On 30th April 2019, the United Arab Emirates (UAE) issued Cabinet of Ministers Resolution No. 31 of 2019 concerning economic substance regulations in the UAE (the “New Law”). The initial implementing rules (the “Guidance”) regarding the New Law was issued in September.
The New Law creates the basis for the UAE to meet the requirements of the European Union Code of Conduct Group (Business Taxation) (COCG) in respect of economic substance. This is to specially ensure that the jurisdiction does “not facilitate structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction” and “avoids profits registered in a jurisdiction that are not commensurate with economic activities and substantial economic presence”. The introduction of the New Law follows the decision of the European Union (EU) to include the UAE in the list of non-cooperative jurisdictions for tax purposes.
The UAE has been firmly committed to its long-standing policy of meeting the highest international standards on taxation, including the requirements of Organisation for Economic Co-operation and Development (OECD). The introduction of the New Law strongly ratifies the country’s commitment to continuously update its domestic legislative framework in this regard.
What is the New Law about?
The New Law has been designed to address concerns that companies could be used to artificially attract profits that are not commensurate with economic activities and substantial economic presence in the UAE.
The New Law requires certain companies, including both incorporated in the UAE mainland or Free Zones (the “Licensees” or the “Companies”), to demonstrate that they have effective substance in the country by satisfying an “economic substance” test in relation to any income-generating “relevant activity”.
A “license” is to be interpreted broadly, including commercial license, certificate of incorporation, or other form of permit required to allow Companies carry out a “Relevant Activity”.
In practice, a juridical person established under the UAE law (e.g. LLC, branches, even rep offices) or a natural person registered to carry out a licensed business (e.g. as a partnership or sole proprietorship) is considered a “Licensee” and therefore within the scope of ESR (although not necessarily subject to the Economic Substance Test).
The Economic Substance Test is met if the licensee:
- conducts a core income generating activity (or “CIGA”) in the country;
- is directed and managed in the UAE in relation to that activity;
- has an adequate number of qualified full-time employees in relation to that activity and are physically present in the UAE;
- has premises and adequate level of expenditure in the country;
What is the scope of the New Law?
The substance requirements apply to licensees carrying out and deriving incomes from one of the activities listed below (the “Relevant activities”):
- Banking business;
- Finance and leasing business;
- Fund management business;
- Headquarters business;
- Holding company business;
- Insurance business;
- Intellectual property holding business;
- Shipping business; or
- Distribution and service centre business.
A licensee is not required to pass the economic substance test if it does not derive income from the Relevant activity that it carries out.
In terms of holding activity, a “pure equity” holding company benefits from reduced economic substance requirements.
What does it mean in practice?
Starting from 2020, every licensee will have to notify the Regulatory Authority on a yearly basis stating:
- whether or not it carries out a Relevant activity;
- whether or not all or any part of the company’s gross in- come in relation to a Relevant activity is subject to tax in a jurisdiction outside of the UAE; and
- the date of the end of its Financial Year.
Should the Licensee be required to pass the Economic Substance Test (based on its notification), additional information is to be reported to the Regulatory Authority (e.g. type of Relevant Activity being conducted, amount of income being generated; number of full-time employees with qualifications).
Existing entities must comply with the New Law from 30 April 2019, with the first returns due in 2020. New entities must comply with the New Law upon receiving their license, with the first returns due in 2020 or later.
Reporting is individual, even in the case of a group of companies or a business with several entities registered in the UAE.
Directed and managed in the UAE
The New Law contains specific requirements on how a company has to be “directed and managed” in the UAE. e.g. number of board meetings being held and attended in the country, composition and competence of the board of directors, record of the minutes of all board meetings.
The number of meetings required will depend on the activities and the amount of decision-making required by the board of directors. The meetings must take place in the UAE with a quorum of knowledgeable directors physically present in the country and its minutes shall record the making of strategic decisions of the licensee and be signed by the directors attending the meeting. There should be at least one meeting held in the country each year even for companies with minimal activities.
In the event that the company is managed by an individual (general manager or CEO) rather than a board, the above requirements will apply to such individual, i.e. the decisions made by this individual must be properly documented and the individual must be physically present in the country when taking key decisions relating to the management and operation of the licensee.
Adequate employees, expenditure, physical assets
What is adequate for each licensee depends on the particular facts of the company and its business activity. A company has to ensure it maintains and retains appropriate records to demonstrate the adequacy of the resources utilized and expenditure.
Acknowledging the reality that many groups have centralised their resources and business infrastructure in one (or a few) company/ies in the UAE, the Guidance confirms that all substance requirements including CIGAs can be outsourced to both third-party service providers and related companies.
However, the burden of proof to demonstrate that the outsourcing arrangement is not done for the purpose of circumventing ESR lies on the Licensee.
States core income generating activities
Another requirement necessary to meet the economic substance test is for the UAE company to have its CIGA in the UAE.
To demonstrate substance, the company will not have to perform all of the listed CIGA but only the ones that are relevant in its situation.
If the company registered in the UAE does not provide required information or knowingly submit inaccurate information to the regulatory authority, it will be sanctioned by an administrative fine of not less than AED 10,000 but not exceeding AED 50,000 in the first year; AED 50,000 but not exceeding AED 300,000 in the subsequent year, and ultimately, deregistration in case of continuous non-compliance.
Exchange of information
Besides the fines, the New Law provides that tax authorities may exchange information on the non-compliant UAE registered companies with the tax authorities overseas where their holding companies and UBOs are resident.
Presumably, a group would then run the greater risk of attribution of the UAE-allocated profits to the foreign
However, whether this would be included in, or additional to the country-by-country reporting regime remains to be seen.
Time for action!
ESR took effect on 30 April 2019. There are a number of actions which relevant Licensees must undertake to ensure compliance – from clarifying their entity classification, to the structuring of contractual and delegation arrangements, the review and organization of their internal governance, to their employment and premises arrangements and the capturing of relevant business information. These will be required for the preparation and filing of reporting information to the Regulatory Authority.
Even entities not deploying a Relevant Activity should implement proper corporate governance mechanisms in order to avoid any risk of failing the Economic Substance Test.
If you operate a business in the UAE or hold shares in a UAE structure, we highly recommend that you take an active role in auditing your corporate arrangements with the view to bring in the necessary level of corporate substance.