A guide to economic substance regulations in the UAE

The Economic Substance Regulations (ESR) were introduced in the United Arab Emirates (UAE) in April 2019 to comply with the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) initiative. The ESR in the UAE require certain companies to demonstrate that they have a substantial economic presence within the UAE, and that they are conducting real business activities rather than just being used as a vehicle for tax evasion or avoidance.

Under the ESR in Dubai, Abu Dhabi and the wider UAE, companies are required to submit annual notifications and economic substance reports to the relevant regulatory authority. The regulations apply to companies engaged in specified activities, including banking, insurance, investment fund management, lease-finance, headquarters, shipping, holding companies, intellectual property, and service centre businesses.

Companies that fail to meet the economic substance requirements may face penalties, including fines and the potential loss of their UAE tax residency status. The regulations are aimed at enhancing transparency, fairness, and compliance in the UAE's tax system and promoting economic growth and diversification.

What is the OECD BEPS initiative?

The OECD BEPS initiative is a comprehensive plan developed by the Organisation for Economic Co-operation and Development (OECD) to address concerns about base erosion and profit shifting (BEPS). BEPS refers to tax planning strategies used by multinational companies to shift profits to low-tax jurisdictions, thereby reducing their overall tax liabilities.

The BEPS initiative aims to create a more coordinated and coherent international tax system, ensuring that multinational companies pay their fair share of tax in the countries where they conduct business. The initiative includes a range of measures, including changes to international tax rules, guidelines on transfer pricing, and recommendations on the design of tax policies and treaties.

The BEPS initiative has been endorsed by more than 135 countries and jurisdictions, including both developed and developing economies. Its implementation is intended to promote greater transparency and consistency in international tax practices, reduce opportunities for tax avoidance, and strengthen the ability of countries to raise revenue for public services and investments.

The UAE's participation in the BEPS initiative helps to enhance its reputation as a responsible and compliant jurisdiction, which will help to attract further foreign investment and promote economic growth. By aligning its tax practices with international standards, the UAE is demonstrating its commitment to being a reliable and stable partner for businesses.

What is the scope of the Economic Substance Regulations in the UAE?

The UAE's Economic Substance Regulations (ESR) apply to both UAE onshore and freezone companies.

This includes offshore companies and holding companies, although holding companies will have reduced substance requirements and will not be expected to be directed or managed from the UAE.

Branch offices are considered as extensions of a parent company. As such separate reports are not necessary and the head office will be responsible for submission of a single report including the activities of any of the branches associated with it.

The regulations apply to all of the aforementioned businesses conducting the following activities:

1. Banking businesses
2. Insurance businesses
3. Investment fund management businesses
4. Lease-finance businesses
5. Headquarter businesses
6. Shipping businesses
7. Holding company businesses
8. Intellectual property businesses
9. Service centre businesses

Companies engaged in any of the above activities are required to meet the economic substance test, which means they must demonstrate that they are carrying out real business activities in the UAE and that they have a sufficient level of economic substance in the country. This includes having an adequate number of qualified employees, appropriate physical assets, and conducting core income-generating activities in the UAE. Determining what adequate substance is will depend on the nature of the activities carried out and the level of income that the licensee derives from it. The Federal Tax Authority (FTA) will use an Economic Substance Test to make appropriate regulations on a case-by-case basis and will also take into consideration that the level of activity of a licensee may fluctuate over the course of a financial period.

The purpose of the UAE ESR is to ensure that companies are not simply being used as vehicles for tax evasion or avoidance but are genuinely operating in the UAE and contributing to its economy.

In order to successfully establish a company or obtain a commercial licence in Dubai or Abu Dhabi, the UAE ESR needs to be considered, should the UAE company registering, fall under a relevant regulated activity.

How can a business demonstrate substance and how will the ESR be enforced?

In order to demonstrate sufficient substance, the licensee of a business will have to carry out an economic substance test showing that management or directorship for activity being carried out is in the UAE and that the applicable Core Income Generating Activities (CIGAs) are conducted in the UAE. The licensee will also be expected to demonstrate that the business has sufficient staff, premises and expenditure in the UAE.

