UAE Economic Substance Regulations Updated

The economic substance requirements (“ESR”) were introduced by the United Arab Emirates (“UAE”) in April 2019. On the 10th of August 2020, the UAE introduced significant changes to the ESR regulations under the Cabinet of Ministers Resolution No.57 of 2020, which amends and repeals the previous resolutions. New guidelines have been issued by the Ministry of Finance by way of Ministerial Decision No. 100 of 2020, providing a new legal framework for the ESR in the UAE.

What Are Economic Substance Regulations in the UAE?

Economic Substance Regulations in the UAE—or ESR—were introduced as a means of ensuring the country’s compliance with international initiatives to combat unlawful avoidance, evasion, and other harmful tax practices. In a country where low or no corporate taxes used to be enforced, this measure attests to the government’s will to keep up with international standards. Under the requirements of ESR, certain legal entities must be able to demonstrate that the economic activities they are carrying out in the jurisdictions in question qualify as “substantial economic activities”. An Economic Substance Test serves to verify their claims.

The UAE enacted the Economic Substance Regulations in response to the European Union’s review of the country’s tax reporting framework. These regulations aim to ensure UAE-based entities report actual profits that align with their economic activity in the country. The regulations also enhance transparency and demonstrate the UAE’s commitment to global tax standards, preventing base erosion and profit shifting.

Company registration in the UAE is a convenient and beneficial process for foreign entrepreneurs. That being said, every rule needs to be understood and observed, be it the most recent updates to the ESR, the introduction of corporate tax in the UAE, or changes made to company law.

Any legal entity or unincorporated partnership carrying out a “relevant activity” is required to take Economic Substance Regulations into account. The relevant activities under the regulations are:

• Insurance
• Banking
• Lease-finance
• Investment fund management
• Shipping
• Headquarters
• Intellectual property
• Holding companies
• Distribution and service center

The list of relevant activities is subject to change reported in the Economic Substance Relevant Activities Guide issued by the Ministry of Finance.

Economic Substance Regulations in the UAE: The Key Changes

The key changes introduced by these new ESR regulations can be summarized as follows:

• Definition of a “Licensee”: The definition has been amended to be limited to juristic persons and unincorporated partnerships registered in the UAE, whether by way of commercial/trade license or other form of permit, that carry out a relevant activity in the UAE. This includes offshore companies incorporated in Ras Al-Khaimah International Corporate Center (“RAKICC”) and Jebel Ali (JAFZA) Offshore Authority. On another note, natural persons, sole proprietorships, and other business forms that are not juridical entities are no longer within the scope of the ESR regulations.
• Exempted entities: UAE companies that are majority (51% or more) owned by the UAE government are no longer exempt from the ESR. In addition, an updated list of exemptions has been issued that includes the following categories:
  1. 1. UAE companies that are tax resident outside of the UAE;
  2. 2. Investment Funds
  3. 3. UAE entities wholly owned by a UAE resident that are not part of a multinational group, and that only carry out business activities in the UAE;
  4. 4. UAE branches of a foreign company if the relevant income of the branch is subject to tax in the foreign jurisdiction.

To claim an exemption under any of the aforementioned grounds, the licensee must file a notification and provide sufficient documentary evidence to show that it meets the requirements of the relevant exemption category for each financial year in which it claims to be exempt.
• Relevant activities: Updates and clarifications were made in relation to the definitions of several relevant activities, including high-risk intellectual property (IP) businesses, and distribution and service center businesses.
• National Assessing Authority: The UAE Federal Tax Authority (“FTA”) has been appointed as the National Assessing Authority for the purposes of the ESR regulations. In this capacity, the FTA will be primarily responsible for assessing whether a Licensee has met the requirements of the economic substance test during the relevant period and levying penalties in cases of non-compliance. The regulatory authorities governing onshore, freezone and offshore jurisdictions such as RAKICC and Jebel Ali (JAFZA) Offshore will continue to be responsible for the collection and verification of information regarding their Licensees and shall assist the FTA in carrying out its role as the National Assessing Authority.
• Notification and ESR Reports: Moving forward, notifications and ESR reports shall be filed via the Ministry of Finance Portal, once available. Notifications must be filed within six months from the Licensees and/or exempted Licensee’s financial year-end. The deadline for ESR reports for the financial year 2019 remains set on the 31st December 2020.
• Penalties: A new regime of penalties has been introduced with fines up to AED 400,000, including suspensions and nonrenewal of trade licenses.

