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Economic substance requirements in U.A.E.

Publications UAE
Background

The United Arab Emirates joined the OECD Inclusive Framework on Base Erosion and Profit Shifting (“BEPS”) on 16th May 2018 and committed to implement the following minimum standard actions:
Action n. 5: Harmful tax practices
Action n. 6: Prevention of tax treaty abuse
Action n. 13: Country-by-Country Reporting (“CbCR”)
Action n. 14: Mutual agreement procedures
Substantial activities requirements in no or only nominal tax jurisdictions is one of the three keys areas covered by Action 5. In order to comply with BEPS minimum standard action n. 5 the United Arab Emirates introduced new Economic Substance Regulations (“ESR”).


Legislation

ESR has been initially adopted in UAE toward Cabinet Resolution No. 31 of 2019 and Ministerial Decision No. 215 for the year 2019.
On August 2020 the UAE Cabinet of Ministers has issued Cabinet Resolution No. 57 of 2020, hereinafter referred to as the “ESR Regulations” and Ministerial Decision 100 of 2020, hereinafter referred to as the “ESR Directive”, which replaced and repealed the previous legislation (hereinafter the combined disposition of ESR Regulations and ESR Directive shall be referred to as the “ESR Legislation”).


Entry in force

ESR Legislation have a retroactive effect as of 01st January 2019.
All entities affected shall have to comply with requirements of the ESR Legislation with reference to financial years started from 01st January 2019.


Scope of ESR Legislation

The target of the ESR Legislation is to enforce Licensees that carry out a Relevant Activity to meet substance requirements in UAE.

Relevant activities are the followings:

  1. Banking
  2. Insurance
  3. Fund management
  4. Lease-finance
  5. Headquarters
  6. Shipping
  7. Holding company
  8. Intellectual property (IP)
  9. Distribution and service centre.


The definition of Licensee includes all companies (FZ/Mainland/Offshore), unincorporated partnership and UAE branches of foreign companies, registered in UAE.


Exemptions

A) Entities that are tax resident outside the UAE
The UAE entity must submit a tax residence certificate or other documentation issued by the tax authority in the foreign jurisdiction in which it claims to be a tax resident to prove that it is treated as a local tax resident entity in that foreign jurisdiction, in support of its ESR notification claiming exemption.

B) Investment Funds
The exemption applies to the Investment Fund as well as any UAE entities used by the Investment Fund to make or hold investments, but does not extend to the entity or entities in which the Investment Fund ultimately invests.

C) Entities that are wholly owned by UAE residents and that (i) are not part of a multinational group, and (ii) only carry out business activities in the UAE

D) UAE branches of a foreign head office/parent whose relevant income is subject to tax in the jurisdiction of the foreign head office/parent.


Special focus on Distribution and service centre activity.

Over the years the economic success and popularity of U.A.E. has been largely determined by its peculiar geographical position and political stability that contributed to develop the country as an efficient business hub linking Europe, Africa, Asia and the Far East. As a result, it is very common that companies established in UAE are part of international groups and hence are involved in commercial transactions with foreign group entities that may attract these companies under the scope of ESR for conducting the activity of Distribution and Service Centers.

As per ESR Legislation the definition of Distribution and Service Centre Business refers to any of the following activities:

a) Purchasing from a foreign group company components parts or materials for goods; or goods ready for sale, and reselling such components parts, materials or goods.

b) Providing services to foreign group companies.

There are basically two distinct activities included in the Distribution and Service Centre Business

1 – Distribution center when the licensee purchases from foreign group entities goods or materials to be sold.
2 – Service center when the licensee provides any kind of service to foreign group entities.


Substance requirements.

During each financial year in which a Licensee earns income from a Relevant Activity, the Licensee must satisfy the criteria below in relation to the Relevant Activity in order to meet the Economic Substance Test:

  1. the Licensee conducts the necessary core income-generating activity in the UAE;
  2. the Relevant Activity is directed and managed in the UAE, this is satisfied if the following conditions are met:
    1.  the Licensee’s board of directors meet in the UAE at an adequate frequency and there is a quorum of directors physically present in the UAE;
    2.  the board meetings are recorded in written minutes noting the making of strategic decisions in relation to the Relevant Activity and are signed by the directors attending such meetings;
    3. the minutes of all board meetings and the records relating to the Licensee are kept in the UAE; and The directors have the necessary knowledge and expertise to discharge the duties of the board;
  3. having regard to the Relevant Activity:
    1. there is an adequate number of qualified full-time employees who are physically present in the UAE;
    2. there is adequate operating expenditure incurred by the Licensee in the UAE; and
    3. there are adequate physical assets in the UAE.


A Licensee whose activity is restricted to carrying out a Holding Company Business is not required to conduct core income generating activity in UAE.
Core income-generating activities are activities that are of central importance to a Licensee for generating income from a Relevant Activity. Further details and guidance on Core Income-Generating Activities referred to each Relevant Activity can be found in Article 3 of ESR Regulation and Schedule 1 of ESR Directive.

ESR legislation allow to outsource services to external providers in order to meet substance test.


Notification and Reporting filing.

Within six months from the closure of each relevant financial year (special deadline apply for the first notification referred to financial year 2019) all Licensees and exempted Licensees that conduct a Relevant Activity are required to submit an Economic Substance Notification setting out (the Notification):
• The nature of the Relevant Activity being carried out;
• Whether Relevant Income was generated;
• Whether an exemption is claimed.

Within twelve months from the closure of each relevant financial year (special deadline apply for the first reporting referred to financial year 2019) Licensees that carry out a Relevant Activity and earned income generated from such Relevant Activity must submit an Economic Substance Report that include, among others:
• Details of parent company, ultimate parent company and ultimate beneficial owner
• Total revenues
• Accounting profit
• Net book value of tangible assets


Failure to comply.

Failure to comply with the ESR Regulations triggers penalties and potential disclosure of information with foreign authorities.

• AED 50,000 for failure to submit report or failure to meet the requirements of the tests in the first year
• AED 400,000 for failure to submit report or failure to meet the requirements of the tests in the second year
• AED 50,000 for providing inaccurate information to the RA or FTA
• AED 20,000 for failure to submit a notification
• License annulment for persisted non-compliance


CONCLUSIONS

Due to the nature of UAE as international business hub it is likely that a large number of companies fall under the scope of UAE ESR. At the same time, being established in a real international business hub also provides these companies with tools and instruments to successfully meet the substance test. Recommendation is to consult with professionals in order to assess the ESR position of any relevant Licensee and meet, within the given deadlines, the ESR requirements.

Contact your consultant at Fidinam DMCC today

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