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The United Arab Emirates (UAE), honoring its commitment as a member of the OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS), introduced the Economic Substance Regulations (ESR) in 2019. These regulations aim to prevent multinational companies operating in the UAE from evading taxes in their home countries. By implementing ESR, the UAE strives to avoid being blacklisted as ‘non-cooperative’ by the EU, thereby promoting a fairer and more transparent business environment.
According to the ESR, UAE onshore and free zone companies, as well as certain other business forms involved in specified “Relevant Activities,” must sustain and demonstrate sufficient economic presence in the UAE. This is known as the “Economic Substance Test.” This blog post will provide an overview of ESR, highlighting its benefits, penalties, and guidance on ensuring compliance.
What is the Economic Substance Regulations (ESR) in UAE?
The Economic Substance Regulations (ESR) in the UAE are a set of business taxation rules introduced in 2019 to ensure that UAE-based entities engaging in certain business activities maintain adequate economic presence within the country. These regulations are part of the UAE’s commitment to the OECD Inclusive Framework on Base Erosion and Profit Shifting (BEPS), aiming to prevent multinational companies from using the UAE as a base to evade taxes in their home countries.
Under ESR, UAE onshore and free zone companies, as well as other specified business forms conducting “Relevant Activities” (such as banking, insurance, investment fund management, lease-finance, headquarters, shipping, holding company, intellectual property, and distribution and service centers), must meet the “Economic Substance Test.” This test requires entities to demonstrate substantial activities in the UAE, including having sufficient staff, premises, and expenditures relative to the activities undertaken.
The UAE’s Economic Substance Regulations (ESR) appoint the Federal Tax Authority as the National Assessing Authority. This authority is responsible for determining whether entities meet the Economic Substance Test and for issuing penalties for any violations of the amended ESR. Adhering to these regulations is crucial for the UAE to avoid being labeled as a ‘non-cooperative’ jurisdiction by the EU, thereby promoting a fairer and more transparent business environment. Failure to comply can lead to substantial penalties and other regulatory actions.
Benefits of Compliance with Economic Substance Regulations (ESR)
Compliance with the Economic Substance Regulations (ESR) in the UAE offers several key benefits for businesses:
Enhanced Reputation: Adhering to ESR demonstrates a commitment to international tax standards and corporate governance, enhancing the company’s reputation among global stakeholders and business partners.
Avoidance of Penalties: Compliance helps businesses avoid significant financial penalties, administrative sanctions, and other legal consequences that arise from non-compliance with ESR requirements.
Business Continuity: Meeting ESR requirements ensures smooth and uninterrupted business operations by avoiding potential disruptions caused by regulatory scrutiny or sanctions.
Market Access: By complying with ESR, companies can maintain and expand their access to international markets, as non-compliant jurisdictions may face restrictions or blacklist by other countries or economic blocs like the EU.
Investment Attraction: Compliance with ESR can attract foreign investment, as investors prefer jurisdictions that adhere to international tax standards and provide a stable and transparent regulatory environment.
Tax Planning and Efficiency: ESR compliance can lead to more efficient tax planning and better management of tax risks, helping businesses optimize their tax positions while adhering to legal requirements.
Alignment with Global Standards: By complying with ESR, businesses align themselves with global best practices in economic substance and tax transparency, contributing to a fairer international tax system.
Regulatory Confidence: Demonstrating compliance with ESR instills confidence in regulatory authorities, reducing the likelihood of audits and inspections, and fostering a cooperative relationship with regulators.
Overall, compliance with ESR not only helps businesses mitigate risks and avoid penalties but also positions them favorably in the global marketplace, fostering long-term growth and sustainability.
Who Has to File ESR in the UAE?
In the UAE, compliance with Economic Substance Regulations (ESR) mandates specific entities to file notifications and reports. These entities include:
Onshore Companies
Onshore companies are entities incorporated or registered under UAE mainland jurisdiction. These companies operate under the federal laws of the UAE and are subject to ESR requirements if they conduct any of the defined Relevant Activities. Compliance ensures these entities demonstrate adequate economic substance in the UAE, aligning with international tax standards and avoiding penalties.
