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22 October 2019
Introduction of Economic Substance Regulations in UAE

Background
  • Earlier this year, the Cabinet of Ministers in the United Arab Emirates (UAE) released Resolution No 31 of 2019 (Resolution) on Economic Substance Regulations (ESR) that would apply with immediate effect.
  • ESR was introduced to ensure that entities that are doing business in UAE, pursuant to trade license obtained from authorities (Licensee), meet the Economic Substance Test. Interestingly, the resolution provides useful guidelines/ parameters to conduct such substance tests.
  • This Resolution is also a step to meet the European Union’s requirement to remove UAE from the EU Blacklist i.e. EU list of non-co-operative jurisdiction for tax purposes. Subsequently, on 10 October 2019, the EU has removed UAE from its Black List.
 
Applicability
  • ESR applies to all UAE entities who have obtained a trade license or permit from relevant authorities to carry out ‘Relevant Activity,’ including Free Zone and Financial Free Zone. 
  • However, the Resolution shall not apply to companies owned by the Government of state,  Emirate of the state or other Government authority/ body, directly or indirectly.
 
Relevant businesses and corresponding core income generating activity
 
Relevant Activity/ Business
 
Illustrative Core income generating activity
Shipping
  • Managing crew/ voyages 
  • Overhauling and maintaining ships
  • Overseeing and tracking shipments
Holding Company
  • All activities related to business
  • For income other than dividend/ capital gains, any activities to earn that other income
Banking 
  • Raising funds and managing risk
  • Taking hedge positions
  • Providing loans or credit
Insurance 
  • Predicting and calculating risk
  • Insuring/ re-insuring against the risk 
  • Underwriting insurance/ re-insurance
Investment Fund Management
  • Deciding upon holding/ selling
  • Calculating risk and reserve
Lease-Finance
  • Agreeing funding terms
  • Identifying and acquiring assets to be leased (for leasing activity)
  • Managing risks
Headquarter
  • Taking management decisions
  • Incurring operating expenditure on behalf of group entities
  • Coordinating group activities
Intellectual Property (IP) (where IP is patent/non-trade intangible) and it is High-Risk IP Licensee* 
  • Taking strategic decisions and managing the risk related to developing (or acquiring)/ exploiting/ protecting of intangible assets
  • Carrying out ancillary trading activities for exploiting intangible assets
Distribution and Service Centre
  • Transporting and storing 
  • Managing inventories
 
* High-Risk IP Licensee is a licensee who
  1. Did not create IP held for business and acquired IP from Connected persons, in consideration for funding research and development by another person situated outside UAE and licenses such IP to connected persons or generates income
  2. Does not carry out research and development or branding, marketing and distribution  as part of core income generating activity
 
Key parameters for Economic Substance Test 
Licensee must satisfy the following criteria to meet Economic Substance Test in relation to Relevant Activity
  • Conduct core income-generating activities in UAE
  • Licensee shall be directed and managed in UAE
    • Adequate frequency of Board of Directors meeting in UAE
    • Directors should possess the necessary knowledge/expertise to discharge duties
  • To employ adequate number of qualified full-time employees, or adequate outsourcing expenditure incurred for third party service provider
  • To possess adequate physical assets in UAE
 
Compliance requirement
  1. Notification to be submitted
    Licensee shall annually notify  Authority on following
    • Whether or not it is carrying on Relevant Activity
    • If yes for above, gross income for Relevant Activity is subject to tax outside UAE
    • Financial year followed by Licensee
  2. Report to be submitted
    If Licensee is carrying out the Relevant Activity, it is required to submit a detailed report  annually within 12 months from end of Financial Year, containing various operations related information, including but not limited to Employee details – experience, type of contract, qualifications, duration of employment etc. and also information on intangible related details of the Licensee. 
 
What are the offenses and penalties prescribed
 
The Resolution has prescribed the following offenses and corresponding penalties as under
Offenses Quantum of penalty
Failure to meet Economic Substance Test AED 10,000 – AED 50,000 (First Year)
AED 50,000 – AED 300,000 (Subsequent Year)
Failure to provide information or inaccurate information AED 10,000 to AED 50,000
 
However, before levying a penalty, the Authority must issue a notice (i.e. opportunity of being heard) to Licensee.
 
Further, the Authority may neither determine economic substance test of licensee nor levy a penalty post 6 years from the end of Financial year (unless there is deliberate misrepresentation/ fraudulent action by Licensee or any other person)

Way Forward
  • Recently, UAE has introduced Country-by-Country-Reporting (CbCR) Regulations in line with its commitment to implement Base Erosion and Profit Shifting (BEPS) standard for Action Plan 13. Now, with the introduction of ESR, UAE has most certainly sent a positive signal to the sovereigns of its trade partners in other jurisdictions. 
  • As referred, the introduction of the regulations has already helped UAE in taking their name out of the EU blacklist. However, the implementation of these regulations in UAE, which till date does not have any taxation related law, is likely to pose challenges.
  • Despite, the regulations providing useful guidelines, the Licensees would require lot of judgment in a professional capacity to determine if the activity meets the substance test.
  • The above regulations also introduce additional compliance requirements on part of the Licensee/ businesses in UAE who are still grappling with the GST related compliances in the region.
  • It is recommended for multinationals to be pro-active and revisit their existing operational activities to mitigate/ avoid potential risk of non compliance with the above regulations
 
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