Economic Substance Regulation in the UAE is basically derived from the inclusive framework on BEPS Action 5 of OECD which requires that Enterprises should not be allowed to park their profits in a jurisdiction with No or low tax regime without core functions of the enterprise being carried out in the jurisdiction and thus leading to harmful tax practice in eroding the tax base of other countries.

As per the mandate under the OECD (2018), Resumption of application of substantial activities for no or nominal tax jurisdictions-BEPS Action 5, OECD, such jurisdiction which did not levy any corporate tax or levied very low corporate tax were required to pass legislation for complying with the Substantial activities requirements. Also, under the said Inclusive Framework, certain business activities were identified to which such regulation must apply. The business activities as identified are geographically mobile activities, such as financial and other service activities, including the provision of intangibles and typically identified these types of mobile activities as falling into the categories of headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping, holding companies and the provision of intangibles.

Accordingly, as part of the UAE’s commitment as a member of the OECD Inclusive Framework, and in response to an assessment of the UAE’s tax framework by the European Union Code of Conduct Group on Business Taxation, the UAE issued Economic Substance Regulations (Cabinet of Ministers Resolution No. 31 of 2019), (the “Regulations”) on 30 April 2019. Amendments to the Regulations were made by Cabinet of Ministers Resolution No. (57) of 2020 on 10 August 2020, and updated Guidance was issued on 19 August 2020 (Ministerial Decision No. (100) of 2020.

Scope:

The Regulations require UAE onshore and free zone companies and certain other business forms that carry out any of the defined “Relevant Activities” listed below to maintain and demonstrate an adequate “economic presence” in the UAE relative to the activities they undertake (“Economic Substance Test”). The Regulation further requires such entities to file Notification and Economic Substance Report (“ESR”) with the relevant Regulatory Authority every year.

Relevant Activities:​

Entities (referred to as “Licensees” in the Regulation)  carrying out following “Relevant Activities” are required to comply with the Regulation in terms of maintaining the Economic Substance in the UAE and filing the Notification and the Economic Substance Report with the Regulatory Authority.

  • Banking Business
  • Insurance Business
  • Investment Fund management Business
  • Lease – Finance Business
  • Headquarters Business​​
  • Shipping Business
  • Holding Company Business
  • Intellectual property Business (“IP”)
  • Distribution and Service Centre Business​

The Regulations apply to financial years commencing on or from 1 January 2019. Entities that are within the scope of the Regulations are required to submit an annual Notification form to their Regulatory Authority , and complete and submit to the same Regulatory Authority an Economic Substance Report (ESR) within 12 months from the end of their financial year (e.g. 31 December 2020 for entities with a financial year ending 31 December 2019). The Notification and the ESR is required to be filed online on the portal of the Ministry of Finance.

Exempted Licensee:

Licensees, which meet certain conditions and although carrying out the relevant activity has been specifically exempted under the Regulation in terms of meeting the requirement of Economic Substance and filing ESR. However, Exempted Licensee are still required to file Notification with the Regulatory Authority. The following have been considered as Exempted Licensee:

  1. a Licensee that is an Investment Fund;
  2. a Licensee that is a tax resident in any other jurisdiction other than the UAE;
  3. a Licensee that is wholly owned by one or more residents in the UAE and meets the following two conditions :
    1. it is not part of a Multi-National Enterprises Group; and
    2. it only carries out business in the UAE.
  4. a Licensee that is a branch of a foreign entity the Relevant Income of which is subject to tax in a jurisdiction other than the UAE; and
  5. any other Licensee as determined pursuant to a decision of the Minister of Finance.

A Licensee, which meets the condition of being Exempted or does not has any Income from the Relevant Activity in any particular year then such Licensee is not required to meet the Economic Substance Test and file an Economic Substance Report for that financial period. However, a Notification form will still need to be submitted regardless.

Economic Substance Test:

A Licensee that is not an Exempted Licensee, must satisfy the following criteria to satisfy the Economic Substance Test in relation to any Relevant Activity carried on by it:

  • the Licensee conducts the necessary Core Income-Generating Activity in the UAE. The Regulation defines core income generating activities in respect of each Relevant Activity and such activities are regarded of central importance to a Licensee for generating income from a Relevant Activity and therefore must be conducted in the UAE;
  • the Relevant Activity is directed and managed in the UAE by way of periodical conducting of the Board Meetings of the Directors with adequate quorum present physically and recording the minutes thereof and maintaining the records of the minutes of the meeting in the UAE;
  • having regard to the level of Relevant Activity, as follows:
    • there is an adequate number of qualified full-time employees in relation to that activity who are physically present in the UAE;
    • there is adequate operating expenditure incurred by the Licensee in the UAE; and
    • there are adequate physical assets in the UAE.

