Doctrine of Economic Substance in the UAE

1. Introduction

In response to the global standards set by the Organisation of Economic Cooperation and Development (“OECD”) in relation to harmful tax practices, which require companies to have substantial activities in a jurisdiction, the European Union of Conduct Group (“COCG”) adopted a resolution on a code of conduct for business taxation, the aim of which is to curb harmful tax practices. This note discusses the applicability and effect of the implementation of the doctrine of economic substance (the “Doctrine”) in the UAE.

The Doctrine requires a transaction to have both:

(i) a substantial purpose aside from the reduction of tax liability; and
(ii) an economic effect aside from the tax effect in order to be considered valid.

In effect, the transaction must change the taxpayer's economic position in a "meaningful way" apart from the federal income tax effects, and the taxpayer must have had a "substantial purpose" for entering into the transaction, apart from the federal income tax effects.

2. The Doctrine in the UAE

2.1 - The Cabinet of Ministers Resolution no. 31/2019 effective 30 April 2019 concerning Economic Substance Regulations in the UAE (the “Resolution”) read with the UAE Ministry of Finance’s Ministerial Decision No. 215 of 2019 dated 11 September 2019 setting out the directive for implementation of the provisions of the Resolution (the “Decision”), sets out the requirements for a natural or juridical person licensed to carry out any activity specified under the Resolution in the UAE to derive an income from such activity, to meet the test of economic substance (the “ESR Test”).

The key features of the ESR Test are:

(a) such a person conducts ‘State Core Income Generating Activity’ in the UAE, as defined in the Resolution. These activities include banking, insurance, investment fund management, lease finance, acting as the headquarters of a group, acts as a holding company, shipping, intellectual property business and distribution and service centre business. Definitions for each of these activities are set out in the Resolution;
(b) such person is directed and managed in the UAE in relation to the activity – this requires the board of directors of that person to meet at least once in a financial year in the UAE, have written minutes of such meeting signed by the attending directors, record the strategic decisions taken and maintain the same in the UAE subject to the applicable license requirements or under applicable law or its constitutional documents and directors should be fit for purpose. If the UAE activities of a company are being managed by a sole manager, such manager should be present at the time of the company making key decisions relating to the branch or representative office in the UAE;
(c) the person has an adequate number of qualified full-time employees, whether on temporary or long-term contracts in the UAE or outsourced in the UAE and is incurring adequate expenditure on such employees for carrying out the relevant activity;
(d) the person is incurring adequate expenditures on outsourcing to third-party service providers whose activities, employees and premises are in the UAE and are adequate for carrying out the relevant activity;
(e) it has adequate physical assets in the UAE whether in-house or outsourced to third parties for its activities;
(f) it has the ability to monitor and control the carrying out of a relevant activity outsourced to a third-party service provider; and
(g) the person has the ability to demonstrate adequate supervision of the outsourced activity.

2.2 - All existing entities are required to comply with the requirements of the ESR Test from April 30, 2019, and new licensees are required to comply with the requirements upon receiving the trade license, with the first report due in 2020 in both cases. Entities in which the UAE Federal Government, the Government of any Emirate of the UAE or any UAE governmental authority has at least 51% direct or indirect ownership interest are exempt from complying with the ESR Test.

2.3 - The degree of substance requirements for an entity depends on the type of relevant activity of that entity. For example, holding companies that do not carry on any other relevant activity and solely hold equity participation in other entities have a reduced substance requirement, such as submission of documents, records or information to the relevant authority when required by it and maintaining adequate employees and premises for holding and managing the holding company’s business.
Other holding companies that undertake a relevant activity and derive income from such activity are required to comply with the full substance requirements of the ESR Test. Entities that derive an income from intellectual property assets that are considered to be high risk must comply with higher reporting requirements and standards to meet the requirements of the Resolution. A brief description of the relevant activities is set out in the Appendix.

2.4 - There are reporting requirements applicable to all licensed entities carrying out a relevant activity, summarized below.

2.5 - Reporting Requirements A licensee is required to report certain information annually to its regulator (being the authority that issued its trade license) with effect from 1 January 2020.

(a) whether or not it is carrying on a relevant activity;
(b) whether the income generated by the relevant activity is subject to tax in a jurisdiction outside the UAE;
(c) the date of the end of its financial year;
(d) submit a report on certain matters to the regulator within 12 months of the end of its financial year such as the type of relevant activity, the amount of income and operating expenses relating to the activity, location of business, plant and machinery, number of personnel, declaration on satisfaction of ESR Test, information relating to high-risk intellectual property business and outsourced activities as prescribed.

2.6 Record-Keeping

(a) While no specific period has been prescribed for retention of records relating to the ESR Test by a licensee who is subject to the Resolution, a regulatory authority has a six-year period to determine whether a licensee has met with the requirements of the Test in relation to its relevant activity. Hence, it will be advisable to maintain records of any relevant information evidencing compliance with the Resolution for a period of 6 years after the end of each financial year.
(b) All records must be maintained in English.

2.7 Penalties for non - compliance

(a) An administrative penalty of AED 10,000 to AED 50,000 for failure to meet the ESR Test is imposed in the first financial year. This amount may be increased to an amount not less than AED 50,000 but not exceeding AED 300,000 in the subsequent years, subject to a six-year limitation period. The six-year limitation implies that the relevant regulatory authority need not give its decision as to compliance with the ESR Test by a licensee immediately at the end of the relevant financial year and has six years after the end of the relevant financial year to decide such compliance.
f such regulatory authority does not give its decision within this period, the licensee will not be subject to any consequence for non-compliance with the ESR Test for that relevant financial year unless the relevant authority has not been able to make such decision by reason of gross negligence, fraud or deliberate misrepresentation by the licensee or any other person.
(b) The trade license of the relevant entity may be suspended, revoked and renewal may be refused if the entity fails to meet the ESR Test.

3. Conclusion

The introduction of the Regulations in the UAE brings the UAE in line with other jurisdictions that have recently issued economic substance legislation and affirms the UAE’s commitment to addressing concerns around the shifting of profits derived from certain mobile business activities to “no or nominal tax jurisdictions” without corresponding local economic activities. This move will go a long way in meeting the OECD requirements and recognising UAE as a co-operating country globally while reasserting its position in the global list of ‘Ease of Doing Business’.

Written by:

Nicole Shroff | ​Ansh Legal