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Economic Substance Regulation (ESR) in UAE

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Overview of Economic Substance Reporting

The United Arab Emirates (UAE) released the Cabinet of Ministers Resolution n. 31/2019 with effect from 30 April 2019, concerning the Regulations for Economic Substance (ES) in the UAE. The introduction of the new ES rules is a milestone for the UAE’s tax policy towards its alignment with the global Organization for Economic Co-operation and Development’s(OECD) Base Erosion and Profit Shifting (BEPS) directives.

In May 2018, the UAE joined the OECD Inclusive Framework on BEPS and committed to introduce the minimum standards. One of the requirements to be adopted by the UAE refers to BEPS Action 5 which aims to prevent businesses from setting up corporate structures by relocating activities to jurisdictions with a privileged tax system for the sole purpose of benefiting from a more advantageous tax regime.

The purpose of the ES rules is to bring specific requirements for businesses to demonstrate the actual economic activity in the UAE. The UAE is in line with other jurisdictions that are parties of the OECD Inclusive Framework and have similar tax environments, i.e. no or only nominal tax (NOONs), which have also introduced ES regulations recently (for example, Bahrain, Cayman Islands, Mauritius and British Virgin Islands).

The UAE ES rules are broadly similar to the regulations introduced by other countries, as they follow the guidance issued by the EU and OECD. Essentially, there are three tests that a resident entity (or ‘Licensee’ as foreseen in the UAE law) that undertakes relevant activities (further details below) should fulfill to demonstrate economic substance.

Applicability

The Regulations apply to all UAE onshore and free zone companies that carry on a "Relevant Activity". It is yet to be confirmed whether the Regulations will also apply to sole proprietorships and branches, but we expect entities incorporated under offshore (free zone) companies regulations that carry on a“Relevant Activity” to be within the scope of the Regulations.

Entities that are directly or indirectly owned by the UAE government (both federal and local) are specifically excluded from the Regulations. On this basis, UAE sovereign investment funds and other UAE government related entities would not need to meet the UAE economic substance requirements. The following are considered as “Relevant Activities” under the Regulations:

- Banking

- Insurance

- Fund management

- Lease-finance

- Headquarters

- Shipping

- Holding company

- Intellectual property (IP)

- Distribution and service centre

Reporting requirements

The UAE Regulatory Authority has 6 years to assess the compliance of an UAE entity with the ES rules during any financial year within this period. In order to monitor and control the adherence of the UAE entities with the new rules, an annual report will need to be submitted to the Regulatory Authority within 12 months after the end of the financial year. The annual report shall include information that demonstrates the compliance with the Economic Substance Test, such as the type of relevant activity, location of the place of business, number of full time employees, information supporting the CIGA elements and details on the outsourced activity.

Penalty for non-compliance

In the event of any non-compliance of the Economic Substance Test, the UAE legislation foresees penalties of up to AED 50,000. If the UAE entity fails to comply with the ES rules in a subsequent financial year, penalties can be imposed at up to AED 300,000 and other administrative actions can be applied including the suspension, exclusion or non- renewal of the company’s trade license.

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