ESR in UAE: Ensuring Economic Substance in Free Zones

In recent years, the United Arab Emirates (UAE) has been taking significant steps to enhance its regulatory framework and foster economic transparency. Among these initiatives are the Economic Substance Regulations (ESR) and the introduction of the Concept of Core Income-Generating Activities (CIGAs) and Economic Substance Test (EST) for businesses operating within the country’s free zones. These measures aim to promote fair taxation practices and ensure that businesses registered and operating in the UAE maintain adequate economic substance to meet the “Qualifying Free Zone Person” definition.

Background of UAE Economic Substance Regulations (ESR)

The UAE introduced the Economic Substance Regulations (ESR) in April 2019, with the goal of addressing concerns raised by the European Union regarding economic substance in the UAE. These regulations were subsequently repealed by Cabinet Resolution No. 57 of 2020 in August 2020, incorporating more comprehensive provisions and clarifications.

The ESR requires certain juridical persons and unincorporated partnerships that engage in “Relevant Activities” within the UAE to maintain adequate economic presence in the country relative to their activities. Relevant Activities include core income-generating activities such as banking, insurance, fund management, leasing, headquarters, shipping, holding company, intellectual property, and distribution and service centers.

Scope of Application

The Economic Substance Regulations apply to both mainland companies and businesses registered in UAE free zones. Free zones have been an integral part of the UAE’s economic development, offering various incentives to attract foreign investments and promote trade. However, the concern regarding potential erosion of economic substance through these zones led to their inclusion within the scope of the ESR.

Under the Cabinet Decision No. 55 of 2023, which came into effect on 1 June 2023, businesses registered and operating in one or more UAE free zones will be subject to the same economic substance requirements as mainland companies.

Compliance and Administrative Requirements

UAE Licensees, which include entities with separate legal personality and branches, must fulfill two main filing requirements under the Economic Substance Regulations:

Economic Substance (ES) Notification: UAE Licensees are required to submit an ES Notification through the Ministry of Finance (MoF) online portal within six months of their financial year-end. This notification is applicable to all businesses within the scope of the ESR, irrespective of whether they undertake Relevant Activities or generate relevant income.

ES Annual Report: UAE Licensees engaged in Relevant Activities and generating relevant income must also submit an ES Annual Report through the MoF portal within twelve months of their financial year-end. This report requires detailed information on the Licensee’s activities, CIGAs, income, operating expenses, and more.

Exemption Claims

Certain UAE Licensees may be eligible to claim an exemption from demonstrating economic substance in the UAE if they meet specific conditions. The following entities can be considered for exemption:

Investment Funds: Licensees that function as investment funds are exempt from the economic substance requirements.

Branches of Foreign Entities: If a foreign entity’s branch’s relevant income is subject to taxation in a jurisdiction other than the UAE, it may claim exemption.

Entities Tax Resident Outside the UAE: Licensees that are tax residents in a jurisdiction other than the UAE are eligible for exemption.

Entities Wholly Owned by UAE Residents: Licensees wholly owned by one or more residents in the UAE, not part of a Multinational Enterprise (MNE) Group, and exclusively conducting business in the UAE may claim exemption.

It is essential to note that the acceptance of an exemption claim lies at the discretion of the UAE authorities. Additionally, if a Licensee meets the exemption criteria, it must still file a claim for each financial period to maintain its exemption status.

Conclusion

The Economic Substance Regulations (ESR) and the recent Cabinet Decision No. 55 of 2023 bring increased regulatory scrutiny to businesses operating in UAE free zones. These measures are part of the UAE’s commitment to international tax standards and aim to ensure that companies have real economic substance in the country relative to the activities they undertake. Businesses within the scope of the ESR must take proactive steps to comply with the filing requirements and satisfy the applicable economic substance test to avoid potential penalties and ensure a strong presence in the UAE’s thriving business landscape. As the UAE continues to develop its regulatory framework, it remains essential for businesses to stay informed and adapt to the changing landscape to thrive in this dynamic economic environment.