Free Zone Companies
Free Zone companies are entities incorporated or registered in any of the UAE’s free zones, including financial free zones such as the Dubai International Financial Centre (DIFC) and Abu Dhabi Global Market (ADGM). These zones offer various business incentives, including tax exemptions and 100% foreign ownership. However, companies operating in these zones must comply with ESR if they engage in Relevant Activities. Filing ESR notifications and reports is crucial to demonstrate that they maintain a substantial economic presence within the UAE.
Other Business Forms
Other business forms include a range of entities such as branches, representative offices, and partnerships that engage in Relevant Activities.
Branches: These can be branches of foreign companies operating in the UAE. They must comply with ESR to show that their UAE operations have sufficient economic substance.
Representative Offices: While these offices primarily engage in marketing and liaison activities, they must file an Economic substance notification if they conduct a Relevant Activity.
Partnerships: Various forms of partnerships, including general and limited partnerships, must adhere to ESR requirements if they are involved in any Relevant Activities.
What are the Relevant Activities to Which Economic Substance Regulations (ESR) Apply
The Economic Substance Regulations (ESR) in the UAE apply to entities engaged in specific business activities known as “Relevant Activities.” These activities are essential to the regulations as entities engaged in them must show significant economic presence in the UAE. The Relevant Activities include:
Banking: Engaging in deposit-taking, lending, and other financial services typically performed by banks.
Insurance: Providing insurance products and services, including life, non-life, and reinsurance activities.
Investment Fund Management: Managing investment funds, including activities such as portfolio management, fund administration, and advisory services.
Lease-Finance: Offering leasing and financing services, including the provision of credit or financing of any kind.
Headquarters: Providing services to group companies, such as managing, coordinating, and overseeing activities.
Shipping: Engaging in the transportation of goods and passengers by sea, including activities like chartering, operating, and managing vessels.
Holding Company: Holding shares or equitable interests in other entities, primarily to earn dividends and capital gains.
Intellectual Property (IP): Holding, exploiting, or managing intellectual property assets, including patents, trademarks, copyrights, and other intangible assets.
Distribution and Service Centre Business: Distributing goods or providing services to entities within the same group, including procurement, storage, and logistics services.
Laws and Regulations Related to Economic Substance Regulations in the UAE
The Economic Substance Regulations (ESR) in the UAE are governed by a comprehensive legal framework designed to ensure that businesses maintain adequate economic presence within the country. This framework includes laws, regulations, and guidance issued by various UAE authorities. Key components of this framework include:
1. Cabinet Resolution No. 31 of 2019
As a foundational mandate for ESR in the UAE, this regulation require UAE onshore and free zone companies, as well as certain other business forms engaged in Relevant Activities to demonstrate a substantial economic presence in the UAE.
The regulation specifies the Economic Substance Test, which includes criteria such as conducting core income-generating activities (CIGAs), maintaining adequate employees, premises, and expenditures, and being directed and managed within the UAE. Additionally, this law identifies the regulatory authorities tasked with administering and enforcing the ESR regulations.
2. Ministerial Decision No. 215 of 2019
Internal audits focus on
This decision provides further clarification and guidelines for implementing the Economic Substance Regulations. It details the procedures for filing ESR notifications and reports, the criteria for assessing compliance, and the penalties for non-compliance.
evaluating and improving the effectiveness of a company’s internal controls, risk management, and governance processes. This helps in identifying operational inefficiencies and areas for improvement.
What is the Economic Substance Test?
The Economic Substance Test is a key requirement under the Economic Substance Regulations (ESR) in the UAE, designed to ensure that entities engaging in specific business activities, known as Relevant Activities, have a substantial economic presence in the UAE. To pass the Economic Substance Test, an entity must meet the following criteria:
1. Core Income-Generating Activities (CIGAs)
Entities must conduct CIGAs within the UAE. Examples include:
Banking: Raising funds, managing risk, and providing loans.
Insurance: Calculating risk, underwriting.
Investment Fund Management: Making investment decisions, and managing risks.
Lease-Finance: Setting terms, acquiring assets.
