Economic Substance Regulation (ESR)

Alyah Audit > Economic Substance Regulation (ESR)

Economic Substance Regulation (ESR) is a set of regulations introduced by the UAE to align with global efforts to prevent harmful tax practices and curb tax avoidance. The regulations require certain businesses engaged in specific activities in the UAE to have substantial economic presence in the country, ensuring that they are not merely “letterbox” companies with minimal or no real operations in the UAE.

The Economic Substance Regulation was implemented in the UAE in 2019 as part of the country’s commitment to the Organisation for Economic Co-operation and Development (OECD)’s Base Erosion and Profit Shifting (BEPS) initiative, which aims to combat tax avoidance strategies that exploit gaps and mismatches in international tax rules.

Key Aspects of Economic Substance Regulation (ESR)

1. Who is Affected by ESR?

The regulations apply to all UAE entities engaged in relevant activities, regardless of whether they are established on the mainland or in free zones. However, companies in certain Free Zones may be exempt from ESR if they satisfy certain conditions.

The key criteria for companies to fall under ESR include:

  • They must be taxable persons in the UAE.
  • They must be conducting one or more of the relevant activities (explained below).
  • They must have operations in the UAE that qualify as substantial (meeting specific criteria related to the activity conducted in the UAE).

2. Relevant Activities

Businesses engaged in the following activities are subject to ESR:

  • Banking (e.g., conducting banking activities)
  • Insurance (e.g., underwriting or carrying out insurance business)
  • Investment Fund Management (e.g., managing investments or assets)
  • Lease Financing (e.g., providing finance leases or operating leases)
  • Headquarters (e.g., managing or coordinating business activities of group entities)
  • Shipping (e.g., transportation of goods by sea)
  • Intangible Assets (e.g., licensing or exploiting intellectual property rights)
  • Distribution & Service Centre (e.g., providing logistical support or managing a distribution network)
  • Holding Company (if the company earns income from holding or managing shares or similar investments)

Entities carrying out one of the above activities are required to demonstrate that they have sufficient economic substance in the UAE to ensure that their business is not just being used for tax avoidance.

3. Economic Substance Requirements

Entities that engage in relevant activities are required to meet certain criteria, including:

  • Adequate Number of Full-Time Employees: The business must employ a sufficient number of qualified personnel in the UAE, commensurate with the activity being conducted.
  • Expenditure on Operations: The business must incur adequate expenditure in the UAE for conducting its operations.
  • Physical Presence: Depending on the activity, there must be a physical presence in the UAE, such as an office space and assets located within the country.
  • Active Operations: The company must demonstrate that its core income-generating activities are directed and managed in the UAE.

These requirements are designed to ensure that businesses are not simply established in the UAE to take advantage of its tax regime but are genuinely operating with substance and economic activity in the country.

4. Economic Substance Test

The UAE requires entities conducting relevant activities to pass the Economic Substance Test. The test ensures that businesses have substantial operations in the UAE and are not just shell companies. The test is based on:

  • Location of decision-making (where the key decisions related to the activity are made).
  • Number of qualified employees in the UAE.
  • Level of expenditure incurred in the UAE related to the activity.
  • Physical office or assets in the UAE, if applicable.

5. Reporting and Documentation Requirements

Entities subject to ESR must file an Economic Substance Notification with the UAE Federal Tax Authority (FTA) within 6 months from the end of their financial year. The notification requires businesses to:

  • Confirm whether or not they conduct relevant activities.
  • Provide details about their economic substance in the UAE.

If a business is conducting a relevant activity, it must also submit an Economic Substance Report to the FTA. The report includes detailed information on how the company meets the economic substance requirements for each relevant activity.

6. Penalties for Non-Compliance

The UAE imposes significant penalties for non-compliance with the Economic Substance Regulations. These penalties include:

  • Administrative fines for failure to submit the Economic Substance notification on time.
  • Fines for non-compliance with the substance requirements.
  • Potential dissolution of the entity if the non-compliance is severe or continues for multiple years.
  • Other penalties could include restrictions on the company’s ability to conduct business in the UAE.

7. Exemptions from ESR

There are certain exemptions for specific types of companies or activities:

  • Pure Holding Companies: A holding company that only holds and manages shares and does not carry out other business activities may be exempt if it meets certain conditions.
  • Businesses in Qualifying Free Zones: Some free zone entities may be exempt from ESR requirements if their activities are solely carried out within the free zone, meet specific criteria, and do not generate income from the UAE mainland. However, the exemption only applies under strict conditions, and free zone businesses must carefully evaluate whether they qualify for this exemption.

8. Impact of ESR on Businesses

  • Increased Compliance Burden: Companies need to ensure they have the right documentation, employees, and operational presence in the UAE to comply with ESR.
  • Transparency: The regulation promotes transparency and discourages businesses from using the UAE as a “tax haven” without real economic activity.
  • International Alignment: The ESR aligns with global efforts to combat tax avoidance and protect the integrity of the international tax system, helping the UAE maintain a favorable reputation in the global market.
  • Reputational Risk: Non-compliance or insufficient economic substance can damage a company’s reputation and affect its ability to do business in the UAE or internationally.

Alyah Audit’s Role in Economic Substance Regulation (ESR) Compliance

As a Dubai-based firm, Alyah Audit can assist businesses in the UAE in meeting their Economic Substance Regulation (ESR) requirements. Here’s how Alyah Audit can help:

  1. ESR Advisory: Providing advice on whether your business is subject to ESR, helping you understand the specific requirements that apply to your activities.
  2. Compliance Review: Conducting an assessment of your company’s activities to ensure they meet the economic substance requirements.
  3. Documentation and Filing: Assisting with the preparation and filing of the Economic Substance Notification and Report to the UAE Federal Tax Authority (FTA).
  4. Economic Substance Planning: Helping businesses structure their operations to ensure they meet ESR requirements, including identifying areas for improving their economic presence in the UAE.
  5. Penalty Risk Mitigation: Advising on the potential penalties for non-compliance and providing solutions to mitigate any risks of non-compliance.

Conclusion

The Economic Substance Regulations (ESR) are designed to ensure that businesses in the UAE are genuinely conducting substantial activities in the country and not just taking advantage of tax benefits without real operations. Companies engaged in relevant activities must adhere to the regulations and demonstrate that they have sufficient economic presence in the UAE.

Alyah Audit can help businesses navigate the complexities of ESR, ensuring they remain compliant and avoid penalties. This includes advising on the application of the regulations, conducting compliance reviews, and assisting with documentation and filings.