The Crucial Reasons Behind Implementation of Economic Substance Regulations in UAE

We must first comprehend Base Erosion and Profit Shifting before discussing Economic Substance Regulations (ESR) (BEPS). The practice of lowering the taxable base in high-tax countries is known as 'base erosion.' Profit shifting is when profits are moved from high-tax jurisdictions to low-tax jurisdictions.

High-tax Jurisdiction and Tax Savings Scenario

For example, a corporation situated in a high-tax jurisdiction may be offered high-interest loans to lower taxable profits in that jurisdiction. For instance, a group company in a low-tax country may provide loans to a company in a high-tax jurisdiction at a high-interest rate. As a result, a firm in a high tax jurisdiction will pay a lower tax jurisdiction company more interest. In high-tax nations, the high-interest expense will reduce taxable profits, resulting in tax savings.

Transfer of Ownership of Intellectual Property

Another example is the transfer of intellectual property such as trademarks, designs, and patents from a high-tax country to a low-tax jurisdiction, followed by the imposition of royalties on group firms to use the intellectual property. This will result in tax savings by increasing income in low-tax jurisdictions and increasing expenses in high-tax jurisdictions.

For illustration, software was produced in the United Kingdom (UK) by a UK-based firm (company A), and ownership of the program was transferred to a UAE-based group company (company B). Company B leased the software to several group companies, including Company B. It demonstrates that income is being stashed in a low-tax country, resulting in tax savings, which is a good thing.

Multinational corporations commonly use this method to avoid paying taxes. According to the Organization for Economic Cooperation and Development (OECD), BEPS results in yearly revenue losses of $100–$240 billion.

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Measures to Address the Massive Revenue Loss

? The first was the OECD's inaugural report on BEPS, released on February 12, 2013.

? On July 19, 2013, the OECD released a detailed action plan on BEPS. This strategy outlined 15 actions to address flaws in current international taxation principles. The Finance Ministers of the G20 countries endorsed the idea.

? On September 16, 2014, the OECD released the action plan's initial deliverables.

? The United Nations (UN) took action on BEPS by forming a UN subcommittee on the subject.

? The European Commission (EU) published its proposal for a council regulation on tax avoidance tactics in the EU on January 28, 2016.

Implementation of BEPS Package

Countries and jurisdictions began cooperating to implement the BEPS package consistently and establish further BEPS-related standards. The BEPS package has fifteen action points, with each OECD member nation needing to implement at least four of them:

? Defend against unfair tax practices

? Preventing the abuse of tax treaties

? Reporting on a country-by-country basis

? Procedures for mutual agreement

Significance of ESR Laws

The ESR law and related rules are beneficial in combating unfair tax practices and preventing tax cheating.

As a member of the OECD inclusive framework, the UAE implemented the ESR law through Cabinet Decision No. 31 of 2019, which was later replaced by Cabinet Decision No. 57 of 2020. For the smooth implementation of ESR in the UAE, the UAE published Guidance No. 215 of 2019, which was replaced by MD 100 of 2020.

Business/Activities Subjected to ESR

ESR applies to nine different enterprises and activities. These are I banking, (ii) insurance, (iii) investment fund management, (iv) lease financing, (v) headquarters, (vi) shipping, (vii) holding company, (viii) intellectual property, and (ix) distribution and service sector businesses. Businesses are not subject to ESR if they are not involved in any of these activities.

Along with passing the functional, managerial, and sufficiency tests, licensees must also submit the notification and accompanying report by the deadlines outlined in the ESR Law.

The Concluding Statement Encircling ESR

The law and related rules are intended to ensure that UAE entities do not artificially attract profits that are out of proportion to their economic activity in the UAE. Furthermore, the Law and accompanying laws mandate that enterprises maintain an economic presence in the UAE to conduct business there. As per the law, all firms engaging in the related operations must meet the ESR test. The law mandates that such companies pass functional, managerial, and sufficiency standards.