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The UAE’s Economic Substance Regulations (ESR) have gained momentum again. While not a tax, the rules aim to determine that entities undertaking ‘relevant activities have adequate ‘economic substance’ in the UAE, are directed and supervised, and have adequate assets, resources and qualified people in the UAE.

 Recently, significant changes were made to the ESR through Cabinet resolution No. 57 of 2020 and ministerial decision 100 of 2020. The amended ESR is a positive development. UAE businesses should take note of the amendments to reassess the implications and where they stand on compliance.

 Extends the scope

The amended ESR covers juridical persons or unincorporated partnerships, while ‘natural persons’ possibly including sole proprietors, trusts and foundations are now excluded. Four categories of licensees have been specifically exempted from the ESR covering (a) investment funds, (b) a licensee that is tax resident in a foreign jurisdiction, and (c) a UAE branch of a foreign entity if the branch’s income is taxed in a foreign jurisdiction. The exempt category also includes entities wholly-owned by UAE residents/ nationals and are not part of a multinational group provided it carries out business in UAE. This is a big relief for local businesses. All exempted licensees are required to submit only the ESR notification along with prescribed documents on an annual basis.

 Clarity has also been provided on businesses with multiple branches within the UAE, for foreign branches of a UAE entity, and for entities that undertook the ‘relevant activities’ but did not earn any income.

 Among other changes, ESR now covers purchasing of goods from a foreign-connected person as well as the reselling of such goods. Under the original ESR, coverage under the D & SC business required (a) purchasing of goods from a foreign-connected person; (b) importing and storing those goods in the UAE; and (c) reselling the outside the country. With the removal of conditions (b) and c), purchasing of goods from foreign group companies for international distribution typically referred to as “bill to-ship to” transactions, or for local distribution within UAE, would trigger ESR compliance. Mother welcome change is the introduction of a concept of ‘group’ to identify foreign-connected person and link it with the requirements to prepare consolidated financial statements.

Resubmission necessary

A landmark change is the appointment of the Federal Tax Authority (FTA) as the ‘National Assessing Authority’. In addition to VAT and excise tax, the FTA will undertake assessments to determine compliance with economic substance tests by the entities. The FTA will also be responsible for administrative penalties, appeal processes and other prescribed functions. An online portal will be launched by the Ministry of Finance for submission of ESR notification/reports and other documents. Businesses will have to resubmit ESR notifications submitted earlier. The new deadlines for the resubmissions are yet to be announced by the authorities as on date.

 ESR notifications and reports should be submitted within six-and 12 months respectively, calculated from the end of the financial year of the company, which is typically December, March or June. It has been clarified that the board members (or equivalent) of the business need not be UAE residents, but must be physically present in UAE when taking strategic decisions. Increased and stringent penalties for non-compliance could range from Dh20,000 to Dh50,000, further increasing to Dh400,000 and possible cancellation/suspension of trade license. Considering that limited time is available to prepare a detailed ESR report and submit/resubmit ESR notification, it is strongly recommended that businesses reassess the implications under the amended ESR.

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News Courtesy : Gulfnews

Background

The UAE introduced economic substance requirements for certain businesses on 30 April 2019 by way of Cabinet of Ministers Resolution No.31 of 2019 concerning Economic Substance Regulations (“the original ES Regulations”). Guidance on the application of the original ES Regulations was issued on 11 September 2019 pursuant to Ministerial Decision No. 215 of 2019 (“Guidance”).

On 10 August 2020, the UAE Cabinet of Ministers issued Cabinet Resolution No. 57 of 2020 (the “amended ES Regulations”) which repeals and replaces the original ES Regulations, along with updated Guidance clarifying the amended ES Regulations (Ministerial Decision 100 of 2020 dated 19 August 2020). In addition, the UAE MoF has updated the information on its dedicated economic substance website (link here).

The amended ES Regulations apply from 1 January 2019 and introduce important changes to the scope and administration of the economic substance regime in the UAE, which are discussed below. 

Critical changes in the amended ES Regulations

The amended ES Regulations introduce a number of important changes:

Definition of a “Licensee”

• The amended ES Regulations only apply to (i) juridical persons (persons with separate legal personality) and (ii) unincorporated partnerships that carry on a relevant activity in the UAE. 
• Natural persons, sole proprietors, trusts and foundations (that were considered as “Licensees” under the original ES Regulations) are no longer in scope of the ES regulations, and therefore do not need to file a notification or meet the Economic Substance Test.
• The amended ES Regulations also clarify the treatment of UAE and foreign branches (see page 4). 

