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  • Economic Substance Regulations - What they mean for business and tax planning in the UAE

Economic Substance Regulations - What they mean for business and tax planning in the UAE

13 October 2021

The UAE offers many benefits to businesses wishing to locate there: excellent infrastructure, a safe and stable environment, an ideal strategic position for Middle Eastern, African, and Asian markets and low rates of taxation. However, as with any well-developed business destination, the business environment is supported by a framework of law and regulation, and it’s important to take time to understand all the requirements before making decisions about how a business will be set up.

In this publication, we focus on the Economic Substance Regulations (ESR), and their implications for international businesses investing or considering investing in the UAE. This is a relatively new area of regulation and can have a significant impact on how a business is set up and operated in the UAE.

The overall purpose of the ESR is to make it difficult for international businesses to use the UAE for abusive tax avoidance. It supports efforts made by international organisations such as the OECD and the EU to combat this type of avoidance.

In the past, some multinational businesses have sought to reduce their tax bills by artificially shifting profits from the country where the income is earned to a low tax jurisdiction. The ESR prevents this by requiring a business that reports revenue in the UAE to have sufficient resources to generate that revenue in the UAE.

Each year, businesses established in the UAE, including branches of foreign companies, must decide whether they are within the scope of the ESR. If they are, the entity (referred to in the ESR as ‘Licensees’) must notify the Ministry of Finance (MOF) within six months of the entity’s financial year-end. The MOF has a dedicated portal for the notifications, which must be made according to a set format.

Licensees that make the notification are then required to make a more detailed report before the end of the entity’s financial year. In this report, the business must confirm whether or not it meets various ESR tests.

Generally, a Licensee will fall within the scope of the ESR and will therefore be obliged to notify and report to the MOF if it is engaged in one of nine ‘Relevant Activities’. However, certain businesses are exempt from these requirements. Exempt businesses must notify if they carry out a Relevant Activity in order to claim the exemption, but they are then excused from the need for further reporting.

The exemptions cover:

  • Licensees that are tax resident outside the UAE

  • Investment funds and their underlying investment holding entities.

  • wholly UAE resident-owned businesses that are not part of a multinational group and that only carry on business in the UAE.

  • Branches of a foreign entity that are subject to tax on all their Relevant Income in a foreign jurisdiction. 

The exemptions reinforce the point that the purpose behind the ESR is to combat international tax avoidance – it is not designed to create complexity for purely UAE trade or businesses that pay tax elsewhere (although, as mentioned, exempt businesses do need to make a notification to the MOF, claiming the exemption if they carry out a Relevant Activity).

The Relevant Activities are:

  • Banking

  • Insurance

  • Investment Fund management

  • Lease Finance

  • Headquarters Business

  • Shipping

  • Holding Company Business

  • Intellectual property

  • Distribution and Service Centres

The MOF has published, on its website, detailed definitions for Licensees, Exempt Licensees and for the Relevant Activities. It’s important that a licensee makes sure it fully understands the definitions so that it can meet its compliance obligations.

Any business that carries out a Relevant Activity must meet a series of tests set out in the ESR. These are as follows:

  • The core income-generating activities (CIGA) for each Relevant Activity must be carried out in the UAE

  • The Licensee and the Relevant Activity must be managed and directed in the UAE

  • There must be adequate people, premises, and expenditure in the UAE.

There are also additional tests for Intellectual Property businesses and reduced tests for certain holding companies. Further details on the tests can be found on the MOF website - here.

In the section below, covering ‘implications for business and tax planning, we have looked in more detail at the impact of the additional tests for IP as this is an area where difficulties can arise.

This is where the significance of the ESR starts to become clear because there are a number of sanctions that can be used against licensees that do not comply.

Firstly, there are fixed penalties of AED 20,000 for failing to submit a notification and AED 50,000 for failing to submit a report or failing to demonstrate that the substance tests have been met.

These are significant penalties in themselves; however, the sanctions become much more significant for second, consecutive failures. In this event, the maximum financial penalty rises to AED 400,000. In addition, information can be exchanged with the foreign competent authority of the licensee’s parent company, ultimate parent company, and ultimate beneficial owner. And finally, the licensee’s trade or commercial license could be suspended, withdrawn, or not renewed.

This brings home the importance of the ESR. It is not merely an administrative hurdle to be negotiated. It is a very real and important business obligation, and if it is not taken seriously, the business will not be able to trade in the UAE. That said, if the business is bonafide and set up correctly, the ESR will be relatively easy to live with, and the compliance is reasonably straightforward. The secret for any business setting up in the UAE for the first time, is to make sure it is aware of the ESR requirements and to check whether the business can meet them. In the next section, we look at some of the issues that we have seen when advising clients on the ESR.

In the sections above, we have looked at the main characteristics of the ESR, the compliance and the potential penalties, and at first glance, this might give the impression that the ESR is a problem and a hindrance to business. However, it’s important to stress that although the ESR adds to the compliance burden, the overall impact of ESR is positive, and it brings benefits to the UAE and to the business community in the country. By introducing ESR, the UAE has demonstrated its commitment to the programs instigated by the OECD and others. In doing so, it has laid down a marker that it welcomes businesses that genuinely wish to contribute to the region rather than those that are merely aiming to take advantage of the UAE’s tax system. In turn, this benefits international businesses located in the UAE, as the business has the comfort of establishing in a jurisdiction that has credibility and is part of the global movement for good tax governance and visibility.

