INSIGHT: United Arab Emirates Economic Substance Rules—Are You Prepared?

The United Arab Emirates (UAE) Cabinet issued the “Cabinet of Ministers Resolution No.31 of 2019 concerning economic substance regulations” on April 30, 2019, requiring all in-scope UAE “Relevant Entities” that carry on “Relevant Activities” to satisfy economic substance requirements in the UAE.

The Economic Substance Regulations (ESR, the Regulations) are issued pursuant to global standards set by the Organization for Economic Co-operation and Development (OECD) on harmful tax practices, which require companies have substantial activities in the jurisdiction, in response to the UAE’s commitment as a member of the OECD Inclusive Framework. The Regulations apply to all UAE onshore and free zone companies that carry on a Relevant Activity within the UAE.

This article will analyze the regulations, and the requirements which affected businesses in the UAE will need to comply with.

Economic Substance Requirements

Article 3 of the Regulations states that businesses by virtue of having a relevant license for holding Relevant Activities are required to comply with ESR requirements. Article 3 further defines “Licensee” as any natural or judicial person licensed by the competent licensing authorities in the UAE to carry out Relevant Activities in the UAE including free zones and financial free zones. This would mean that all businesses whether sole proprietors, corporations or foreign branches carrying on Relevant Activities whether onshore or in a free zone are required to maintain an adequate “economic presence” in the UAE relative to the activities they undertake. The Regulations are specifically excluded for businesses that are directly or indirectly owned by the UAE government (holding more than 51% ownership).

To satisfy the economic substance requirements in relation to a Relevant Activity, a Relevant Entity must:

• conduct the relevant “core income generating activities (CIGA)” in the UAE;
• be “directed and managed” in the UAE; and
• with reference to the level of activities performed in the UAE:
  • have adequate number of qualified full-time employees in the UAE;
  • incur an adequate amount of operating expenditure in the UAE;
  • have adequate physical assets in the UAE.

Core Income Generating Activities Test

Article 5 of the ESR provides guidance on CIGA and it provides a list of activities which will satisfy the definition of CIGA. It is worth mentioning that the guidance provided in Article 5 of the ESR is not exhaustive. Whether or not a UAE business undertakes a Relevant Activity determines whether the entity is a “Licensee” that is within the scope of the Regulations, i.e. any UAE businesses that have obtained a license from the relevant regulatory authority in the UAE. A Licensee needs to demonstrate economic substance and file an economic substance return in respect of those financial periods in which any gross income was earned from a Relevant Activity.

For the purposes of the Regulations, “gross income” means all income from whatever source derived, and in whatever form realized, including revenues from sales of inventory and properties, services, royalties, interest, premiums, dividends and any other amounts. The CIGA are those activities that are of central importance to the Licensee for the generation of the gross income earned from its Relevant Activity. For the benefit of readers, we have summarized below CIGA as per Article 5 of the ESR.
(Source: https://www.mof.gov.ae/en/StrategicPartnerships/Pages/ESR.aspx)

Directed and Managed Test

The “directed and managed” test ensures that there are an adequate number of board meetings held and conducted in the UAE. A determination as to whether an adequate number of board meetings are held and attended in the UAE will be dependent upon the level of Relevant Activities carried out by the Licensee. The Regulations require that at least one board meeting is held in a year. The directed and managed test further requires that:

• meetings are recorded in the written minutes and signed by all the attendees and that such minutes are kept in the UAE;
• quorum for such board meeting is met and all those attendees are locally present in the UAE;
• directors have adequate knowledge and expertise to discharge their duties.

Licensees should have an adequate number of qualified employees physically present in the UAE in relation to the Relevant Activities carried out in the UAE. Moreover, Licensees should incur adequate expenditure in the UAE and have adequate physical assets in the UAE. The Regulations allow a company to outsource some or all of its activity to third-party service providers. These service providers must have adequate presence in the UAE in their own right and the company must be able to demonstrate that it has adequate supervision of the outsourced activities.

The Regulations acknowledge that businesses vary in size and that there is no “bright-line” test for determining what is “adequate” or “appropriate” substance requirement in form of employees, expenditures and premises/assets. What is adequate and appropriate will depend on the nature and level of activities carried out, and the level of income earned, by the Licensee.

The guidance provides that the regulatory authority shall take a pragmatic approach when assessing whether a Licensee has met the economic substance test, recognizing that CIGAs may fluctuate during the course of a financial year and from year to year. The regulatory authority shall consider various forms of documentary evidence (e.g. timesheets, sector statistics) and take into account that directors of a Licensee may also perform some of the CIGAs. The approach of not including a “minimum” standard for what is considered “adequate” or “appropriate” is consistent with other jurisdictions that have introduced economic substance regulations.

Reporting Requirement

A Relevant Entity will be required to report certain information on its Relevant Activities on an annual basis to the relevant regulatory authority (being the authority that issued the trade license to the Relevant Entity).

Existing entities: Must comply with the Regulations from April 30, 2019, with the first return due in 2020

New entities: Must comply with the Regulations upon receiving a trade license, with the first return due in 2020 (or later)

Failure to comply would result in administrative penalties (not less than 10,000 Emirati dirham ($2,700) but not exceeding 50,000 dirham in the first year, increased to an amount not less than 50,000 dirham but not exceeding 300,000 dirham in the subsequent year), subject to a six-year limitation period. Additional penalties such as suspending, revoking or not renewing the UAE Relevant Entity’s trade license could also apply.

Planning Considerations

The introduction of the Regulations brings the UAE in line with other jurisdictions that have recently issued economic substance legislation (e.g. Cayman Islands, Bermuda, Mauritius), and indicates the UAE’s commitment to addressing concerns around the shifting of profits derived from certain mobile business activities to “no or nominal tax jurisdictions” without corresponding local economic activities.There should be limited impact on UAE-headquartered businesses and foreign multinationals with genuine commercial operations and management in the UAE (aside from complying with additional disclosure requirements going forward).

Multinationals undertaking Relevant Activities in the UAE but managed remotely should reassess their governance structure and operating models in accordance with the UAE economic substance requirements, and make any necessary adjustments to ensure they comply with the Regulations.

All UAE businesses are strongly recommended to assess whether their activities fall within the scope of the Regulations, and how to ensure they can meet the Economic Substance test in respect of each Relevant Activity. This involves consideration of operational, financial, tax/transfer pricing, legal and governance aspects. It is also advisable to prepare documentation demonstrating substance requirement which can be filed with the Relevant Authority on request.

There are reporting requirements that need to be complied with. Considering the Covid-19 pandemic crisis, the UAE government has provided a relaxation in annual filing requirements and notifications. However, non-compliance with the ESR requirements can lead to penalties levied on the UAE business, including revocation of license.

Disclaimer: The content of this article is intended for general information purposes. You should always seek professional advice before acting. No responsibility is taken for any loss because of any action taken or refrained from in consequence of its contents.

Rajeev Agarwal is Head of Global tax with Qatar Navigation QPSC based out of Doha, Qatar.

He may be contacted at: rajeagar2012@gmail.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.