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Adhering to UAE’s Economic Substance Regulations (ESR) is now a ‘must do’ reality facing business owners in the region, amid the challenging financial circumstances brought on by the COVID-19 pandemic.

New regulations, which were implemented in the UAE for fiscal years commencing January 1, 2019 and onwards, were announced by the government the last year and encompasses several industries in the country.

ESR has off late been and henceforth will be tackled with a renewed sense of urgency by many business owners in the UAE.

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It has off late been and henceforth will be tackled with a renewed sense of urgency by many business owners in the UAE.

Confusing?
If you are a new business owner, these rules can appear confusing – which is why the article walks through in depth on what you need to know before you incorporate it into your company.

While these new rules may appear to be additional red tape, the main aim is to prevent non-domiciled directors – who register and operate companies in the UAE – from tax evasion in their home nations.

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What are economic substance regulations?

The Economic Substance Regulations, or ESR, was issued by the UAE and is aimed at curtailing harmful tax practices and closely tracks the global standard set by the OECD (Organisation for Economic Co-operation and Development).

The Economic Substance Regulations, or ESR, was issued by the UAE and is aimed at curtailing harmful tax practices by non-domiciled business operators!

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As the UAE is a member of the OECD framework, in response to an assessment of the UAE’s tax framework by the European Union (EU) Code of Conduct Group on Business Taxation, the UAE introduced a resolution on Economic Substance on April 30, 2019.

What is ‘economic substance’?
Economic substance is primarily a doctrine in the tax law of the United States – followed by several others worldwide - under which any transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside from the tax effect in order to be considered valid.
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Why impose such regulations?

The UAE is not a tax free jurisdiction. In 2018, the UAE introduced VAT to the country, as well as an excise tax applicable to certain goods.

Corporation tax is levied on foreign banks and oil companies operating in the country, and the UAE Ministry of Economy has been clear for some time that it is studying the effect of the introduction of a more general federal corporate income tax.

There is no widely applicable tax on business profits yet, and, in contrast to other jurisdictions, the UAE remains a low tax environment for most businesses.

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However, there is no widely applicable tax on business profits yet, and, in contrast to other jurisdictions, the UAE remains a low tax environment for most businesses.

With fiscal transparency and regulation being a global priority, international financial organisations such as the OECD champion better global co-ordination on tax regulation, including measures to tackle tax evasion, so that businesses cannot make profits from differences in tax legislation around the world.

How are such regulations combating tax evasion?
Specifically, governments are coordinating to produce a consistent network of legislation to facilitate transparency – enabling exchange of fiscal information on request.

In particular, for zero and low tax jurisdictions, this includes taking measures to tackle the use of the local tax regime to create artificial structures with no substantive economic activities, and combating other harmful tax practices.

Here is where the economic substance regulations (ERS) rules come into play. In particular, the European Union has chosen to actively police these principles by applying sanctions against countries which do not meet specific objectives based on these principles.
Tax evasion
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Rules track similar moves made worldwide

The UAE is one of the several tax-free or low tax countries that have put similar regulations into practice last year – some of them being the Bahamas, Cayman Islands, British Virgin Islands, Mauritius, Seychelles, Jersey, Guernsey, the Isle of Man, and Bermuda.

As the UAE eyes propects as an international incorporation destination, analysts say the country will be targeting to keep its most promising regard as one of the easiest countries in the world to do business in.

The UAE is one of numerous tax-free or low tax countries that have put similar laws into practice last year.

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What firms fall under the scope of UAE ESR norms?
The regulations simply require UAE companies and other UAE business forms that carry out the below-listed activities to prove that they maintain adequate economic substance in the UAE relative to the activities they undertake.

All UAE onshore, offshore and free zone companies like banking and insurance firms, investment fund managers, financing and leasing firms, shipping, distribution and service centers, intellectual property firms, holding companies or the top of a corporation taking full responsibility for managing all business activities.

Companies active in these sectors are considered ‘relevant entities’ and must comply with economic substance regulations.

It applies to all companies established in the UAE (except those entities in which a minimum 51 per cent direct or indirect investment is from government authorities) and which have income from a relevant sector in any accounting period commencing on or after January 1, 2019.

It applies to all companies established in the UAE, except those entities in which a minimum 51 per cent direct or indirect investment is from government authorities

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However, allowances will be less stringent for those managing holding companies (such as those that only derive equity-based interest income) and additional requirements apply to anything related to high-risk intellectual property.

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What are the economic substance tests that firms should get done?

All the firms falling under the above-mentioned list of activities, getting income in the relevant sector in the specified accounting period will be required to demonstrate adequate “substance” in the UAE

These are the pre-requisite tests that will allow the government to determine if firms comply with the norms.

The ‘Directed and Managed’ Test
The regulations contain specific requirement on how a company must be directed and managed in the UAE.

For example, this looks at whether your business has board meetings with an adequate frequency, quorum of directors physically present at such meetings, the directors having the necessary knowledge and expertise to discharge their duties as directors, meeting minutes kept in the jurisdiction, etc.

• The Core Income Generating Activities’ (CIGA) Test:

The company must establish these activities are undertaken in the jurisdiction and in relation to the level of income derived from the relevant activity.

The CIGAs could be outsourced to a corporate service provider in the jurisdiction, under the supervision by the firm itself, in the form of constant monitoring. In reality, however, it is unlikely that corporate service providers would be comfortable assuming key CIGA functions due to liability concerns.

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Dubai skyline along Shaikh Zayed Road. Picture used for illustrative purposes. Image Credit: Sankha Kar/ Gulf News Archives

• The ‘Adequate’ Test:

This essentially checks whether your firm has an adequate number of qualified full-time employees in the UAE; incur an adequate amount of operating expenditure in the UAE; and hold adequate physical assets here.

The firm will need to have an adequate number of qualified employees in the jurisdiction, incur adequate expenditure in the jurisdiction proportionate to the level of activity and have adequate physical presence in the jurisdiction (for instance, office space, facilities, etc).

What you need to get done immediately?
What needs to be done immediately is some formalities namely, ESR Impact Assessment, ESR Gap Analysis, ESR Implementation and ESR Compliances (Compilation and submission of ESR Notification Forms and ESR Returns to the relevant regulating authorities) for your respective companies. To do this you need to get in touch with tax advisory firms!

The reason why you need to get on this head-on without any further delay, is to avoid being levied with significant fines and penalties and other serious consequences, in the event of non-compliances with ESR requirements.

What are the penalties levied because of non-compliance or failure to disclose?

The reason why you need to get on this head-on without any further delay, is to avoid being levied with even bigger fines and penalties

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Failure to file a notification will result in a penalty of Dh10,000-Dh50,000 and if you do not provide complete information, this will result in a fine of Dh10,000-Dh50,000.

If you do not demonstrate sufficient ‘economic substance’ in the UAE for the relevant financial year, it can result in fines of up to Dhs300,000, so it’s important you know the rules.

If you run a UAE-based business, you should re-examine their corporate structure and ensure their activities fall within the definition of ESR. They must then evaluate the impact of these on their operations.

Key takeaway?
Whether you’re setting up an onshore or free zone business, a multinational company or a one-man band in the UAE – if your company plans to carry out one of numerous relevant activities here in the UAE, it must meet new economic substance rules.

In short, certain types of companies must be managed or directed from within the UAE, have adequate UAE-based full-time staff, generate most of their income in the UAE, maintain adequate assets and demonstrate adequate operating expenditure in the UAE.