INTRODUCTION
On 30 April 2019, the Economic Substance Regulation (ESR)[1] was introduced in the UAE to align the country with the global standards to prevent Base Erosion and Profit Shifting (BEPS).
According to the UAE legislation, the ESR applies to nine business activities called “Relevant Activities” but all businesses licensed in the UAE shall have to submit a notification within 30 June 2020.
The ESR has a retroactive effect as of 1 January 2019; consequently, the first financial year of assessments starts on or after 1 January 2019.
The purpose of ESR is to assess and ensure that businesses within the UAE conducting Relevant Activities have in the UAE the necessary substance.
Relevant Activities are the followings:
- Banking
- Insurance
- Fund management
- Lease-finance
- Headquarters
- Shipping
- Holding company
- Intellectual property (IP)
- Distribution and service center
All businesses licensed in the UAE, including branches, partnerships, offshore companies, etc. have to notify to the competent Regulatory Authorities[2]:
- whether or not they carry out a “Relevant Activity”;
- whether or not all or any part of gross income in relation of a relevant activity is subject to tax in a jurisdiction outside UAE;
- the date of the end of its financial year.
Only those businesses that carry out a Relevant Activity, are required to meet substance requirements. Within twelve months from the end of each relevant financial year, they shall have to submit a report to the competent Regulatory Authorities providing the following information:
- the type of Relevant Activity conducted by it;
- the amount and type of relevant income in respect of the Relevant Activity;
- the amount and type of operating expenses and assets in respect of the Relevant Activity;
- the location of the place of business and, if applicable, plant, property or equipment used for the Relevant Activity of the Licensee in the State;
- the number of full-time employees with qualifications and the number of personnel responsible for carrying on the Licensee’s Relevant Activity;
- information showing the State Core Income-Generating Activity in respect of the Relevant Activity that has been conducted;
- a declaration as to whether or not the Licensee satisfies the Economic Substance Test;
- in the case of a Relevant Activity being an Intellectual Property Business, a declaration as to whether or not it is a high-risk intellectual property business.
Assessing whether or not your company carries out a “Relevant Activity is, therefore, a crucial task since such assessment will determine whether or not your company is required to meet substance requirements and implement duly organized administrative records for filing ESR yearly report.
Most of Free Zones and other Regulatory Authority set 30 June as the final deadline for the submission of the ESR notification. Despite guidelines published last April by the Ministry of Finance, there are still many aspects that remain uncertain and open to interpretation.
Fines are imposed by Competent Authorities on the Licensees who do not satisfy the substance requirements if Relevant Activities are assessed to be carried on.
DISTRIBUTION AND SERVICE CENTRE
Over the years, the economic success and popularity of UAE have been largely determined by its peculiar geographical position and political stability that contributed to developing 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 “Connected Persons”[3] that may attract these companies under the scope of ESR for conducting the activity of Distribution and Service Centers. Moreover, due to UAE’s peculiarity as a business hub, it is also the normality that the natural market for goods and services sold by UAE companies is not restricted to UAE.
As per ESR the definition of Distribution and Service Centre Business is the following:
Distribution and Service Centre Business: any of the following businesses:
- Purchasing from a Foreign Connected Person and importing and storing in the State: parts or materials for goods; or goods ready for sale and reselling such component parts, materials or goods outside the State.
- Providing services to Foreign Connected Person in connection with a business outside the State.
There are two distinct activities included in the Distribution and Service Centre Business Relevant Activity, and the Relevant Activities Guide published by the Ministry of Finance on April 2020 defines these two activities as follows.
A Licensee is considered engaged in a “Distribution Business” if the Licensee purchases raw materials or finished products from a foreign group company, and distributes those raw materials or finished goods.
A Licensee is considered engaged in a “Service Centre Business” if it provides consulting, administrative or other services to a foreign group company. Those services are connected with the foreign group company’s business outside the UAE
It is worth noting that the definition quoted in the Relevant Activities Guide regarding Distribution Business doesn’t specify where raw materials and finished goods are sold, while the definition of ESR clearly states that Distribution Business refers only to businesses that resell parts, materials, and goods outside the State.
It is, therefore, my understanding that companies that resell goods and material only to the client within UAE shall not be considered as carrying out a relevant activity, nevertheless, for the reasons explained above, it is extremely unlikely that companies established in UAE do not have among their customers someone based outside of UAE.
Unfortunately, neither the ESR nor the Relevant Activities Guide contemplates a principle of prevalence; hence, even a single client weighting for an irrelevant percentage of the total turnover shall attract companies that purchase goods from related parties under the scope of ESR.
The same concept is also applicable to “Service Centre Business”. Companies established in UAE, providing services to third parties that also provide few services to intragroup companies connected with the foreign group company’s business outside the UAE shall be attracted under the scope of ESR.
The Relevant Activities Guide clarifies that only “one-off transaction” that are not in the ordinary course of the business can be disregarded.
COMMON CASES
UAE Co distributing goods in UAE and KSA
UAE company is part of a group with a holding company in France and a sister company in Italy. The UAE company purchase goods from the Italian sister company and resell them in UAE and KSA.
Since UAE company resell goods also to KSA customers, the company is carrying out a relevant activity.
UAE Co reselling to UAE third party customers goods shipped overseas
UAE company is part of a group with a holding company in France and a sister company in Italy. The UAE company purchases goods from the Italian sister company and resell them to a third-party company based in UAE, which resells to Australia. Goods are shipped directly from Italy to final clients in Australia.
Since the UAE company is selling goods to third party company based in UAE and has no commercial relation with final customers in Australia, it is my interpretation that the UAE company is not carrying out a relevant activity.
UAE Co promoting sales in UAE and KSA for intragroup company
UAE company is part of a group with a holding company in France and a sister company in Italy. The UAE company is promoting sales in UAE and KSA for the Italian sister company. Goods are sold directly by the Italian Company to UAE third party customers and KSA third party customers.
The UAE company invoices to the Italian sister company 5% commissions on all sales procured in UAE and KSA.
Since UAE Co provides services to the Italian Sister company, including promoting sales outside UAE the company is carrying out a Relevant Activity.
UAE Co promoting sales in UAE only for the intragroup company
UAE company is part of a group with a holding company in France and a sister company in Italy. The UAE company is promoting sales in UAE for the Italian sister company. Goods are sold directly by the Italian Company to UAE third party customers.
The UAE company invoices to the Italian sister company 5% commissions on all sales procured in UAE.
Are these services to be considered in connection with the Italian sister company’s business outside UAE or since they are related to promoting the Italian sister company’s sales in UAE, are out of the scope of ESR?
ESR doesn’t provide a definition of “company’s business,” and here there is room for interpretation. Considering that the scope of ESR is to prevent base erosion by the arbitrary allocation of the revenue stream in zero-tax countries, likely these services would be considered as related to a business in UAE of the sister company and hence outside of the scope of ESR until further official clarification on this matter will occur.
CONCLUSIONS
Due to UAE’s nature as an international business hub, it is likely that a large number of companies shall 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. The recommendation is to consult with professionals to assess the ESR position of any relevant Licensee and meet the ESR requirements within the given deadlines.
[1] Cabinet of Ministers Resolution No. 31 of 2019 concerning ECONOMIC SUBSTANCE REGULATIONS.
[2] To determine the competent “Regulatory Authority” reference has to be done to Cabinet Resolution No. 58 of 2019.
[3] As per ESR definition a “Connected Person” is a natural or juridical person who is related to one or more natural or juridical person(s) through direct or indirect ownership or control, or common control.
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