A Licensee may outsource a Core Income-Generating Activity to an Outsourcing Provider, provided certain conditions as prescribed in the Regulations are met.

Reporting:

Each Licensee and Exempted Licensee shall by way of Notification, as prescribed, submit with the Regulatory Authority annually, within six months from the end of the financial year, of the following –

  • the Relevant Activity being carried out by such Licensee or Exempted Licensee during the Relevant Financial Year;
  • whether it has generated Relevant Income during the Relevant Financial Year ;
  • the date of commencement and end of its Financial Year;
  • any other information or documents as may be requested by the Regulatory Authority.

A Licensee, which has Income from Relevant Activity during the year and is not an Exempted Licensee, is required to meet the Economic Substance Test and shall, no later than twelve (12) months after the last day of the end of each Financial Year, prepare and submit to the Regulatory Authority an Economic Substance Report, as prescribed containing such details as are required by the Authority.

Administrative Authorities:

The Regulation shall be administered by such authorities as have been described in the Regulation and are as under:

  • Regulatory Authority: Regulatory Authority are such Authorities which have been tasked under the Regulation to collect relevant information by way of Notification and ESR from the Licensee carrying out Relevant Activity, review and report the same to the National Assessing Authority. Generally such authorities are the Regulatory Authorities in respect of the Licensee under which such License has been obtained such as relevant Free Zone Authority or Financial Authority.
  • National Assessing Authority: The Federal Tax Authority has been appointed as National Assessing Authority and has been entrusted with the task of assessing whether the Licensee or the Exempted Licensee, has met Economic Substance Test, wherever required. Further, National Assessing Authority shall have powers to impose administrative penalties and hear appeal.

Further, the authorised personnel of Regulatory Authority and the National Assessing Authority has power to enter the premises during the business hours and examine and make copies of the documents available at the business premises. The Authorities may serve notice requiring the official of the Licensee to produce such documents as may be relevant for determining of the carrying on the Relevant Activity or for exercising other powers as entrusted under the Regulation.

Assessment:

Pursuant to the information received by the National Assessing Authority, it may determine that the Licensee fails to meet the Economic substance Test as was required in relation to the Relevant Activity. National Assessing Authority shall inform Ministry of Finance of such determination and the same shall be informed by the Ministry to the relevant authority of the other tax jurisdiction of which the Ultimate Beneficial Owner is a resident.  Such information shall be exchanged pursuant to the international treaty or agreement that the UAE may have with the other tax jurisdiction State.

Penalties:

Penalty of AED 20,000 shall be imposed for failure to submit Notification by the Licensee or the Exempted Licensee, who is so required to submit under the Regulation.

Penalty of AED 50,000 shall be imposed on such Licensee or Exempted licensee who fail to submit ESR or fails to meet the Economic Substance Test as is required under the Regulation. In case the Licensee or the Exempted Licensee fails to submit ESR or fails to meet Economic Substance Test for the second consecutive year then penalty of AED 4,00,000 shall be imposed on the defaulting Licensee. Further action such as cancellation or suspension of license may also be taken against such Licensee.

Appeal:

A Licensee who has been imposed with a penalty can prefer an appeal against the order imposing penalty and such appeal shall lie with the National Assessing Authority and shall be in such form and shall follow such procedure as may be laid out separately.

Further to the Regulation, Ministry of Finance has issued various Guidance for clarification on various provisions under the Economic Substance Test Regulation which may help the Licensee to determine whether any activity carried out by the Licensee can be termed as Relevant Activity and therefore the Licensee is required to submit the Notification or ESR and demonstrate presence of Economic Substance in the UAE.

The Regelation and the Guidance issued by the Ministry emphasis that “substance over the form” approach to be applied while determining whether the entity is carrying out Relevant Activity and it is not necessary that the Relevant Activity be listed in the License or the permit issued to the entity. For instance, any loan advanced against consideration (interest or other consideration) by a Licensee shall be construed as Lease – Finance Business Activity and therefore the Licensee will be required to comply with the provisions under the Economic Substance Regulation.