Economic Substance Regulations (ESR) is a set of regulations introduced by the UAE as a part of UAE’s commitment as a member of the OECD which was effective from 2019 onwards. UAE is a business-friendly country and has the advantage of tax laws. Due to this, some people may try to set up companies with the intention to shift profits from one country to another without real substance or enough substance in the business either to reduce the tax or to pay no tax. Sometimes this creates problems in the country’s tax transparency and globally as well. To prevent this kind of harmful tax practice, the UAE has introduced this ESR regulation. The purpose of ESR is to prove the Economic presence and adequate substance in UAE for the companies established in UAE onshore (i.e. Mainland), freezone and certain other business forms. There are 9 activities which are called as “Relevant activities” under ESR. If any company undertakes any relevant activities under ESR, then such companies must comply with the ESR regulations.   The relevant activities listed under the ESR regulations are

1. Banking Businesses
2. Insurance Businesses
3. Investment Fund Management Businesses
4. Lease-Finance Businesses
5. Headquarter Businesses
6. Shipping Businesses
7. Holding Company Businesses
8. Intellectual Property Businesses
9. Distribution and Service Center Businesses

  To know more about ESR: https://www.spectrumaccounts.com/advisory-services-dubai/economic-substance-regulations  

Practical challenges in ESR

 

1. Understanding the applicability of ESR

Economic Substance Test is a detailed study to analyze a business’s activity from the view of Economic Substance Regulations to determine whether the business falls under the requirement of ESR or not. There are 9 relevant activities listed under ESR. If an entity undertakes any of the relevant activities, then it will come under ESR regulations and have to comply with all the regulations of the law. A ‘substance over form’ approach must be adopted when determining whether an entity is carrying out any of the Relevant Activities. The assessment is required to be made for individual UAE entities. Determining the applicability of ESR depends on the business activity, business operation, business structure etc. If any information is wrong, or unable to provide important information, it will affect the ESR assessment and therefore, the company might fail to determine the applicability.

2. Complexity of Business Structure

Determining the applicability of ESR for Entities with complex business structure will be a challenging task. Companies with many foreign connected persons should be assessed carefully to check the applicability and determine the appropriate relevant activity.

3. Determining the appropriate relevant activity for the company which is involved in multiple relevant activities

Some companies will carry out multiple relevant activities under the ESR. As per ESR regulations, to prevent duplicate reporting, ancillary relevant activities will be consolidated under the “Main Relevant Activity”. There will be circumstances where the companies have to demonstrate which is the Main relevant activity to be reported out of the multiple relevant activities.

4. Challenges in demonstrating the substance

If a company undertakes a related activity and earns relevant income during the financial year, then the company is required to meet the economic substance test. In the economic substance test, the companies must demonstrate that the CIGA (Core Income Generating Activities) being carried out in the UAE, the companies and the relevant activities are being directed and managed in the UAE, the companies have adequate personnel, premises and expenditure for carrying out the relevant activity etc. Demonstrating these requirements will be a challenge for many companies. Failure to meet the economic substance test will result in huge penalties.

5. Identifying the relevant income, expenditure, and other financial information

Some companies will struggle to identify the relevant portion of income, expenditure, and other financial information from the overall level. Reporting the proper figures in the ESR report will be also a challenging task. Wrong reporting might attract penalties.

6. Documentation of relevant information

Licensees will have to document the relevant information to demonstrate the economic substance and should be kept carefully. If the authority asks to produce some information, then the companies should be in a position to provide it in time.

7. Adjustments in the business operations

Licensees will have to adjust their operations to meet substance-related compliances. This could involve restructuring, modifying the operations, adjustments in respect of directions and management etc. This might burden the company in terms of costs and other factors.

8. Risks of Non-compliance

If the companies fall within the scope of ESR regulations, then the companies have to comply with many requirements under the ESR in terms of demonstrating the economic substance, submission of ESR notification and ESR report etc. Failure to meet these compliances will result in huge penalties and other legal actions from the authorities.  

Frequently Asked Questions on ESR released by Ministry of Finance (ESR FAQs)

  Q1 – Who is subject to ESR regulations? A: Companies that carry out the relevant activities listed under the ESR regulations during a financial year will fall under the scope of ESR regulations and will be required to comply with them.   Q2 – What is a licensee? A: A Licensee is a juridical person or an unincorporated partnership that is registered in the UAE and that undertakes a Relevant Activity. By way of example, a Licensee can be:

• A limited liability company
• A private shareholding company
• A public shareholding company
• A joint venture company
• A partnership (e.g. a limited liability partnership, a limited partnership, a general partnership, etc.)

  Q3 – Are branches subject to the Regulations? A: Branches registered in the UAE are an extension of their “parent” or “head office” and do not have separate legal personalities.  As such, the “parent” or “head office” registered in the UAE must file as a single Licensee, reporting the Relevant Activities of itself and all its branches in one composite Notification and / or Economic Substance Report.   Q4 – Will the Regulatory Authorities tell businesses if they are subject to the Regulations? A: No, businesses are responsible to self-assess whether they undertake a Relevant Activity and have a filing requirement under the Economic Substance Regulations and cannot rely on Regulatory Authorities to inform them of their requirements under the Economic Substance regulations. It is advisable to get an expert professional advise from a tax consultant to conclude a proper ESR assessment.   Q5 – Is a company registered under an ‘offshore’ free zone company regime subject to the Regulations? A: Yes, if the ‘offshore’ company undertakes a Relevant Activity.   Q6 – Do the activities listed on the commercial license determine whether a Licensee undertakes a Relevant Activity? A: In determining whether the relevant activity is carried out or not, a ‘substance over form’ approach must be used. This means looking beyond what is stated on the commercial license to the activities actually undertaken by the Licensee during a financial period.   Q7 – When should a Licensee assess whether it undertakes a Relevant Activity? A: This assessment needs to be done for each financial period and should take into account the activities undertaken by the Licensee at any time throughout the relevant financial period.   Q8 – Who is exempt from the Regulations? A: The following Exempted Licensees are exempt from filing an Economic Substance Report and the requirement to demonstrate substance in the UAE:

• A Licensee that is tax resident outside the UAE;
• An Investment fund and its underlying SPVs / investment holding entities;
• A wholly UAE resident-owned business that is not part of a multinational group and that only carries on business in the UAE;
• A branch of a foreign entity that is subject to tax on all of its Relevant Income in a foreign jurisdiction.

  Sufficient evidence must be submitted along with the Notification form to claim any of the above exemptions. Please refer to the Notification guide for details on the evidential documents that must be submitted,   Q9 – What if a Licensee does not undertake a Relevant Activity during a financial period? A: If a Licensee does not undertake a Relevant Activity during a financial period, it does not need to meet the Economic Substance Test.  The Licensee would not be required to submit a Notification or submit an Economic Substance Report for the relevant financial period.   Q10 – if I undertake a Relevant Activity (or plan to) by when should I file the ESR Notification and ESR Report?

• A: Notifications must be filed within six months from the end of the relevant financial period in which you carried on a Relevant Activity; and
• Economic Substance Reports must be filed within 12 months from the end of the relevant financial period in which you carried on a Relevant Activity.

If you have just set up a business and did not carry on a Relevant Activity in your first financial period, you are not in the scope of the Regulations.   Q11 – What if a Licensee undertakes a Relevant Activity, but does not earn any income from that activity during a financial period? A: A Licensee that undertakes a Relevant