Before discussing Economic Substance Regulations (ESR), we need to understand Base Erosion and Profit Shifting (BEPS). ‘Base erosion’ refers to the practice of reducing the taxable base in high-tax countries. ‘Profit shifting’ refers to shifting profits from high tax jurisdictions to low tax jurisdictions.
For example, high-interest-rate loans are being granted to a company based in high tax jurisdiction to reduce the taxable profits in high tax jurisdiction. For example, the group company in low tax jurisdiction is granting loans at high-interest rate to a company located in high tax jurisdiction. As a result, the high tax jurisdiction company will pay higher interest to a company in low tax jurisdiction. The high-interest expense will reduce the taxable profits in high tax jurisdictions which will lead to tax savings.
Another example is the transfer of ownership of intellectual property like trademarks, designs, patents etc from high-tax to low-tax jurisdiction and then charging royalties to group companies for the use of the intellectual property. This will increase the income in low tax jurisdictions and enhance the expenses in high tax jurisdictions, ultimately resulting in tax savings. For example, software was developed in the United Kingdom (UK) by a UK based company (company A), and transferred the ownership of the software to a group company (company B) in the UAE. Company B is leasing the software to various group companies, including company B. It shows that income is being parked in the low tax jurisdiction, it will lead to tax savings, which is in fact a tax evasion.
Multinational companies usually adopt this technique to avoid tax. However, as per the Organisation of Economic Cooperation and Development (OECD), due to BEPS, there is a loss of revenue between $100 –$240 billion annually.
To tackle this huge loss of revenue, various initiatives were taken by various bodies, like:
• The first one was the publication of an initial report on BEPS by the OECD on 12 February 2013.
• This was followed by an extensive action plan on BEPS,” published by the OECD on 19 July 2013. This plan provided 15 action points to tackle weaknesses in the existing international taxation principles. The plan was endorsed by the Finance Ministers of the G20 countries.
• On 16 September 2014, the OECD published the first deliverables of the action plan.
• The United Nations (UN) had also taken action on BEPS by creating the UN subcommittee on BEPS.
• On 28 January 2016, the European Commission (EU) issued its proposal for a council directive dealing with tax avoidance practices within the EU
Countries and various jurisdictions started working together to implement the BEPS package consistently and develop further standards to address BEPS issues. The BEPS package contains fifteen action points, and every member country of the OECD is required to implement at least the following four action points:
• Counter harmful tax practices
• Prevent tax treaty abuse
• Country by country reporting
• Mutual agreement procedures
ESR law and related regulations are helpful to counter harmful tax practices and helpful to curb tax evasion.
The UAE, being a member of the OECD inclusive framework, introduced ESR law (the Law) under the Cabinet Decision No.31 of 2019, which was replaced by Cabinet Decision No. 57 of 2020. The UAE issued Guidance no. 215 of 2019, which was replaced by MD 100 of 2020 for the smooth implementation of ESR in the UAE.
The purpose of the law and related regulations is to ensure that UAE entities do not artificially attract profits that are not commensurate with the economic activities undertaken by them in the UAE. Moreover, the Law and related regulations require that businesses have an economic presence in the UAE related to their activities in the UAE. The Law requires that the businesses involved in the relevant activities should comply with the ESR test. In a nutshell, the Law requires such companies must fulfil the functional, management and adequacy tests, and we will discuss these in detail in our coming articles.
There are nine businesses/activities that are subject to ESR. These are (i) banking business, (ii) insurance business, (iii) investment fund management business, (iv) lease finance business, (v) headquarters business, (vi) shipping business, (vii) holding company business, (viii) intellectual property business and (ix) distribution and service sector business. If the businesses are not involved in any of these activities, they are not subject to ESR. We will discuss these in detail in our future articles.
Along with compliance of functional, management and adequacy tests, where applicable, licensees are liable to submit the notification and related report within the due dates as required by the ESR Law.
Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer. For any queries/clarifications, please write to him at email@example.com
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