Insights: Economic substance regulations in the UAE

The concept of economic substance has become increasingly important in recent years, as governments and regulatory bodies have sought to crack down on tax avoidance and ensure that companies are paying their fair share of taxes in the jurisdictions where they operate. As a result, many countries, including the UAE, have introduced economic substance regulations (ESR) to ensure that companies have a real and substantial presence in the jurisdictions where they claim to be operating, but what is economic substance and how are companies required to demonstrate it?

What is economic substance?

Economic substance refers to the tangible and real economic activity that a company carries out, rather than just having a legal or nominal presence in a jurisdiction for tax or other regulatory purposes. In other words, it refers to the actual economic value that a company generates through its business activities, such as creating jobs, investing in assets, and producing goods or services.

The introduction of ESR in the UAE is in response to an assessment of the country’s tax framework by the European Union Code of Conduct Group on Business Taxation. It also represents the UAE’s commitment to addressing tax avoidance and fulfilling its obligations as a member of the OECD Inclusive Framework.

When did the UAE introduce the ESR and when is it effective from?

The UAE ESR were introduced on 30 April 2019, via Cabinet of Ministers Resolution No 31 of 2019 on Economic Substance Regulations. They are applicable to financial years beginning on or after January 1, 2019.

The regulations were introduced to align the UAE’s tax framework with international best practices and as part of the country’s commitment to compliance with requirements set forth by the Organisation for Economic Co-operation and Development.

Which companies fall within the scope of the UAE Economic Substance Regulations?

UAE onshore and free zone companies are both subject to the regulations as well as other business entities that engage in any of the broadly defined ‘relevant activities’ below:
1. Banking businesses
2. Insurance businesses
3. Investment fund management businesses
4. Lease-financing businesses
5. Business headquarters
6. Shipping businesses
7. Holding companies
8. Intellectual property businesses
9. Distribution and service centre businesses

Trusts and foundations fall outside the scope of the ESR since they are generally not permitted to carry out commercial activities and would therefore not engage in any of the relevant activities. However, in the event a trust or foundation does undertake a relevant activity, it will be considered as a licensee and as such, be expected to comply with the regulations (as a holding company business).

UAE registered branches are considered an extension of their parent office and therefore do not have a distinct legal personality. Responsibility for ESR lies with the parent company, which would register as a single licensee and include all of its subsidiaries under one economic substance report. Foreign branch offices are required to comply with the regulations unless the foreign branch is already subject to taxation in the jurisdiction where the parent company is registered.

How do companies demonstrate adequate economic substance?

There is no minimum income threshold for ESR nor is there a minimum standard required to be met. The UAE recognises that companies differ greatly in terms of size and type, and what is sufficient and appropriate will be determined on a case-by-case basis, dictated by the nature of the activities carried out and the income generated by the licensee. Allowances will also be made for fluctuations in activity levels and income that invariably occur throughout a financial year.

Businesses which fall within the scope of the ESR will be required to pass an economic substance test and submit a notification and economic substance report to the relevant regulatory authority responsible for the industry and jurisdiction where the company operates.

The test determines whether:
• The company is directed and managed in the UAE.
• The core income generating activities are being carried out in the UAE.
• The licencee has sufficient staff, premises and expenditure in the UAE.
The Ministry of Finance is the governing body responsible for assessing these criteria, deciding whether a company meets requirements and enforcing any sanctions if applicable.

What exemptions are there to the regulations?

Certain individuals and entities are exempt from the requirement to demonstrate economic substance or file a report. These are:
• Company licence holders who are tax residents outside the UAE.
• Investment funds and underlying SPVs/investment holding entities.
• Wholly UAE resident-owned businesses that are not part of a multinational group and conduct business exclusively in the UAE.
• Foreign branches that are already subject to taxation in a foreign jurisdiction.

Next steps

Failure to comply with ESR or demonstrate sufficient economic substance in the country can result in significant fines or other penalties. It could also result in a trade licence being cancelled, withdrawn or not renewed. It is therefore advisable to engage a reputable corporate services provider with local experience and legal knowledge to assist you with your ESR obligations.

John Hanafin is the founder and CEO of Huriya Private