Economic Substance Regulations (ESR)
A Concept to Familiarise!
Despite the fact that most of the countries are having full-fledged tax authorities, tax profile and tax treaties, annual tax revenues are being leaked through loopholes, or call it “creative tax planning”.
In order to combat harmful tax practices including unlawful avoidance or tax evasion and to comply with initiatives introduced by the Organization for Economic Co-operation and Development (OECD), Economic Substance Regulation was introduced.
The Organisation for Economic Co-operation and Development, (OECD), came up with 15 Action Plan to tackle tax avoidance caused by Base Erosion and Profit Shifting and G20 countries took joint action and developed these action plans.
Under the OECD/G20 Inclusive Framework on BEPS, over 135 countries are collaborating to put an end to tax avoidance strategies that exploit gaps and mismatches in tax rules to avoid paying tax.
Economic Substance Regulation (ESR) been introduced in countries with low or no corporate taxes. The Economic Substance Regulation is an act that requires specific legal entities (Such as free zones) to demonstrate that they carry out substantial economic activities in these jurisdictions.
Economic Substance Regulations were introduced as a part of action plan 5 to curb harmful tax practices and became effective in the UAE as of 1 January 2019.
As a member of the OECD Inclusive Framework, the UAE is committed to ensuring that the UAE’s legal and commercial framework is in line with global standards and is subject to review by the OECD to ensure that these standards are implemented.
The Regulations require UAE onshore and free zone companies and other UAE business forms that carry out any of the Relevant Activities listed below to maintain an adequate economic presence in the UAE relative to the activities they undertake.
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Holding Company Business
Intellectual Property Business
Investment Fund Management Business
Distribution & Service Center Business
To ensure an entity fall under this legislation, there are specific questions that you can ask concerning your entity:
If the answer to all the questions is “Yes”, then the entity is in the scope of this legislation and has to meet the Economic Substance Requirements.
Are you exempt from ESR?
The provisions of the Economic Substance Regulation do not apply to those entities who are at least 51% directly or indirectly owned by the UAE Government. This includes the Federal Government, the Government of any Emirate of the UAE, or any governmental authority or body. Such entities are exempted.
What does it mean to be within the scope of ESR?
➤ The Core Income Generating Activity (CIGA) for each relevant activity should genuinely be conducted in the State.
➤ The majority of board meetings should be conducted in the State.
➤ Minimum quorate board meetings per year should be conducted in the State.
➤ Minutes of the meeting should be signed and maintained in UAE.
➤ Directors in the UAE should have the necessary knowledge and expertise.
➤ Strategic decisions should be taken in the UAE.
➤ An adequate number of employees should be physically present in the UAE.
➤ There should be adequate expenditure incurred in UAE or adequate expenditure on outsourcing.
➤ There should be adequate physical assets in the UAE
➤ Third-party service providers are permitted, provided that the entity has sufficient control and supervision.
The Regulatory Authority Requires Notification To Be Submitted Stating The Following:
➤ Whether or not it carries out a relevant activity.
➤ Whether or not all or any part of the licensee’s gross income in relation to the Relevant Activity is subject to Tax in the jurisdiction outside the UAE.
➤ The date of the end of its Financial Year.
Once an Entity Conducts The Economic Substance Test and Analyses its Economic Substance Impact in UAE, A Report Should be Submitted to the Regulatory Authority Containing the Following Information:
➤ Type of Relevant Activity carried out.
➤ Amount and type of relevant income regarding the Relevant Activity.
➤ Amount and type of operating expenses and assets regarding the Relevant Activity.
➤ Location of the business.
➤ The number of full-time employees with qualifications and personnel responsible for carrying out the Relevant Activity.
➤ Information showing the Core Income Generation Activity regarding Relevant Activity.
➤ Declaration as to whether the Economic Substance test has been satisfied.
➤ Where the Relevant Activity is outsourced, additional information to be provided.
➤ For IP Activity, Additional requirements applicable and information to be provided.
There are precise specifications to Intellectual Property Business under economic Substance Regulations. A UAE business is regarded as carrying on an Intellectual Property Business if it holds, exploits, or receives gross income from “Intellectual Property Assets”.
What makes IP activity different from other relevant activities is that If IP business is categorized as High Risk, there is an automatic exchange of information with the foreign competent authority and there are additional compliance requirements to be fulfilled.
In anticipation of its higher risk, the ESR presumes that a Licensee who carries out such activity is not complying with the Economic Substance Test.
A Licensee can rebut such an assumption, provided the Licensee demonstrate the increased substance requirements, which are:
➤ The licensee has a high degree of control over developing the IP asset.
➤ The licensee has adequate full-time employees with the necessary qualifications that permanently reside and perform their activities in the UAE. It is important to note that relevant employee information (like experience, contracts, qualifications, etc.) would need to be provided.
➤ The licensee has a business plan showing the reasons for holding the IP in the UAE.
➤ Relevant decision making has and continues to take place in the UAE.
Familiarise the core income generating activities (CIGA)
The Core Income Generating Activities requirements in an ESR test is tailored for each Relevant Activity.
1. Banking business
- Raising funds, managing risk including credit, currency, and interest risk.
- Taking hedging positions.
- Providing loans, credit, or other financial services to customers.
- Managing capital and preparing reports to investors or any government authority with functions relating to the supervision or regulation of such business.
