Scope of Economic Substance Regulations

In our previous article, we discussed the reasons for implementing Economic Substance Regulations (ESR), which were to counter harmful tax practices and curb tax evasion.

We highlighted that the UAE, being a member of the Organisation of Economic Cooperation and Development (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 law requires that every licensee who earns relevant income from a relevant activity must comply with the followings:

• submit notification within six months from the end of the relevant financial year

• satisfy economic substance test

• submit the report within twelve months from the end of the relevant financial year

The term licensee used above means a juridical person (a legal entity — incorporated inside or outside the state); or an unincorporated partnership registered in the state, including a free zone and financial free zone, and carries out relevant activity.

In the light of the above, any legal entity and unincorporated partnership that meets the above-mentioned criteria can be classified as a licensee, but there are following exceptions to the above definition, and the excepted entities are not required to comply with ESR law and related regulations.

• A licensee that is an investment fund

• A licensee that is a tax resident in a jurisdiction other than a state

• A licensee that is:

o Owned by resident or residents (directly or indirectly) in the state

o It’s not part of the MNE Group (a group that has entities in different jurisdictions or an entity that is tax resident in one jurisdiction and subject to tax in another jurisdiction due to its activities carried through permanent establishment or branch).

o It only carries out business in the state.

• A licensee that is a branch of a foreign entity the relevant income of which is subject to tax in a jurisdiction other than the state; and

• Any other licensee as determined pursuant to the decision of the Minister of Finance

• Sole proprietorships, trusts and foundations

From the above exceptions, it is evident that if the entities are carrying business only in the UAE, or entities whose income is being taxed in other countries are not subject to ESR in the UAE. ESR is not applicable to natural persons, sole proprietorships, trusts and foundations.

The juridical persons and unincorporated partnerships if not earning any relevant income, are not subject to ESR. The entities owned by the government will also be tested based on the above criteria and have not any notable exceptions.

The juridical persons and unincorporated partnerships which are conducting relevant activities and earning relevant income as well can further be classified into exempted entities and non-exempted entities. The exempted entities will have to submit a notification and they will have to prove the reasons for not being subject to ESR. In case of non-compliance, these would be treated as normal licensees. The non-exempted entities will have to submit the ESR notification within six months from the end of the relevant financial years, and if they are earning relevant income, they will have to comply with the ESR test and submit the related report as well within twelve months from the end of the relevant financial years.

The term relevant income means all gross income from a relevant activity that is recorded in the books and records of the licensee or the exempted Licensee under the accounting standards, whether earned in the UAE or outside the UAE and irrespective of whether the entity has derived a profit or loss from its activities. In the context of income from sales or services, gross income means gross revenues from sales or services without deducting the cost of goods sold or the cost of services.

The word relevant activity means any of these nine activities. Like the activity of (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.

It is recommended to assess your business based on the above criteria to ascertain whether your entity is subject to ESR or not. The entities that are not conducting relevant activities, but their trade license is carrying the relevant activities, it is highly recommended that such entities should submit notification within the due date to avoid penalties.

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 compliance@kresscooper.com.