What is Economic Substance Regulation?

March 4, 2024

In April 2019, the UAE issued economic substance regulations (the “Regulations”) that required UAE entities to maintain sufficient “economic presence” within the country in relation to their undertaken activities. However, these regulations were later repealed by Cabinet Resolution No.57 of 2020 in August 2020.

The economic substance requirements are applicable to all UAE onshore and free zone companies, along with certain other business forms that engage in one or more “Relevant Activity” for financial years starting on or after 1st January 2019.

Entities that meet the criteria to be considered “exempt” from economic substance requirements are not obligated to demonstrate economic presence in the UAE. Nevertheless, they must submit a Notification and provide substantial evidence to support their exempt status.

The implementation of economic substance requirements aligns the UAE with other jurisdictions that have recently introduced similar legislation (e.g., Cayman Islands, Bermuda, etc.). This move underscores the UAE’s commitment to addressing concerns related to the shifting of profits from specific mobile business activities to “no or low tax jurisdictions” without corresponding local economic activities.

UAE entities will need to evaluate whether their activities fall under the purview of the economic substance regulations and how to ensure compliance with the economic substance requirements for each Relevant Activity. This assessment involves considering various factors, both qualitative and quantitative, such as operational, financial, tax/transfer pricing, legal, and governance aspects.

What are the Relevant Activities under ESR?

  • Banking activities
  • Insurance activities
  • Fund management activities
  • Financing or leasing activities
  • Headquarters activities
  • Shipping activities
  • Holding companies
  • Intellectual property (“IP”) holding or exploitation
  • Distribution of goods purchased from foreign connected persons
  • Provision of services to foreign connected persons

Requirements to be met by entities in the UAE.

UAE entities that engage in a Relevant Activity and earn income during a financial year must demonstrate the performance of “Core Income Generating Activities” (CIGAs) in the UAE by fulfilling the following conditions:

  • The entity and Relevant Activity are “directed and managed” from the UAE, which involves holding and documenting board meetings in the UAE, having UAE-based managers and/or directors, among other factors.
  • The entity must have an adequate number of qualified employees, premises (such as office space), and annual operating expenditures in the UAE relative to the specific activity undertaken.

An entity can be involved in multiple Relevant Activities simultaneously, and in such cases, it must satisfy the economic substance requirements for each Relevant Activity separately.

The economic substance requirements differ depending on the nature of the Relevant Activity being carried out. For instance, pure holding companies have less stringent economic substance requirements, whereas additional requirements apply to “high-risk” intellectual property (IP) related activities.

What needs to be reported by companies?

UAE entities engaged in a Relevant Activity must submit an annual notification within six months after the end of their financial year. The notification should indicate whether they conducted a Relevant Activity during the financial year and whether any income from that activity was subject to taxation outside the UAE. Even if UAE entities qualify for an exemption from the Regulations or did not earn income from their Relevant Activity in a specific financial period, they are still required to submit a notification.

Furthermore, UAE entities undertaking a Relevant Activity and earning income from it must also file an annual economic substance report. This report includes a self-assessment to determine whether they met the economic substance requirements. It should be supported by relevant information such as the income earned from the Relevant Activity, details about the number and qualifications of staff involved, and information about the premises and other assets used in conducting the Relevant Activity.

When do companies need to do the ESR notification and filing?

For existing entities, compliance with the regulations must begin from the start of their financial year that commences on or after 1st January 2019. Their first report will be due 12 months after the end of their financial year, which is likely to be 31st December 2020 in many cases.

As for new entities, they must adhere to the regulations starting from the commencement of their financial year. Their first report will be due 12 months after the end of their financial year.

Penalties associated with non-adherence.

Aside from sharing information with foreign authorities, non-compliance with the regulations would lead to administrative penalties. The first year of failure to comply would result in a penalty of AED 50,000, which would increase to AED 400,000 in the subsequent consecutive year(s) of non-compliance, subject to a limitation period of six years. Moreover, additional penalties such as suspending, revoking, or not renewing the trade license of the UAE entity could also be imposed. At ATC Group, our team is well versed with the ESR laws and regulations and can guide your company to complete the ESR assessment, ESR notification and ESR reporting effectively and avoid penalties.

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