Economic Substance Regulations in the UAE: Recap and Updates
October 13, 2020
By Mustafa Khalid
Effective from 30 April 2019, the UAE issued economic substance regulations for certain businesses by way of Cabinet of Ministers Resolution No. 31 of 2019 (the “Original ESR Regulations”). Guidance on the ESR Regulations was issued on 11 September 2019 through Ministerial Decision No. 215 of 2019 (the “Guidance”).
The Original ESR Regulations were issued as part of the UAE’s commitment as a member of the Organisation for Economic Co-operation and Development (OECD) Inclusive Framework and were aimed at, inter alia, curtailing harmful tax practices. By issuing such regulations, the UAE affirmed its commitment to addressing concerns regarding the shifting of profits derived from internationally mobile activities (such as financial and other service activities) to low- or no-tax environments with no substantive economic activities.
What is the update?
Presumably, with a view to clarifying the scope and application of the economic substance requirements, the Original ESR Regulations were repealed and replaced on 10 August 2020 by way of Cabinet Resolution No. 57 of 2020 (the “Amended ESR Regulations”). The Guidance was also updated on 19 August, 2020, through Ministerial Decision No. 100 of 2020.
The key changes promulgated by the Amended ESR Regulations can be summarised as follows:
Definition of “Licensee”
As per the Amended ESR Regulations, a “Licensee” shall be:
- any corporate person i.e. person with a separate legal personality; and
- unincorporated partnerships
that carries on a ‘relevant activity’ in the UAE.
Unlike the Original ESR Regulations, natural persons, sole proprietors, trusts and foundations will no longer fall within the ambit of the Amended ESR Regulations.
The Amended ESR Regulations exempts the following entities from the economic substance regime:
- Entities that are tax residents outside of the UAE, provided that such entity can provide evidence that it is treated as a local tax resident entity in the foreign jurisdiction in which it claims to be;
- Investment funds. For the avoidance of doubt, it is clarified that the exemption does not extend to the entity(ies) in which the investment fund ultimately invests;
- Branches of foreign companies subject to tax outside of the UAE; and
- Entities that are wholly owned by UAE residents and which are:
- not part of a multi-national group; and
- only carry out their activities in the UAE.
It may be noted that in order to avail their exempt status, exempted licensees still need to file a notification and provide the aforementioned documentary evidence demonstrating their position.
As per the Original ESR Regulations, entities with at least 51% UAE government ownership, whether direct or indirect, were exempt. Under the Amended ESR Regulations, such entities are no longer specifically exempted.
A UAE branch of a company incorporated outside the UAE is not subject to the Amended ESR Regulations provided that the income earned through the branch is reported in the tax return of the company in the jurisdiction in which it is incorporated.
A foreign branch of a company, incorporated in the UAE is not subject to the Amended ESR Regulations provided that the income earned through the branch is subject to tax in the jurisdiction in which it is incorporated.
As per the Amended ESR Regulations, a “Connected Person” is defined as an entity which is part of the same “Group” as the Licensee.
A “Group” is now defined as “two or more entities related through ownership or control such that they are required to prepare consolidated financial statements for financial reporting purposes under the accounting standards applicable thereto”.
Distribution and Service Centre Business
Previously, goods imported by a company had to be stored in the UAE for such company to be considered within the scope of the relevant activity of “Distribution and Service Centre Business”. As per the Amended ESR Regulations, there is no longer a requirement for the goods to be imported and stored in the UAE for a company to fall within the scope of the aforementioned activity.
Additionally, it is no longer a requirement that services be provided in connection with a business outside of the UAE. As such, it appears that any services provided to a foreign related party would fall within the remit of the relevant activity of “Distribution and Services Centre Business” under the Amended ESR Regulations.
High Risk Intellectual Property Business
As per the Amended ESR Regulations, the relevant activity of “High Risk Intellectual Property Business” has been limited to an intellectual property business that:
- Did not create the IP asset;
- Acquired the IP asset from either;
- a Connected Person; or
- in consideration for funding R&D by another person situated in a foreign jurisdiction; and
- Licenses or has sold the IP asset to a Connected Person, or earns separately identifiable income from a Foreign Connected Person in respect of the use or exploitation of the IP asset.
The Federal Tax Authority has been appointed as the “Assessing Authority” responsible for overseeing the implementation of the Amended ESR regulations. In particular, the Assessing Authority will, inter alia, be responsible for assessing and enforcing compliance with the “Economic Substance Test”, imposing administrative penalties for non-compliance and exchanging information with the respective foreign authorities.
As for regulatory authorities, their primary responsibility shall be to collect and verify information regarding the Licensees, and to assist the “Assessing Authority” in carrying out its role.
The Amended ESR regulations stipulate that notifications must be filed directly via the Ministry of Finance online portal within six months from the end of the financial year of the Licensee.
Licensees who have already submitted a notification to their regulatory authorities are required to re-submit their notification on the Ministry of Finance online portal.
Penalties for non-compliance have been made more stringent and now range from AED 20,000 to AED 50,000, with a further risk of possible cancellation/suspension of trade license. A strict policy against non-compliance can be expected now that the Federal Tax Authority has been appointed as the Assessing Authority.
In view of the above and considering the limited time available to prepare an ESR report and submit (or re-submit) a notification, it is strongly recommended that businesses reassess whether their previous economic substance analysis is still accurate in accordance with the provisions of the Amended ESR Regulations.