Why UAE Needs Economic Substance Regulations

UAE has been a business-friendly country for many years. It made a name in the international space based on its oil and gas industry stronghold. Over a period of time, developments in all industry sectors have made it a favorable destination for investors. One of the key factors that make UAE investor-friendly is its no or low-tax environment.

But companies take advantage of this environment by eroding tax base and shifting profits to UAE. Therefore, OECD implemented a BEPS Project, which aims to correct all the initiatives of tax base erosion and profit shifting employed by companies in such no or nominal tax countries. It is one of the key projects to restrict tax evasion and avoidance.

One of the ways to do that is through economic substance regulations. These regulations require companies to prove enough economic presence in the country in proportion to the profits reported. Thus, it ensures transparency of taxpayer information and a level playing field for all jurisdictions.

Let’s understand more about the ESR regulations in detail:

OECD’s Inclusive Framework on BEPS

Many preferential tax regimes exist around the world. The OECD defines a preferential tax regime as a regime with a nominal or no tax environment or a reduced tax base. It can lead to a benefit for some entities or activities in comparison to other jurisdictions.

Companies worldwide take advantage of such preferential tax regimes by establishing offices in such countries. Either they report the activity as being conducted in such a preferential tax regime or shift their profits. Thus, they have to pay lower taxes and, as a result, benefit from higher actual profits.

UAE is one of such preferential tax regimes.

The OECD has been taking appropriate steps to control such practices by companies. One of them is asking countries to commit to the Inclusive Framework on BEPS. One of the standards of this framework, Action 5, is maintaining a sufficient economic presence in the country.

Moreover, members are required to participate in reviews to check if their taxation rules damage other jurisdictions’ tax bases. The OECD’s Forum on Harmful Tax Practices (FHTP) conducts such assessments. It reviews the companies’ substantial economic substance in the country where they have their core operations.

In addition to proving their economic substance, countries must also exchange this information with foreign competent authorities. The data is exchanged only if some company fails to prove their economic substance or is subject to tax in other countries.

OECD’s progress report on harmful tax practices in preferential tax regimes of January 2022 rates UAE as not dangerous. It states that UAE’s domestic regulations for economic substance align with the expected standards. Let’s look at the economic substance regulations of UAE.

UAE’s Economic Substance Regulations

In regards to these expectations from OECD, UAE became a member of the Inclusive Framework on BEPS. As a member of the framework, UAE must implement four action points, one of which is Action 5 – Countering Harmful Tax Practices. Along with this, the UAE must share its information with other jurisdictions and update DTAAs.

As per the Action 5 of the BEPS Project, UAE introduced the Economic Substance Regulations in 2019. These regulations prove the country’s commitment to complying with fair tax practices. Also, these regulations removed UAE from the blacklist of ‘non-cooperative jurisdictions for tax purposes’ of the European Union (EU).

The Cabinet of Ministers Resolution No. 57 of 2020 concerning Economic Substance Requirements of August 10, 2020, is the latest regulation. It revoked and repealed Cabinet of Ministers Resolution No. 31 of 2019. The Ministerial Decision 100 of 2020 ESR Guidance and Relevant Activities Guide of August 19, 2020, provides more details for implementing the regulation.

As per the regulations, a licensee is required to:

File and submit an annual Notification within six months from the end of the relevant financial period
File and submit an Economic Substance Report within 12 months from the end of the relevant financial period
Meet Economic Substance Test to show that it is tax-resident in UAE, the relevant activity is being directed and managed in UAE, the relevant Core Income Generating Activities (CIGAs) are being conducted in UAE, and the licensee has enough people, expenditure, and premises in UAE

The relevant activities include:

Banking
Insurance
Shipping
Lease finance
Intellectual property (IP)
Fund management
Distribution and service centres
Headquarters
Holding Company

These reports include all information on the licensee, such as the relevant activity, income earned from it, expenses spent on it, assets, and financial statements. Companies are also required to divulge information on employees working on the relevant activity. They must submit all this information to the relevant authority before deadlines in correct formats.

The licensees that are exempt from ESR are:

A licensee that is an investment fund
A licensee, which is a tax resident in a jurisdiction other than UAE
A licensee that is a branch of a foreign firm whose relevant income is subject to tax in a jurisdiction other than the UAE
A licensee wholly-owned by one or more residents of UAE is not a part of an MNE Group and operates in UAE only
Any other licensee as defined by the Ministry of Finance

But the exempted licensees are not entirely exempted from complying with these regulations. They need to prove that it is exempted with relevant proof documents and notify the relevant authority.

Conclusion

Thus, the comprehensive and standard Economic Substance Regulations of the UAE show its commitment to eliminating harmful tax practices from its jurisdiction. By proving their economic activity in proportion to the actual profits reported in the UAE, it complies with OECD’s framework. Thus, it preserves its reputation as a hub for international business.

If you find it difficult to understand these regulations or seek further advice on any provisions, UAE ESR is the place to be. UAE ESR provides advisory services and ESR Notification services to clients in the UAE. We offer full support to companies to ensure that they comply with the national ESR regulations.

We also help you fill in the details of relevant forms and templates and submit them to relevant competent authorities. You can also consult us to know your eligibility for economic substance regulations. Whatever work you have related to ESR, you know UAE ESR can do it for you to make your life easier.

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