2. Insurance business
- Predicting and calculating risk.
- Insuring or re-insuring against risk and providing Insurance Business services to clients.
- Underwriting insurance and reinsurance.
3. Investment fund management business
- Taking decisions on the holding and selling of investments.
- Calculating risk and reserves.
- Taking decisions on currency or interest fluctuations and hedging positions.
- Preparing reports to investors or any government authority with functions relating to the supervision or regulation of such business.
4. Lease – finance business
- Agreeing on funding terms.
- Identifying and acquiring assets to be leased (in the case of leasing)
- Setting the terms and duration of any financing or leasing
- Monitoring and revising any agreements
- Managing any risks
5. Headquarters business
- The provision of senior management
- The assumption or control of material risk for activities carried out by foreign group companies
- Substantive advice in relation to the assumption or control of such risks.
6. Shipping business
- Managing crew (including hiring, paying, and overseeing crew members).
- Overhauling and maintaining ships.
- Overseeing and tracking shipping.
- Determining what goods to order and when to deliver them, organizing, and overseeing voyages.
7. Holding company business
- Activities related to a Holding Company Business.
8. Intellectual property business (IP)
- Taking Strategic decisions and managing (as well as bearing) the principal risks related to the development and subsequent exploitation of intangible asset generating income.
- Taking Strategic decisions and managing (as well as bearing) the principal risks related to the acquisition by third parties and subsequent exploitation and protection of the intangible asset.
- Carrying on the ancillary trading activities through which the intangible assets are exploited leading to the generation of income from third parties.
9. Distribution and service centre business
- Transporting and storing component parts, materials, or goods ready for sale.
- Managing inventories.
- Taking orders.
- Providing consulting or other administrative services.
In case an entity does not adhere to the Economic Substance Regulations and fails to notify its Regulatory Authority, the entity will face penalty charges for the following situations:
Failure to notify:
➤ AED 10,000 to AED 50,000
Failure to provide accurate or complete information:
➤ AED 10,000 to 50,000
➤ Deemed failure to demonstrate economic substance in the UAE.
Failure to demonstrate sufficient economic substance in the UAE for the relevant financial year:
➤ FIRST FAILURE: The penalty of AED 10k to 50k and information exchange with the foreign competent authority of (1) parent company, (2) ultimate parent company, and (3) ultimate beneficial owner.
➤ CONSECUTIVE FAILURE: The penalty of AED 100k to 300k and Trade / commercial license could be suspended, withdrawn or not renewed and Information exchange with the foreign competent authority of (1) parent company, (2) ultimate parent company, and (3) ultimate beneficial owner.
Impact of COVID-19 on Economic Substance Regulation
The UAE Ministry of Finance (MoF) recognizes that with the outbreak of COVID-19, the mobility of individuals may be affected, either due to travel restrictions or due to individuals being subject to self-isolation or quarantine requirements. In this regard, the UAE MoF confirmed that the UAE would take into consideration the impact of COVID-19 on the usual operations of Licensees when deciding whether a Licensee has demonstrated sufficient economic substance in the UAE. These considerations would only apply to those substance requirements that are directly affected by COVID-19 measures (e.g. travel restrictions, self-isolation situations, or quarantine requirements).
Businesses should, however, consider appointing alternate directors in the UAE who can attend meetings in the UAE and address any short-term practical difficulties arising from COVID-19 related measures. MoF also instructed that entities should note that this is only a temporary arrangement and therefore must make every effort to otherwise comply with their obligations under the ESR.
What should you be doing now?
➤ Assess what Relevant Activities it has performed during the financial period (applying a “substance over form” approach).
➤ Assess the amount and type of income earned (if any) from the Relevant Activity during the financial period.
➤ Hold board meetings with a quorum of directors physically present in the UAE.
➤ Ensure board meeting minutes are signed and maintained in the UAE.
➤ Identify the amount and type of expenses and UAE based assets (incl. premises) in respect of the Relevant Activity, and ensure access to assets (incl. premises) can be demonstrated (through agreements and financial records).
➤ Identify the number of UAE based full-time employees or other personnel (and their qualifications) responsible for carrying on the Licensee’s Relevant Activity; and
➤ Ensure control and supervision over any outsourcing arrangements can be demonstrated, e.g. through contractual agreements.
To ensure the Economic Substance Test is conducted accurately, an entity can look for qualified professional help to assess the impact of economic substance that entity has on UAE. Before the end of the financial period, an entity must make sure to consider the list of matters (mentioned above) and report to its relevant regulatory authority in accordance with its requirements.
UAE businesses are expected to use a “substance over form” approach, based on the economic substance doctrine to determine whether they undertake a Relevant Activity and, as a result, fall within the scope of the Economic Substance Regulations. To make this determination, Licensees should not only consider the activities stated in their commercial license or registration certificates but also assess the activities carried out during a financial period.
How can we help?
We consider that complying with the substance rules will be via a three-step process:
Undertaking an impact analysis to understand how and to what extent your business will be affected.
Carrying out a readiness assessment to ensure your business is prepared or to advise on areas requiring improvement/amendment.
Obtaining assistance for tax return preparation and Income Tax Division liaison to ensure timely implementation of the requirements.
To help you navigate the UAE substance requirements, MSATC offers a comprehensive range of options – from a classification check to a full review, as well as advisory services on registering your status with the regulator.
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