Following the introduction of these new ESR regulations, any UAE business falling within the definition of Licensee should re-assess its position to determine whether these changes might have an impact on their ESR approach, and ultimately undertake the necessary steps to comply with the ESR in the UAE, including filing a new notification and ESR report with the authorities when the assessment for financial year 2019 has changed under the new ESR regulations.

For further information about the updated ESR in the UAE, please visit https://www.mof.gov.ae/en/StrategicPartnerships/Pages/ESR.aspx

UAE Free Zones – The Key for Fulfilling Economic Substance Requirement

Incorporating in the UAE offers leverage to foreign businesses to keep up with the requirements of tax authorities for economic substance through its free zone (FZ) structures. Businesses of any size can now take the opportunity to locate their business functions in the UAE and benefit from substantial tax savings while satisfying the criteria for economic substance.

The increasing number of double tax treaties have reinforced anti-avoidance provisions, vanquishing brass plate companies off the face of the UAE. The tax authorities are taking stringent measures to downright exercise central management and control so that they can determine whether an organization is taxable. In addition, they are evaluating the economic grounds behind each organization, especially in countries that are labeled as a low or no-tax country.   The anti-avoidance legislation helps tax authorities in discerning transactions that don’t have sufficient commercial substance or are incorporated to get a more favorable tax position without bona fide reasons. The Organisation for Economic Co-operation and Development (OECD) endorses domestic anti-avoidance stipulations that are designed to take precedence over double-tax treaties.

Anti Avoidance Provisions

A common anti-avoidance clause that is included in double tax treaties is the beneficial ownership requirement. It has always been perceived that the person or entity receiving dividends, royalties, and interest is the beneficial owner. However, a new approach has been developed in which nominees and agents are no longer considered eligible to be the beneficial owners of received income. The OECD commentary to the model tax treaty has presented only a few examples of circumstances where the recipient of income is not considered the beneficial owner. For determining whether a recipient is the beneficial owner under circumstances other than being a nominee or agent, the decision will be left to case law to establish the outcome. While every country has a different set of anti-avoidance provisions in place to take precedence over double tax treaties, and there is still a discrepancy in case law regarding beneficial ownership, a clear direction has been defined. Entities that don’t have economic substance bear the growing risk of not holding up to the standards of tax authorities upon review, resulting in declined tax benefits.   The presence of economic substance gives proof that the company set up for tax reasons is real or has not been incorporated to gain tax favors through unlawful means, which can result in implications of anti-avoidance legislation. Hence, economic substance is mandatory to establish that an entity has genuine reasons for incorporation to achieve a more favorable tax position.

Free Zones

An entity set up in a free zone (FZ) of the UAE can enjoy many tax benefits and business opportunities. However, not all entities can benefit from these commercial zones. A FZ is the best place in the UAE where setting up a business is easy and quick. The concept was first introduced in Dubai, with the first FZ being Jebel Ali. The advantages of operating a business in a free zone include:

• Economic substance is reinforced.
• No limitations on hiring labor.
• Complete foreign ownership.
• Duty-free import of goods, if they are not intended to be supplied to the local market.
• Foreign owners and their management receive residence permits.
• The FZ authorities deal with procedures and formalities instead of various government departments.