The Federal Tax Authority (FTA) is the governing body responsible for enforcing UAE ESR compliance and ascertaining whether a company meets its economic substance obligations. However, the responsibility as to whether a business is subject to the regulations lies entirely with the business itself. It cannot rely on regulatory authorities to inform it of its obligations. Any hearing appeals or issuance of penalties will also be handled by the FTA.

Distribution and Service Centre Business

One key activity that applies to a lot of companies that have multiple entities in other jurisdictions, is the Distribution and Service Centre Business activity. This activity can include companies selling services and management fees from their UAE entity to other companies within the same group globally. The UAE company/subsidiary or branch must demonstrate adequate substance in order to justify placing revenue/profit in that entity – which may have a lower tax rate applied to it.

Key points for the Distribution and Service Centre Business activity are as follows:

1. The storing and transporting of ready-for-sale goods, components and materials
2. Inventory management
3. Taking orders
4. Providing consultation, administration and management services

The Ministry of Finance is the authority for handing and submitting ESR reports, notifications and assessments for mainland and Freezone companies in the UAE.

Who is exempt from the regulations?

Certain individuals and entities are exempt from having to demonstrate economic substance or filing an economic substance report. These are:

• A licensee that is a tax resident outside the UAE
• An investment fund and its underlying SPVs/holding entities
• A wholly UAE resident owned business that’s not part of a multinational group and only conducts business within the UAE
• A foreign branch that’s subject to tax in a foreign jurisdiction

In order to demonstrate exemption based on one of the above circumstances, evidence must be submitted to the FTA alongside a notification form.

FAQs

1. Are businesses below a certain income level exempt from the economic substance regulations?

No, there’s no minimum income threshold. Any licensee carrying out a relevant activity is required to submit a notification and file an economic substance report.

2. If all my income from the relevant activities is earned outside the UAE, am I still subject to the economic substance regulations?

Yes, any income from a relevant activity, whether generated inside or outside the UAE, is subject to economic substance reporting. 

3. Do the activities on my commercial license determine whether I carry out a relevant activity?

Your commercial license may indeed reference one of the relevant activities. However, this is not always the case. You should look beyond the activities stated on your commercial licence and give consideration as to whether any of your commercial activities match the FTA’s relevant activity list. That being the case, you’ll still be required to comply with the regulations.

4. How can I determine the financial period for the purposes of economic substance?

Your financial period should match up to the period in which financial statements are prepared. This may mean that newly incorporated companies may have slightly longer or shorter first financial period.

5. What happens if a company does not submit an ESR report?

If the company does not submit an ESR report annually, then they will not be able to renew their trade licence. ESR assessment and report is now a requirement for Mainland Department of Economic Development (DED) companies, and all Freezone companies in the UAE. Companies need to ensure they have done their ESR assessment, report, notification (as well as the mandatory UBO submissions), otherwise, they will not be able to renew their Trade Licence / Commercial Registration. Delays in submissions and expired licences will incur fines. For assistance on ESR reporting, UBO submissions and Trade Licence renewals for your company in Mainland UAE or Freezone please contact a member of the Sovereign PPG team who can assist you.

How can Sovereign PPG help?

Sovereign PPG can advise you on your ESR obligations in the UAE and guide you through all the subtleties within the regulations. We can help you prepare your ESR report in the UAE and ensure that you are fully compliant with all UAE government regulations.

If you need assistance with any issues pertaining to economic substance regulations in the UAE, or for any other related company setup, restructuring, local partner or PRO support matter in Abu Dhabi, Dubai, the wider UAE, Oman, Qatar or KSA, then please do get in touch with us on +971 (0)4 456 1761 for Dubai or +971 (0)2 448 5120 for Abu Dhabi, email us at SovPPG@SovereignGroup.com or complete the contact form below and we will be delighted to assist you.