Substance is becoming an important word in the corporate field, and for many in the offshore sector, it could become quite a challenge.
It all started a few years ago, when the European Union became sick and tired of issuing huge fines against international companies which do not follow their demands, don’t have a real presence, and don’t pay any or only very little tax. Because their tax residence is somewhere on a nice island, where the biggest thread besides getting a sunburn was the annual hurricane season, they stated that companies like Starbucks, Costa Café and other big players should have a presence in the form of offices, employees, and management which is present at their location.
This initiative was gladly supported by the OECD, and since they cannot act discriminatory, they had to expand it to all companies, not just the big international companies. This means that this request has been expanded to all kinds of legal entities.
In December 2017, the European Union assessed the tax policies of jurisdictions with no or only nominal taxes against the criterion of ‘economic substance.’ The criterion stated that jurisdiction should “not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction”. Subsequently, a list of ‘non-cooperative jurisdictions for tax purposes’ was published.
In November 2018, the OECD announced a new global standard on Base Erosion and Profit Shifting (“BEPS”) Action 5 for inclusive framework jurisdictions. This standard requests that mobile business income cannot be parked in a zero tax jurisdiction without the core business functions having been undertaken by the same business entity, or in the same location.
In response to these new policies and guidelines, and to also circumvent reputational concerns, no or nominal tax jurisdictions have hastily enacted legislation introducing enhanced economic substance requirements for tax purposes. These Economic Substance Rules (ESR) are broadly similar, as they are based on the guidance and requirements issued by the EU, as well as by the OECD.
In a nutshell, the legislations impose the following three requirements on a resident entity that undertakes relevant activity to demonstrate economic substance:
- The ‘Directed and Managed‘ Test or local ManagementTest: The entity will need to be directed and managed in the jurisdiction with regards to the relevant activity (e.g., having board meetings with an adequate frequency, quorum of directors physically present at such meetings, meeting minutes kept in the jurisdiction, etc.).
- The ‘Core Income Generating Activities‘ (“CIGA”) Test: The entity will need to demonstrate that the relevant CIGAs have been undertaken in the jurisdiction. The CIGAs vary depending on the relevant activity in question.
- The ‘Adequacy’ or Office and Employee Test‘: The entity will need to have an adequate number of qualified employees in the jurisdiction, incur adequate expenditure in the jurisdiction proportionate to the level of activity and have an adequate physical presence in the jurisdiction (e.g., office space, facilities, etc.). The Adequacy Test is not designed to be prescriptive, but rather depending on the particular facts and circumstances of the entity and the relevant activity in question.
Substance in the UAE
On 30 April 2019, the UAE Cabinet issued the Cabinet of Ministers Resolution No. 31 of 2019 (“UAE Substance Law 2019”) concerning substance regulations in the UAE, requiring all in-scope licensees (“Relevant Entities”) that carry on certain business activities (“Relevant Activities”) to have demonstrable economic substance in the UAE from 30 April 2019 onwards.
On 11 September 2019, the UAE issued the Ministerial Decision No. 215 of 2019 (“UAE ESR Guidance 2019”) containing clarifying guidance for the Relevant Entities on compliance with the Economic Substance Rules.
Who is within the scope of the Regulations?
The ESR and subsequent requirements apply to all UAE companies, including those incorporated in Free Zones and Financial Free Zones (DIFC and ADGM) or offshore companies that generate income from one of the Relevant Activities as listed hereinafter. The ESR Guidance clarified that a licensee fact includes any judicial person(s) established under UAE law (e.g., LLC, branches, even rep offices) and any natural person registered to carry out a licensed business (e.g., as a partnership or sole proprietorship). Such licensee (“Relevant Entities”) is therefore within the scope of the ESR, although not necessarily subject to the Economic Substance Test.
The nine Relevant Activities are the following:
- Banking Business
- Finance and leasing Business
- Fund Management Business
- Headquarter Business
- Insurance Business
- Intellectual Property Business
- Shipping Business
- Holding Company Business
(a) A holding company as defined in the law governing the respective activity in the UAE.
(b) The entity is having as its primary function the acquisition and holding of shares or equitable interest in other companies.
(c) The entity does not carry on any other commercial activity.
NOTE: The ESR however, distinguishes between “pure equity holding” entities and other holding entities.
- Distribution and Service Centre Business
(a) Purchasing from a Foreign Connected Person and importing and storing in the UAE, component parts or materials for goods, or goods ready for sale and reselling such component parts, materials, or goods outside the UAE.
(b) Providing services (amongst others administrative or consulting services) to Foreign Connected Persons in connection with a business outside the UAE (e.g., Management Consultancy)
NOTE: “Foreign Connected Person” is a natural or judicial person who is related to one or more natural or judicial person(s) through direct or indirect ownership or control, or common control, however not resident or deemed resident in the UAE.
All legal entities in the UAE must now notify their authorities about their substance situation. Not all authorities have given the relevant details yet, but the leading free zones request that the information is given by the end of June 2020. That means that only a few weeks are left. However, a certain motivation to comply is given by informing that failure to provide notification results in fines of AED 10,000 to AED 50,000.
The bellow attached fact sheet gives a more detailed overview of the requirements.
In a future blog, we will inform you that these Substance requirements can also be a huge advantage for the UAE and Dubai in particular. Because since a few years, it is possible to migrate companies from one jurisdiction to another. This means that a company which has difficulties in showing the necessary substance can move to the UAE, where they can choose from any size of the office, where they can employ staff from any part of the world without any restrictions and where the management and families of the employees can live happily in a well-developed country, with more than 200 private schools so that families feel comfortable to stay.
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