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Back-Ground Economic substance regulation in the UAE

The Economic Substance Regulation (ESR) introduced in the UAE in 2019 is a critical law aimed at addressing international tax compliance and ensuring transparency in cross-border transactions. This regulation applies to specific business activities and requires companies conducting these activities to demonstrate economic substance within the UAE. In this article, we will explore the background, objectives, scope, and compliance requirements of ESR.

Background: Why ESR Was Introduced in the UAE

The UAE has long been a hub for international trade and cross-border transactions. However, concerns about tax avoidance and profit shifting led to global efforts to curb harmful tax practices.

The Role of OECD and BEPS

The Organization for Economic Co-operation and Development (OECD) introduced the Base Erosion and Profit Shifting (BEPS) framework, which outlines 15 action plans to address tax avoidance and ensure fair distribution of profits across countries.

The UAE, as a member of the BEPS Inclusive Framework, committed to implementing four key BEPS action plans:

  1. Harmful Tax Practices (Action 5)
  2. Prevention of Tax Treaty Abuse (Action 6)
  3. Country-by-Country Reporting (Action 13)
  4. Mutual Agreement Procedure (Action 14)

To align with these requirements and avoid being listed as a non-cooperative jurisdiction by the European Union, the UAE introduced ESR under Cabinet Resolution No. 31 of 2019 and the Country-by-Country Reporting regulation under Cabinet Resolution No. 32 of 2019.

Key Objectives of ESR

The primary goals of the Economic Substance Regulation in the UAE are:

  1. Compliance with International Standards
    Aligning with OECD and EU regulations to maintain the UAE's global reputation.

  2. Enhancing International Competitiveness
    Strengthening the UAE's position as a transparent and attractive investment destination.

  3. Curbing Tax Exploitation
    Preventing businesses from using the UAE’s tax-friendly regime solely to shift profits without substantial economic activities.

Scope of ESR: Who Does It Apply To?

The ESR applies to all entities (natural or legal persons) that engage in Relevant Activities within the UAE, including those operating in mainland UAE, free zones, or financial centers. License holders such as commercial licensees, certificates of incorporation holders, and permit holders are required to comply if they perform Relevant Activities.

Exemptions

Entities with 51% or more shares owned by the UAE federal or emirate governments or related authorities are exempt from ESR, even if they engage in Relevant Activities.

Relevant Activities Under ESR

Nine specific business activities fall under the ESR's scope:

  1. Banking
  2. Insurance
  3. Investment Fund Management
  4. Lease-Finance
  5. Headquarters
  6. Holding Company
  7. Shipping
  8. Intellectual Property (IP) Business
  9. Distribution and Service Centers

Entities conducting these activities must comply with ESR by demonstrating substantial economic presence in the UAE.

Compliance Requirements for ESR

Companies subject to ESR must meet the following requirements:

1. Economic Substance Test

Entities must prove they meet the following criteria:

  • Core Income-Generating Activities (CIGAs) are conducted in the UAE.
  • Adequate physical presence, employees, and expenditures are maintained in the UAE.
  • Directed and managed within the UAE.

2. Annual Reporting

Entities must submit an annual Economic Substance Report to the relevant regulatory authority. The report includes details of CIGAs, financial information, and proof of economic substance.

3. Record Keeping

Maintain comprehensive records of business activities, expenses, and employment to substantiate compliance.

Enforcement and Penalties

Non-compliance with ESR can lead to severe consequences, including:

  • Monetary penalties
  • Suspension or revocation of business licenses
  • Reporting to foreign tax authorities

Compliance is critical to avoid these repercussions and maintain the integrity of operations in the UAE.

Why ESR Matters for UAE Businesses

The ESR ensures that companies operating in the UAE contribute to the local economy and do not exploit tax advantages without legitimate economic activities. For businesses, it offers an opportunity to align with global best practices, enhancing trust and credibility with international stakeholders.

Conclusion: Staying Ahead with ESR Compliance

The introduction of the Economic Substance Regulation in the UAE reflects the country’s commitment to international tax standards and economic transparency. Businesses engaging in Relevant Activities must prioritize compliance to avoid penalties and contribute meaningfully to the UAE's economy. By understanding ESR and its implications, entities can navigate these regulations effectively and maintain their global competitiveness.

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