VAT ESR EXCISE ADVISOR CONSULTANT UAE DUBAI ABUDHABI

Introduction to Economic Substance Regulation in UAE

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With Globalization and the digitalization of the economy, multinational companies can avoid or reduce their taxes by utilizing low tax or non-tax jurisdictions.  It was increasingly becoming necessary to governments worldwide to tax business profits where the economic activities generating the profit are performed.  

The Organization for Economic Co-operation and Development (OECD) & G20 Summit issued 15 action points. These Actions points were intended to tackle tax avoidance, improve international tax rules’ coherence, and ensure a more transparent tax environment (Base Erosion Profit Shifting package). These 15 action points are known as BEPS Action points, Out of which four action points were considered minimum standards and called as Inclusive framework of BEPS.

The United Arab Emirates (UAE) on May 16, 2018, joined the Inclusive Framework (IF) Base Erosion Profit Shifting (BEPS) and thereby became the 116th jurisdiction to join the Inclusive Framework (IF). The four action points are:

The OECD’s Forum on Harmful Tax Practice (FHTP) conducts a review of the preferential tax regime that is harmful for another Jurisdiction. Preferential tax regimes are those where low tax or no tax on income/profits. Multinational business often takes advantage of such low or no tax jurisdiction to reduce tax in another jurisdiction.

Key Take Aways

  1. UAE’s commitment to the OECD and G20 
  2. Taxes have been avoided legally by shifting profits to the low tax jurisdiction 
  3. ESR targets geographically mobile business
  4. 9 Relevant Activities, but we can say 9+1, 10 Relevant activities
  5. Substance over form, passive transaction to be considered on concluding Relevant Activity.
  6. While arriving at the revenue from relevant activities, the gross amount should be considered. Expenses should not be deducted.
  7. No substance test required if you are exempt license, no revenue from relevant Income.

Illustration

Let’s take an example: Company A (manufacturer, located in country X, whether the tax on profit is 30%), Company B (Customer situated in another country Y, where the tax on profit is 20%) and Company C (A shell company, Subsidiary of Company A located in country Z, where there is no tax on profit).  

Company B procure material manufactured by Company A say for $100,000/-. Goods are manufactured by company A and shipped to company B. However, invoicing happens a bit differently. Let’s assume the cost of manufacturing for Company A comes to around $25,000/-. Company A invoices to Company C for $ 30,000, then company C invoices company B for $100,000. The impact can be assessed as under by plotting a tax calculation:

DetailsCompany ACompany X
Sales30,000100,000
Cost25,00030,000
Profit5,00070,000
Tax rate30%0%
Tax paid to respective Jurisdiction1,5000

The Total Tax that Company A’s government, which is Country X, received is only $1,500 against the total profit of $75,000 that company earned. In this transaction, we can see that the economic Activity (manufacturing) happens in Country X. However, the gains are parked or shifted to Country Z. This transaction is indeed harmful to the Government of Country X. 

The OECD aims to avoid such practices through Action point 5; Harmful Tax Practices. The Forum for Harmful Tax Practices review preferential tax jurisdiction in the member countries and ensure that no jurisdiction allows tax practices harmful to other jurisdictions. 

OECD requires the member countries to adopt substantial activates requirements to counter such harmful tax practices. The UAE, being an OECD member, has adopted such requirements and come up with Economic Substance Regulation (ESR).

In our example, Country Z’s government will implement Economic Substance Regulations to ensure that such profit shifting is reported to Country X. This will enable Country X to assess company A’s correct profit against the economic activity in its jurisdiction and collet due to tax.

UAE ESR Legal Framework

In the UAE, the framework to refer and comply with ESR is as under: 

Regulations: Cabinet of Ministers Resolution No. (57) of 2020 issued on August 10 2020 (which amended the previous regulation called Cabinet of Ministers Resolution No. 31 of 2019).

Guidance on the Regulations’ applicationMinisterial Decision No. (100) of 2020 issued on August 19 2020 (which amended the previous regulation, Ministerial Decision No. 215 of 2019).

Other Guidance Materials:

Economic Substance UAE Economic Substance Flowchart: Key checkpoints for ESR compliance and flow of submissions.

Relevant Activities Summary: Relevant Activates covered under the ESR.

Notice of COVID-19: Flexibility offered due to COVID 19 pandemic. 

Notice regarding ESR Filing Requirements and Deadlines: How to identify your notification and reporting deadlines.

ESR Notification and Reporting guidelines: instructions on how to file ESR notification and reporting.

The Scope

The ESR does not apply to all the business in the UAE. ESR regulations identify geographically mobile company which need to comply with ESR requirements. 

Geographically mobile business is where the economic activity required to generate the revenue can be in two or more jurisdictions. As in our example, Company C is engaged in the distribution business, where its sourced goods from one company are distributed to another company. The economic activity to manufacture the goods is located in some other country. The relation between Company A and Company C profit was shifted from one jurisdiction to another. 

Non-Geographical mobile business-like Real estate development or Hospitality. The economic Activity of construction and revenue from the sale of constructed properties cannot be shifted from one country to another. Likewise, a Company cannot earn an income from renting a hotel room unless it has a hotel in the same country.

The Relevant Activity (RA)

Let us see which are the business, or in ESR term The Relevant Activity (RA):

  1. Banking Business
  2. Insurance Business
  3. Investment Fund management Business
  4. Lease – Finance Business
  5. Headquarters Business​​
  6. Shipping Business
  7. Holding Company Business 
  8. Intellectual property Business (“IP”)
  9. Distribution and Service Centre Business

The above Activity carried out by any corporate, licensed to do business in UAE or an unregistered partnership will bring the corporate or the unregistered partnership under the scope of ESR (Called the Licensee).

