Published in the Official Gazette on 16 September 2024, the Cabinet of the United Arab Emirates (“UAE”) issued a key amendment to the Economic Substance Regulations (“ESR”) regime, effectively limiting its applicability to Financial Years (“FY”) commencing from 1 September 2019 until 31 December 2022. This update is based on certain developments relating to the UAE, both domestically and internationally. Two years ago, we pondered on the future of ESR in the UAE (here). This briefing discusses the background of this update, the implications for Licensees, and the relevance of maintaining economic substance in the UAE even after this development.
1. What happened?
The UAE Cabinet issued Cabinet Resolution No. 98 of 2024, making amendments to the Cabinet Resolution No. 57 of 2020 concerning Economic Substance Requirements. Specifically, it states that the ESR shall apply only to FYs commencing from 1 January 2019 until FYs ending on 31 December 2022 (meaning that there are no requirements to submit ESR Notifications and Reports for FYs ending after 31 December 2022).
In addition, all administrative penalties imposed on Licensees and Exempted Licensee relating to FYs ending after 31 December 2022, shall be cancelled. The Federal Tax Authority (“FTA”) is required to refund any such penalties paid and terminate all grievances thereof.
2. What is the backdrop of this update?
ESR were introduced in the UAE following the Organisation for Economic Cooperation and Development’s (“OECD”) project on Base-Erosion and Profit Shifting (also known as the “BEPS Project”). Particularly, Action 5 of the BEPS Project was meant to combat ‘harmful tax practices’. In this context, the OECD Forum on Harmful Tax Prac tices (“FHTP”) had conducted periodical reviews of the ‘substantial activities’ requirements of no-or-nominal-tax jurisdictions (like the UAE) to ensure that there is a level playing field, and that the activities of jurisdictions such as the UAE do not unfairly impact the tax base of other jurisdictions.
Separately, the European Union (“EU”) had included the UAE in its list of non cooperative jurisdictions for tax purposes.
To comply with the BEPS Action 5 Report and to be delisted from the EU list, the UAE introduced the ESR.
With the introduction of the ESR regime, the UAE complied with the BEPS Action 5 Final Report and was delisted from the EU’s list of non-cooperative jurisdictions.
3. What was necessary under the Economic Substance Requirements?
Under the ESR, Licensees (unless they are Exempted Licensees) conducting certain ‘Relevant Activities’ were required to satisfy certain criteria to meet an Economic Substance Test (“ES Test”), i.e.:
- Undertake the ‘Core Income-Generating Activity’ (“CIGA”) in the UAE;
- The Relevant Activity must be directed and managed in the UAE; and
- There must be adequate employees, physical assets and expenditure in the UAE.
4. Do Economic Substance Requirements play a role in the newly adopted Corporate Income Tax Regime?
Following this, the UAE also introduced a Corporate Tax (“CT”) regime in 2022 by way of the Federal Decree Law No. 47 of 2022 on the Taxation of Corporations and Businesses (“UAE CT Law”). For the first time, the UAE had a comprehensive taxation regime, wherein the business income of almost all persons was captured in the tax base, with a headline rate of 9 %.
One of the features of the UAE CT Law is that the possibility of having a 0 % CT rate for some Free Zone companies (known as ‘Qualifying Free Zone Persons’ or “QFZP”) was still made available if they earn a particular type of income, known as ‘Qualifying Income’. To obtain this benefit, one of the criteria is that the QFZP must maintain ‘adequate substance’. The characteristics of that are quite similar to that under the ESR regime.
5. Outlook and Conclusion
QFZPs availing the 0 % CT rate are still required to comply with ESR according to the UAE CT Law.
Separately, the concept of economic substance will still be relevant to the extent of the Pillar Two regime, particularly, from the point of view of the Substance Based Income Exclusion (“SBIE”) on tangible assets and payroll.
Even though the ESR regime was abolished, there are other considerations by which businesses are required to maintain economic substance to avail certain benefits. Failure to do so may trigger FTA audits.
Hence, it is still nearly as important to maintain adequate substance and ensure the necessary documentary compliance to withstand any potential objections of the FTA as under the ESR CR.
Dr. Constantin Frank-Fahle, LL.M.
Founding Partner
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