Applicable exemptions

• The amended ES Regulations introduce the following exemptions:
• Entities that are tax resident outside the UAE
• Investment Funds
• Entities that are wholly owned by UAE residents and that (i) are not part of a multinational group, and (ii) only carry out business activities in the UAE
• UAE branches of a foreign head office / parent whose relevant income is subject to tax in the jurisdiction of the foreign head office / parent
• Exempt entities must (i) file a notification and (ii) provide sufficient documentary evidence to substantiate and benefit from their exempt status.

Ad 1) The UAE entity will need to submit a tax residence certificate or other documentation issued by the tax authority in the foreign jurisdiction in which it claims to be a tax resident, evidencing that it is treated as a locally tax resident entity in that foreign jurisdiction.

Ad 2) The Investment Fund exemption applies to the Investment Fund as well as any UAE entities used by the Investment Fund to make or hold investments but does not extend to the entity(is) in which the Investment Fund ultimately invests. 

Ad 3) The term UAE residents refers to either (i) UAE citizens or (ii) individuals holding a UAE residency visa who reside in the UAE.

Ad 4) Subject to further guidance, we would expect that the “subject to tax” test is met where the income of the UAE branch is included in the taxable income of the foreign head office / parent, irrespective of whether the foreign head office / parent can claim a branch profit exemption under a double tax treaty with the UAE or under the domestic tax law of the jurisdiction of the foreign head office / parent.  

• Entities directly or indirectly owned at least 51% by the UAE government are no longer specifically exempted under the amended ES Regulations. Such entities may (where applicable), however, benefit from any of the newly introduced exemptions set out above.

Changes to the definition of certain “Relevant Activities”

Distribution and Service Centre Business

• The scope of the “Distribution and Service Centre Business” has been expanded such that:
  • There is no longer a requirement for the goods to be imported and stored in the UAE for an entity to be considered a “Distribution and Service Centre Business”.
  • There is no longer a requirement for services to be provided “in connection with a business outside the State”, resulting in any service provided to a foreign related party to be considered a “Distribution and Service Centre Business”.

High Risk Intellectual Property Licensee

• The definition of a High-Risk Intellectual Property Licensee has been limited to an intellectual property business that meets all of the following conditions:
• The business did not create the intellectual property asset.
• The business acquired the intellectual property asset from either:
  • a Connected Person, or
  • in consideration for funding research and development by another person situated in a foreign jurisdiction; and
• The business licenses or has sold the intellectual property asset to a Connected Person or earns separately identifiable income from a Foreign Connected Person in respect of the use or exploitation of the intellectual property asset.

Changes to the definition of a “Connected Person” and introduction of a definition of a “Group”

• The amended ES Regulations define a Connected Person as an entity that is a part of the same Group as the Licensee or the Exempted Licensee. 
• A Group is 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”.

Administration 

• The UAE Federal Tax Authority has been appointed as the Assessing Authority for the ES Regulations. In this capacity, the FTA will be responsible for assessing and enforcing compliance of UAE businesses with the Economic Substance Test.
• The Regulatory Authorities’ primary responsibility is the collection and verification of information regarding their Licensees and assisting the FTA in carrying out its role as National Assessing Authority. 

Exchange of information

• The amended ES Regulations provide that the Ministry of Finance (as Competent Authority) will exchange information with Foreign Competent Authorities on Licensee that claim to be exempt from the ES Regulations on the basis of: 
  • being tax resident outside the UAE; or
  • being a UAE branch of a foreign entity, whose income is subject to tax outside of the UAE.

Critical areas clarified in the updated guidance

The updated Guidance provides further clarifications on the application of the amended ES Regulations. Included below is a summary of critical clarifications that were not addressed in the previous guidance and/or Relevant Activities Guide.

Treatment of branches

• As branches do not have separate legal personalities from their “parent” or “head office”, they are not regarded as “Licensees”. 
• The Guidance clarifies how branches and their “parent” or “head office” are required to comply with the ES Regulations:
  • UAE branch of a UAE business: The UAE business must file a single notification and (if applicable) an Economic Substance Report to report the relevant activities of itself and all its UAE branches.
  • UAE branches of a foreign business: The UAE branch is not subject to the ES Regulations if its relevant income is reported in the tax return of the foreign parent / head office.
  • Foreign branch of a UAE business: The UAE business does not need to report (and demonstrate economic substance in the UAE related to) the relevant activities of its foreign branch, provided that the foreign branch is subject to tax on its relevant income in the foreign jurisdiction.