It is important to note that it should be a body corporate in the case of the licensed business, meaning it should have a separate legal existence from the owner. This implies that a sole proprietor, a trust will be outside the preview of ESR.

Point to consider while evaluating the RA:

  1. Substance over the form: importance should be given on the actual Activity not what the company is licensed to do. There will be a situation where you undertake business which is not listed in your license. ESR requires you to review, notify and report based on your actual Activity.
  2. More than on RA: if the licensee carries out more than one relevant Activity, he has to demonstrate economic substance for each activity. However, consolidation is permitted.
  3. Passive engagement is sufficient: Active engagement of relevant Activity is not necessary even a passive engagement is enough to bring a business under the scope. E.g., lending money to the sister company, this may be one of transaction in the year. But this will be considered the company has undertaken the relevant Activity.

The Relevant Income – Revenue from relevant Activity

Once a licensee concludes that it carries Relevant Activity. He should identify the revenue earned from the relevant Activity and bifurcate from its other Activity. It is defined as “all of that entity’s gross income from a Relevant Activity as recorded in its books and records under applicable accounting standards, whether earned in the UAE or outside the UAE and irrespective of whether the entity has derived a profit or loss from its activities”.

Income termed as anything will be included, it doesn’t matter what you call in the books. Let it be sales of inventory and properties, services, royalties, interest, premiums, dividends and any other amounts. All such Income should be considered before deducting any expenses incurred for earning that Income. That is to say, to arrive at the Income from the sale of the inventory we should not deduct the cost of goods sold. It should be gross income.

Proving the Substance in the UAE

As we have discussed on how the Income should be correlated with the economic Activity in the country. The main agenda of ESR is to identify whether profit is parked in the country without undertaking the underlying economic Activity. Each licensee has to prove the following to claim that the substance is in UAE:

  1. Core Income-Generating Activities (“CIGA”) for the RA is conducted in UAE. CIGA are the Activity which is central importance to generate the Income. We can otherwise say that we cannot earn the Income without undertaking those activities. 
  2. Activities are directed and managed in the UAE: this requires an adequate number of board meetings held in UAE with the attendees needed in the UAE. 
  3. Level of Activity commensurate with the Income: the Income derived from the relevant Income should have sufficient activities/resource required in the UAE.  This can be proved by 
    • has an adequate number of qualified full-time (or equivalent) employees concerning the Activity who are physically present in the UAE (whether or not employed by the licensee or by another entity and whether on temporary or long-term contracts), 
    • incurs adequate operating expenditure by it in the UAE, and 
    • has adequate physical assets (e.g. premises) in the UAE.

Outsourcing: the above CIGA can be complied if the same is outsourced to an outsourcing provider, provided the outsourcing provided have sufficient employees and resources in the UAE.

The Exempt licensee

There is a licensee who carries out relevant Activity and can claim exemption from ESR. These specific categories are:

  1. Investment Funds: include the Investment Fund itself and any entity through which the fund directly and indirectly invests, but not the entity or entities in which the fund ultimately invests. It also entity whose sole function is to facilitate the investment made by the Investment Fund.
  2. An entity that is tax resident outside UAE: To avail this exemption, the entity must be subject to corporate tax on all of its Income from a Relevant Activity by virtue of being a tax resident in a jurisdiction other than the UAE. The licensee should provide sufficient evidence to the authority to claim the exemption.
  3. An entity which is wholly owned by a resident (UAE national or a person having valid UAE residency), provided:
  4. not part of an MNE Group; 
  5. all of its activities are exclusively carried out in the UAE and 
  6. the UAE resident owners of the entity residing in the UAE.  
  7. A UAE branch of a foreign entity the Relevant Income of which is subject to tax in a jurisdiction other than the State: the branch should submit the documents proving the UAE income is subject to tax in a country other than UAE.

The Compliance

ESR compliance is a Two-Step process. Fist the Notification and second the Substance Reporting.

ESR notification requires the licensee to notify the authority that whether it has engaged in any relevant Activity, whether it has generated any relevant income, and whether he is claiming exemption from reporting.

ESR report will require the licensee to undertake whether or not economic substance for the reported relevant income can be proved in UAE. ESR reporting is not needed if business fall under the exempt category or does not have relevant Income.

The notification and reporting have to be done for the Relevant Period. The relevant period is the period for which the ESR notification and reporting has to be made. The first ESR relevant period shall be any financial period which begins on or after January 1, 2019. 

Deadline for notification shall be six months from the end of the financial year for which the ESR compliances to be made.

The ESR reporting deadline shall be 12 months from the end of the financial year for which the ESR compliance has to be made.

Conclusion

The adoption Economic Substance Regulation (ESR) in UAE’s firm commitment towards OECD inclusive framework. The ESR tackles revenue loss to different government across the globe due to harmful tax practices. It is estimated that total loss on account of such practices ranges from USD 100-240 billion. The UAE being a county with no tax of profits is very attractive to multinational companies who exploit such profit shifting opportunities. ESR will deter such multination companies from parking the profit in the UAE. 

One may argue that this could potentially be detrimental to the UAE economy. However, in the long run, it should be beneficial to the UAE economy on account of two simple factors:

  1. The UAE is still attractive with no corporate tax, and because the global average corporate tax rate is around 23.79%. The countries like Brazil, Venezuela, France, and Japan have a corporate tax rate of more than 30%. AND
  2. Now with ESR, those Multinational companies have to carry out economic Activity in UAE to benefit from UAE no tax rate.

The above conditions may not feasible due to the industries they are in, some due to infrastructural needs and others due to the higher cost of operation in UAE.  

sources: OECD (https://www.oecd.org); Ministry of Finance UAE (https://www.mof.gov.ae)

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