For starting a company in FZ, the owners are required to own or rent premises to fulfill the physical presence requirement. Having only a small office will suffice, and for cost-effective options, Hamriyah and Ajman FZs in the northern Emirates are great places.   If the foreign owners maintain physical presence and a local bank account, they can apply to receive UAE tax residence certificates from the Ministry of Finance. By doing so, they will be able to produce this certificate as proof of tax residency to banking institutions in the UAE and abroad.   One of the benefits of incorporating in the UAE is that it offers plenty of non-tax reasons for a foreign entity to set up their business. The strategic location, being an airline hub and the availability of high-quality professional services make the UAE an ideal choice for establishing a business.   Furthermore, the IT infrastructure has drastically improved over the years and even the ADSL technology has been replaced with fiber optic broadband connections, giving better opportunities for e-commerce. The UAE local authorities don’t impose any minimum wage requirements, as well as offer free immigration, making realizing substance easier.

Double Tax Treaties

Over 100 double tax treaties have been signed by the UAE with several OECD members and other countries. While several tax treaties are quite attractive for businesses, some of them may discourage incorporation in the UAE mainly because of the inclusion of liable-to-tax clauses and limitation of benefits clauses.

However, the beneficial tax treaties outweigh the unattractive ones, such as the treaties with the Netherlands, Austria, and New Zealand, providing the advantage of not having a liability to pay tax.

Other Benefits

The UAE is a renowned international financial center that is located in the Middle East and provides quick access to Africa, Asia, and Europe, with a difference of only a few hours. It has gained a great reputation in the global market because there are proper regulations and controls in place, giving foreign entities the peace of mind that they are doing business in a country with international standards.   Dubai is a progressive, lively city having a well-established infrastructure, providing everything a foreign entity would need to incorporate. The government paperwork and the visa process are relatively simple and straightforward.

Due to its thriving property market, businesses have a wide range of options for purchasing or renting office spaces.   It is home to a myriad of nationalities, with English being the preferred language among all. There are also no limits on repatriation of profits or capital, along with favorable local tax system.

Related: RAK Offshore Company Formation (RAKICC)

Understanding the Penalties Under the Economic Substance Regulations in the UAE

Several aspects of the Economic Substance Regulations in the UAE can lead to sanctions if not observed. These include:

• Failure to file a notification, which exposes the entity to a penalty of AED 20,000
• Failure to submit a report or provide information or documentation in connection with the report, for which companies may be fined a penalty of AED 50,000
• Failure to meet the requirements of the Economic Substance Test for the relevant financial year, for which the sanction is AED 50,000
• The fine for providing inaccurate information is set at AED 50,000

These sanctions apply to first-time offenders. For the second consecutive year of failure, the penalty reaches AED 400,000, and the National Assessing Authority may impose additional administrative actions, including the suspension, withdrawal, or non-renewal of the company’s commercial license.

Register Your Entity in Full Compliance With the ESR With the Help of SFM Corporate Services

Whether you choose to register your company online or by any other means, it is crucial to ensure that your business entity operates in full compliance with company law in the UAE.

Our business set up services are designed to provide guidance at every step of your company formation in Dubai or the UAE and help you navigate all relevant regulations. From becoming a licensee to declaring your activities and income, filing your tax reports, and managing every aspect of your business in compliance with the UAE’s regulatory framework, we’re here to be your trusted partner.

Embrace the benefits of registering your company in the United Arab Emirates, knowing you will be operating 100% legally.

Conclusion

Nowadays, the tax authorities are focused on pressurizing companies to produce real economic substance. But with the UAE’s efficient tax system, businesses can avail the opportunity to locate their operations in this country and leverage significant tax savings. The UAE has signed many tax treaties, including some of the most efficient ones. However, some of them may restrict the extent of applicability of other beneficial tax treaties. It is imperative to carefully study the investment structure for making well-thought-out decisions regarding business activities within the UAE, and also for outbound investments. With due diligence, businesses may be able to develop a highly tax-efficient structure for maximum savings and higher profits.