Economic Substance Regulations (ESR) – Strategic analysis for businesses in UAE
The UAE introduced ESR in 2019 to restrict harmful tax practices, largely in line with Action Plan 5 of the BEPS Project, and ensure that entities doing business in UAE, pursuant to obtaining trade license from the Authority (Licensee), meet the Economic Substance Test.
2019 was the first year of compliance, wherein businesses in UAE experienced multiple challenges to meet the compliance test. Given the penal consequences attached to noncompliance, it was important for the businesses to make the correct disclosures backed by relevant documentation in-house.
In relation to the Indian headquartered companies with a presence in the UAE, the relevant compliance due date would be as follows:
|e-filing of ESR notification for the financial year ended on 31 March 2021||30 September 2021|
|e-filing of ESR Annual report for the financial year ended on 31 March 2021||31 March 2022|
It is assumed that the accounting year followed by the UAE company is April to March.
ESR applies to all private/public shareholding companies, joint venture companies, partnership firms, etc. In other words, the Regulation does not cover individuals, sole proprietorship, trust, or a foundation under its ambit. There are certain exemptions to Licensees from ESR regulations which inter-alia includes Investment Funds, a company that is a tax resident outside the UAE, etc. Furthermore, it is clarified that the ESR regulations would be applicable to the UAE branch of a company that is located outside UAE unless the income of such branch is taxable outside UAE.
Licensee must satisfy the following criteria to meet the Economic Substance Test:
Core Income Generating Activities (CIGA)
- Need to justify that Licensee conducts CIGA
- CIGA need to be conducted in UAE
- Regulations provide an inclusive list of CIGAs – Need to identify what additional could be considered
Directed and Managed
- Need to hold a board meeting in UAE
- Frequency/number of such meetings would depend having regard to decisions to be taken
- Quorum of physically present
- Minutes to be maintained and signed by directors
- Directors should have the necessary knowledge/expertise
Need to demonstrate ‘Adequacy’ Test for:
- Employees - No. of qualified full-time employees physically present in UAE
- Assets – Adequate physical assets in UAE
- Expense – Adequate operating expenses incurred in UAE.
The relevant activities subject to economic test are listed as under:
- Banking business
- Investment fund management business
- Headquarters business
- Holding company business
- Distribution and service center business
- Insurance business
- Lease-Finance business
- Shipping business
- Intellectual property business
Notification to be submitted
Licensee shall annually notify the Authority which inter-alia includes the following:
- Whether or not it is carrying on Relevant Activity;
- If yes for above, gross income for Relevant Activity is subject to tax outside UAE;
- Financial year followed by Licensee;
- Details of Branch.
Report to be submitted
If Licensee is carrying out Relevant Activity, it is required to submit a detailed report annually within 12 months from the end of the financial year, containing various operations related information, including but not limited to employee details – experience, type of contract, qualifications, duration of employment, etc. and information on intangible related details of the Licensee.
The Resolution has prescribed the following offenses and corresponding penalties as under:
|Offenses||Quantum of penalty|
|Failure to meet Economic Substance Test/submit ESR annual return (First year)||AED 50,000|
|Failure to meet Economic Substance Test (Subsequent Year)||AED 400,000|
|Failure to submit the Notification and any other relevant information/documentation||AED 20,000|
Additionally, the penalty included sharing information with the Foreign Competent Authority and suspension/cancellation of license in certain cases. However, before levying a penalty, the Authority must issue a notice (i.e., opportunity of being heard) to Licensee. Furthermore, the Authority may neither determine the Economic Substance Test of Licensee nor levy a penalty post six years from the end of the financial year (unless there is deliberate misrepresentation/ fraudulent action by Licensee or any other person).
The UAE Cabinet of Ministers appointed various authorities that are empowered to oversee the implementation, monitoring, and enforcement of the ESR Regulations in respect of each Relevant Activity. Basis thereon, certain authorities are appointed in the capacity of ‘Regulatory Authorities,’ whose role inter-alia includes collection/ verification of documents (i.e., ESR notifications / Economic Substance Reports). The Federal Tax Authority (FTA) has been appointed as the National Assessing Authority (NAA) whose role includes assessing whether the Licensee has met the Economic Substance Test, imposing a penalty, or hearing appeals.
- Recently, UAE has introduced Country-by-Country- Reporting (CbCR) Regulations in line with its commitment to implement Base Erosion and Profit Shifting (BEPS) standard for Action Plan 13. Now, with the introduction of ESR, UAE has most certainly sent a positive signal to the sovereigns of its trade partners in other jurisdictions.
- Based on the filings of year 1, the concerned authorities have started issuing notices in the situation of noncompliance with the ESR Regulations.
- Despite the regulations providing useful guidelines, the Licensees will require a lot of judgment in a professional capacity to determine if the activity meets the substance test. It is recommended that multinationals be proactive and revisit their existing operational activities to mitigate/ avoid the potential risk of non-compliance with the above regulations. With this being the subsequent year of Regulations, it would be relevant to check and maintain consistency with respect to the positions adopted by the Licensee in the previous year.