From our experience, there are three areas that it is especially important for international businesses to focus on when setting up. These are the ‘directed and managed’ test, the interpretation of the test around having sufficient resources in the UAE and the special rules for intellectual property businesses.

The ESR and the MOF website set out what is required to meet the directed and managed test. In summary, the requirement is that an adequate number of board meetings (for the business in question) need to be held in the UAE, with a quorum of adequately qualified directors physically present in the country. This, in itself, should not be an issue and is in line with normal good management and governance. However, we have seen some businesses that have fallen down simply because proper records of meetings have not been kept. This causes a problem because the business may not be able to demonstrate that the test has been met. The message, therefore, is to ensure that not only are the meetings held in the appropriate manner but that full minutes are taken and retained in the UAE.

With regards to the resources test, the licensee must show that it:

  • Employs adequate full-time staff in the UAE
  • Incurs adequate operating expenditure in the UAE
  • Retains adequate physical assets in the UAE

The emphasis here is clearly that the resources must be ‘in the UAE’. However, many international businesses will use international shared service centres and outsourcing, and this can give rise to doubts as to whether the test can be met.

Fortunately, however, the ESR, and the MOF guidance, is reasonably practical on these matters, and once again, a bona fide UAE based business should be able to meet the requirements. Outsourcing is specifically dealt with, and the general rule is that the outsourcer itself should have adequate resources in the UAE. So, for example, using agency staff or external facilities to carry out any of the core income-generating activities will not be a problem, provided they are located in the UAE.

Evidence that the resources are located in the UAE is important, of course, and in some cases, it will be appropriate to obtain evidence from the outsourcer to ensure the business has all the evidence it will need in the event of an enquiry from the MOF.

International shared service centres can be a concern when considering the resources test, but it is important to remember that the resources test focuses on the CIGA, the core income-generating activities. This means that, for example, a shared service centre outside the UAE supporting the IT needs of the group as a whole – rather than the specific CIGA – should not be a problem. However, this is an area that deserves close attention.

The final area where we frequently see issues to be addressed is in connection with the special rules for intellectual property (IP). The special rules exist because this is an area where some international groups have sought to avoid tax in the past by moving IP to a low tax jurisdiction and then shifting group profits to that jurisdiction through intra-group licensing fees. The ESR, therefore, provides that a licensee that receives income from the holding of intellectual property will be considered a ‘high-risk IP business’ if:

  • The Licensee did not create the Intellectual Property Asset which it holds for the purpose of its business, and
  • The Licensee acquired the IP Asset from either a Connected Person or in consideration for funding research and development by another person situated in a foreign jurisdiction; and
  • The Licensee licenses or has sold the IP Asset to one or more group companies or otherwise earns separately identifiable gross income (e.g. royalties, license fees) from a foreign group company in respect of the use or exploitation of the IP Asset. If a licensee falls into this category, it will be deemed to have automatically failed the ESR test unless it is able to produce evidence to refute the failure.

The evidence required to refute the failure is laid down in the ESR and is as follows:

  • Employee information, including level of experience; type of contracts; qualifications; and duration of employment with the Licensee. The business must have an adequate number of full-time employees with the necessary qualifications who permanently reside and perform their activities in the UAE.
  • A business plan showing the reasons for holding the ownership in the Intellectual Property Asset in the UAE
  • Proof that relevant decision making for the IP business has and continues to take place in the UAE.

The above information would have to prove that in the UAE, there is more than local staff passively holding intangible assets whose creation and exploitation is a function of decisions made and activities performed outside of the jurisdiction. As such, the business would need to evidence that decision making is taking place in the UAE.

These tests and conditions are complex, but they will be very effective in preventing IP from being transferred to the UAE purely to avoid tax. Therefore, any international business that intends to hold IP in the UAE needs to study the rules very carefully and ensure that all the tests can be met.

Interestingly, whilst these rules are complex, they should not be seen as a barrier to genuine businesses holding IP in the UAE. In fact, the UAE, because of -its infrastructure and the skilled workforce it can provide, is an attractive location for research and development operations, and there are many sound, commercial reasons for developing and holding IP in the UAE. The introduction of similar ESR tests for IP in other countries around the world may give the UAE an advantage over jurisdictions that cannot offer the same levels of infrastructure and workforce.

The ESR is an important measure with very real sanctions for non-compliance. Therefore, any business planning to set up in the UAE needs to be aware of the rules and make sure it complies with them.

Nonetheless, the rules are a sign of the UAE’s commitment to support the OECD’s program to combat tax avoidance and should be viewed as a positive for the business environment in the country.

The keys to easy compliance are to make sure the rules are understood, ensure the tests are met, and notify and report on time. Crucially, the business must also make sure that proper evidence, such as board minutes, is available to show that the tests have been met..

Businesses holding intellectual property face the most difficult set of tests and need to take the most care to ensure the tests can be met. If they can, the UAE may be a good choice of location for this type of busines.

If you would like to learn more about this topic or need assistance with any aspect of the ESR, please get in touch with BDO’s UAE tax team or your normal BDO contact.