Understanding the UAE's Economic Substance Regulations (ESR)

Introduction

The Economic Substance Regulations (ESR) were introduced by the United Arab Emirates (UAE) to ensure that UAE entities that undertake certain activities are not used to artificially attract profits that are not commensurate with the economic activity undertaken in the UAE. This aligns with international efforts to combat harmful tax practices, primarily led by the Organisation for Economic Co-operation and Development (OECD).

What is Economic Substance Reporting?

Economic Substance Reporting refers to a regulatory requirement in certain jurisdictions that mandates certain entities to provide information regarding their economic substance and activities. It is primarily aimed at combating tax avoidance and ensuring that companies have a genuine presence and conduct real economic activities in the jurisdictions where they operate.

Under economic substance reporting rules, companies may be required to disclose information such as the nature of their business activities, their level of income, the number of employees, physical assets, and the location of their offices. This information is used to assess whether the company has substance and economic activity in the jurisdiction, rather than simply being used for tax optimization purposes.

The introduction of economic substance reporting is part of global efforts to address base erosion and profit shifting (BEPS) by multinational enterprises. These regulations aim to promote fair taxation, discourage harmful tax practices, and ensure that companies contribute to the economic development of the jurisdictions where they operate.

Why was ESR introduced in UAE?

The ESR in the UAE were introduced in response to the EU's assessment of the UAE's tax framework. The EU's Code of Conduct Group (Business Taxation) examined the tax policies of jurisdictions with zero or near-zero tax rates to determine if they were being used to facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction. As a result, the UAE was included in the EU's list of non-cooperative jurisdictions for tax purposes in 2019. To address the EU's concerns and in line with the UAE's commitment as a member of the OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS), the UAE introduced the ESR in April 2019.

Who It Applies To

The ESR applies to UAE entities that conduct "relevant activities". The definition of a "licensee" has been restricted to apply only to a legal entity (incorporated inside or outside the UAE), or an unincorporated partnership that is registered in the UAE and carries on a relevant activity. Activities have that have been defined as "relevant activities," including high-risk intellectual property (IP) business, distribution business, and service center business need to evaluate whether they meet the criteria in the definitions and accordingly whether they have to submit a detailed report measuring them on the test criteria laid out by the law.

However, new exemptions were introduced, which include:

1. An investment fund.
2. An entity that is not a UAE tax resident.
3. An entity that is wholly owned by UAE residents and (a) is not part of a multinational enterprise (MNE) group, and (b) is only carrying out business in the UAE.
4. A branch of a foreign parent where the relevant income is subject to tax in the jurisdiction of the foreign parent.

It's important to note that entities that are at least 51% owned by the UAE Government are no longer specifically exempted.

Key Dates of Filing

The deadline for the submission of ESR reports is 12 months from the end of the financial period while the deadline to submit the notification is 6 months. The relevant businesses are required to undertake a detailed analysis of their functions and transactions to be able to determine whether and to what extent the conditions prescribed in the ESR are appropriately met. They should initiate the necessary analysis as soon as possible to ensure timely and accurate compliance as well as submit a report highlighting their substance if they do fall under the criteria mentioned in the ESR requirements.

Why Compliance is Important

The UAE Federal Tax Authority has been appointed as the National Assessing Authority and will be responsible for determining whether a licensee has adequately complied with the ESR and the penalties imposed. Non-compliance with the ESR can lead to a range of administrative penalties (of up to AED400,000), including the suspension or non-renewal of trade licenses.

Will this continue after the introduction of Corporate Tax?

Once Corporate tax in fully applicable to all companies, it is unlikely that the ESR requirements will continue for too long but it remains to be seen whether that will be the case. It may be possible that companies operating in Free Zones that qualify for exemptions on Corporate Tax may still be required to file ESR reports.

Do countries with taxes have Economic Substance Reporting requirements?

Not all countries with taxes have economic substance reporting requirements. The implementation of economic substance reporting regulations varies from country to country. These requirements are typically found in jurisdictions that are members of the Organisation for Economic Co-operation and Development (OECD) and have committed to implementing international standards to combat tax avoidance and promote transparency.

Many offshore financial centers and jurisdictions that are known for their tax advantages have introduced economic substance reporting to meet international standards and address concerns related to tax avoidance and harmful tax practices. Examples of such jurisdictions include Bermuda, the British Virgin Islands, Cayman Islands, and others.

However, it's important to note that economic substance reporting is not limited to these jurisdictions. Some countries and regions have also implemented similar reporting requirements to ensure that companies operating within their borders have genuine economic activities and substance. Each country has their own requirements of meeting the substance test.