required
• At such meetings, there is a quorum of directors physically present in the state
• The minutes of meetings are recorded and signed by the directors attending the meeting
• The minutes contain record of strategic decisions taken at that meeting
• The directors have necessary knowledge and expertise to discharge the duties
• The meeting minutes and other records pertaining to the licensee are kept in the state

If the licensee is managed by a shareholder or partner or one or more managers, then the above criteria shall apply to them instead of a board of directors.

Criteria 3: There is an adequate number of qualified full time employees in relation to that activity, who are physically present in the state

Criteria 4: There is adequate operating expenditure incurred by the licensee in the state Criteria 5: There are adequate physical assets in the state

Exempted licensees & high risk intellectual property licensees

Exempted licenses are considered exempted from satisfying the economic substance test and filing the economic substance report. However, they are still required to file the notification and provide additional documents and information to evidence its status as an exempted licensee, each financial year. Currently as per the regulations, the following are exempted licensees:

1. A licensee that is an investment fund
2. A licensee that is a tax resident in a jurisdiction other than the state
3. A licensee that is wholly owned by one or more residents in the state, provided it is not part of an MNE Group and carries out business in the state
4. A licensee that is branch of a foreign entity, the relevant income of which is subject to tax in a jurisdiction other than the state

A specific segment of intellectual property licensees are categorized as high risk and the provisions of this regulation applies to them in a slightly different manner. The onus to prove that licensees who satisfy the below mentioned criteria, are in fact not high risk, is on the licensee itself. High risk intellectual property licensee is a licensee that carries on intellectual property business (a relevant activity) and the licensee:

1. Did not create the intellectual property in an intellectual property asset that it holds for the purpose of its business,
2. Acquired the intellectual property asset from a connected person or in consideration for funding R&D by another person situated in a different country, and
3. Licenses or has sold the intellectual property asset to one or more connected persons, or otherwise earns separately identifiable income from a foreign connected person in respect of use of the intellectual property asset

Assessments & period of limitation

The Federal Tax Authority (FTA, appointed as the National Assessing Authority under the regulations) is assigned the responsibility of assessing whether a licensee has met the economic substance test.

1. With regard to any licensee, the FTA may make an assessment, provided the assessment is made within 6 years from the end of the relevant financial year (I.e. Assessment optional, Period of limitation is 6 years)
2. With regard to a high risk intellectual property licensee, the FTA must make an assessment, unless the licensee provides sufficient information that the test is met (I.e. Assessment mandatory, No period of limitation)

Provided the period of limitation does not apply if FTA is unable to make assessment due to misrepresentation or fraudulent action of the licensee or any other person.

Administrative penalties

In order to ensure strict adherence to the regulations, substantial administrative penalties have been enforced as under:

1. Upon failure to file notification - AED 20,000
2. Upon failure to file economic substance report - AED 50,000
3. Upon providing inaccurate information - AED 50,000
4. If the FTA has determined that a licensee who committed a violation, commits the same violation again in the immediately following financial year - AED 400,000

Exchange of information

Upon receipt of the notification, economic substance report and any other connected information, the regulatory authority shall forward the same to the FTA within 30 business days. Similarly if the licensee fails to make the submission, the regulatory authority shall notify the FTA within 30 business days.

Once the information reaches the FTA, they may or shall make an assessment as the case may be. If the licensee fails to meet the requirements of the test, FTA shall notify and relay the documents to the Ministry of Finance (MoF, appointed as the competent authority under the regulations).

The Ministry of Finance shall, pursuant to an international agreement, provide relevant information about the licensee to the foreign competent authority of the country in which the parent company, ultimate parent company or ultimate beneficiary owner resides. In case of high risk intellectual property licensees, the ministry is mandated to provide such information.

References and suggested further reading

1. Resolution issued by Ministry of Finance - https://www.mof.gov.ae/en/strategicpartnerships/pages/ esr.aspx
2. Key amendments - https://home.kpmg/ae/en/home/insights/2020/09/tax-flash-new-uae-economic- substance-regulations.html
3. FAQ’s - https://www.gccfintax.com/articles/faqs-on-economic-substance-regulations-in-uae-1744.asp

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