Headquarters: Managing group activities, and making key decisions.
Shipping: Managing crew, and maintaining ships.
Holding Company: Managing equity participations.
Intellectual Property: R&D, marketing IP.
Distribution and Service Centers: Managing stock, and fulfilling orders.
2. Directed and Managed in the UAE
Entities must demonstrate management presence in the UAE:
Board Meetings: Holding adequate board meetings in the UAE with a quorum physically present.
Minutes: Keeping minutes of these meetings in the UAE.
3. Adequate Employees, Premises, and Expenditure
Entities must have:
Sufficient employees in the UAE.
Adequate physical premises.
Appropriate levels of operating expenditure in the UAE.
Meeting these requirements ensures compliance with ESR and demonstrates substantial economic activity in the UAE.
Filing Requirements and Deadlines for ESR in UAE
The Economic Substance Regulations (ESR) in the UAE mandate specific filing requirements and deadlines to ensure entities demonstrate adequate economic presence. These requirements include:
Annual Notification Form
Who Must File: All entities conducting Relevant Activities must submit an ESR notification, regardless of whether they earned income from these activities during the financial period.
Deadline: Notifications must be filed annually by the deadline set by the relevant regulatory authority. Typically, this is within six months from the end of the financial year.
Economic Substance Report
Who Must File: Entities that earned income from Relevant Activities during the financial period must submit an Economic Substance Report.
Deadline: The report is generally due within 12 months from the end of the financial year. Specific deadlines are provided by the relevant regulatory authority.
Information Required
For the Annual Notification:
Confirmation of whether the entity conducted any Relevant Activities.
Whether income was generated from these activities.
Details of the entity’s financial year.
For the Economic Substance Report:
Detailed information on the Relevant Activities conducted.
Evidence of the core income-generating activities (CIGAs) performed in the UAE.
Information on employees, premises, and expenditures related to the Relevant Activities.
Details demonstrating the entity is directed and managed in the UAE.
What are the Penalties For Evading ESR in UAE
Failure to meet filing requirements or deadlines can result in significant penalties, including:
Financial Penalties: Fines ranging from AED 10,000 to AED 50,000 for the first year of non-compliance, increasing to AED 50,000 to AED 300,000 for subsequent years.
Administrative Sanctions: Potential suspension, revocation, or non-renewal of business licenses.
Public Disclosure: Non-compliant entities may be publicly disclosed, affecting their reputation.
Entities must ensure timely and accurate submission of ESR notifications and reports to avoid penalties and demonstrate compliance with the Economic Substance Regulations in the UAE.
How to Ensure Compliance with ESR?
Ensuring compliance with the UAE’s Economic Substance Regulations (ESR) involves several essential steps. First, identify if your entity engages in Relevant Activities, such as banking, insurance, or investment fund management. Ensure that core income-generating activities (CIGAs) are conducted within the UAE, involving key operational tasks and decision-making processes domestically.
Next, demonstrate substantial economic presence by having an adequate number of qualified employees, maintaining physical premises, and incurring sufficient operating expenditure in the UAE. Ensure your entity is directed and managed in the UAE by holding regular board meetings with a quorum of directors physically present and maintaining detailed meeting minutes.
Fulfill annual filing requirements, including submitting an ESR notification within six months of the financial year-end and an Economic Substance Report within 12 months if income is generated from Relevant Activities. Keep detailed records of CIGAs, employment contracts, lease agreements, and financial statements to demonstrate compliance.
Seek professional advice from qualified tax advisors for tailored guidance and stay updated with regulatory changes by regularly checking official sources like the UAE Ministry of Finance. By following these steps, entities can ensure ESR compliance, avoid penalties, and support a transparent business environment.
Conclusion
Economic Substance Regulations (ESR) is an important regulation that requires UAE businesses to demonstrate an adequate economic presence in the UAE. Businesses must comply with ESR to avoid penalties and reputational damage. Compliance with ESR can also bring benefits, including improved relationships with regulatory authorities and other stakeholders. Businesses must ensure that they comply with ESR by conducting a thorough review of their operations and filing the Economic Substance Report annually.