Notification filings

• The amended ES Regulations confirm that notifications must be filed electronically on the Ministry of Finance Portal within six months of the Licensees financial year end. 
• Similarly, businesses that already submitted a notification to their Regulatory Authorities will be required to re-submit their notification on the Ministry of Finance portal after it goes live. The guidance does not confirm a deadline for this resubmission. 
• For businesses that are required to file a notification before the portal is available it may be reasonable to anticipate that the deadline for such filings is postponed until the portal goes live. 

Other clarifications

• Gross income means all income from whatever source derived, without deducting any type of costs or expenditure.
• A Licensee is not required to perform all the Core Income Generating Activities (“CIGAs”) listed in the ES regulations for a particular relevant activity. However, any of the CIGAs that generate relevant income must be performed in the UAE.
• The board members (or equivalent) are not required to be resident in the UAE. However, the board members (or equivalent) are required to be physically present in the UAE when taking strategic decisions.
• A Licensee may outsource activities which are not CIGAs to parties outside the UAE, such as back office functions, IT, payroll, legal services, or other expert professional advice or specialist services provided.

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Companies in the UAE are expected to ensure their compliance with the new Economic Substance Regulations (ESR), and failure to do so will invite hefty penalties. Amid a number of financial challenges came with the Covid-19 pandemic, adhering to the UAE’s new ESR is now a mandatory and another reality for businesses to operate in the country.

Aimed at facilitating build business transparency, the UAE introduced ESR on April 30, 2019, and issued the guidance on the application of the regulations on 11 September 2019. The regulations require companies and other business forms registered in the UAE that carry on one or more “Relevant Activities” (together, “Relevant Activities”), to have economic substance in the UAE in relation to these activities, and to comply with notification and return filing obligations.

The ESR has been introduced to facilitate and cooperate with governments of high tax jurisdictions. The ESR is not a source of income and there will be no monetary or financial implications like VAT and excise tax as introduced in the UAE on January 1, 2018.

The objective for introducing ESR is to avoid shifting of profits from high tax jurisdictions to low or no tax jurisdictions. ESR has been implemented to tax heaven countries such as BVI, Cayman Islands, Jersey, Bermuda, Bahrain etc. to cooperate with high tax jurisdictions countries where corporate taxes should have been paid for transactions where economic substance would not be present in the UAE. ESR shall ensure that profits are taxed where economic activities are performed and where actual value is created.

ESR is applicable to NINE relevant activities and substance over form approach shall be applicable while assessing and identifying the applicability of relevant activities. The nine listed activities are Insurance, Banking, Investment Fund Management, Lease-Finance, Headquarters, Holding Company, Shipping, Intellectual Property Business, and Distribution & Service Centre Business.

ESR Compliance shall be performed in 3 phases: Phase 1: Identification and assessment of Relevant Activity & submission of Notification; Phase 2: Action Plan to meet Economic Substance Test (Assess whether business meet; compliance requirements and Substance Test); and Phase 3: Reporting to Relevant Authority.

Distribution & Service Centre, one of the relevant activities of ESR shall cater to plethora of Companies in UAE. Since UAE is strategically located globally, which provides access to companies to trade in or outside the UAE and procuring the goods from the manufacturing plant outside UAE which is mainly foreign connected companies of the UAE based Entity. Such kind of transactions would tantamount to applicability of Distribution & Service Centre Relevant Activity.

The Economic Substance Test requires a Licensee to demonstrate that: the Licensee and Relevant Activity are being directed and managed in the UAE; the relevant Core Income Generating Activities (CIGAs) are being conducted in the UAE; and. the Licensee has adequate employees, premises and expenditure in the UAE.

The biggest challenge in ESR Compliance is to identify income from core income generating activities. Core Income Generating Activity must be conducted in UAE to substantiate the economic substance test in UAE. Other challenge is to prove that the Entity is being managed and directed in the UAE which is also required to substantiate the economic substance test.

Companies must assess all the transactions cautiously and vigilantly to identify the relevant activities and must follow substance over form approach while making the assessment of relevant activities. Understanding of Corporate structure, Business Model and then finally identify the applicability of Relevant Activity are the pre-requisites to file the ESR Notification. The deadline for filing ESR Notification was June 30, 2020 for most of the Free Zones and Mainland Companies for the reportable period January 01 to December 31, 2019. There are few free zones which has extended the deadline to July 31, 2020.

All the licensees need to comply with return filing obligations if income from the relevant activity is earned during the reportable period. It is imperative for the licensees to calculate the income and prepare the financial statements to compute the operating expenditure, net profits, assets held by the Licensee with respect to relevant activity only.

The compliance is indispensable and records and details to be maintained for each reportable period. Non-compliance of Economic Substance Regulations shall not only result in monetary penalties but could also lead to suspension, revocation of the license which can lead to major disruptions.

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