The UAE Cabinet recently introduced economic substance regulations effective April 30, 2019, which bring additional annual compliance requirements for UAE entities carrying out 'relevant activities' in the country.
This follows international movement by the OECD and EU on the need for demonstrating substance by entities in low or no tax jurisdictions, and the UAE regulations are broadly similar to the regulations issued by nine other countries.
Need for these regulations
The OECD's BEPS project, endorsed by the G20 countries, was commissioned with a view to bringing more substance, coherence and transparency to the international taxation system and addressed the requirement of substantial activity in its report on BEPS Action 5.
The European Union has also been actively supporting the introduction of substance requirements in jurisdictions with low/nominal taxation regimes and has released a list of non-cooperative jurisdictions that do not comply with the same (the UAE features on the list along with 11 other countries).
As a result of these developments, nine countries - the British Virgin Islands, Mauritius, Jersey, Guernsey, the Isle of Man, Seychelles, Bahamas, Bermuda and the Cayman Islands - have already introduced economic substance requirements earlier this year. The UAE substance regulations appear to be in direct response to the above developments and aim to address findings issued by the EU, and possible exclusion from the list of non-cooperative jurisdictions for tax purposes.
UAE businesses covered
The regulations apply to a licensee that carries out a 'relevant activity', established in the UAE mainland or the various free zones as a representative office, branch or a commercial enterprise. The regulations would not apply to government-owned enterprises (directly or indirectly).
Businesses covered under the regulations include banking, insurance, investment fund management, shipping, distribution and services, intellectual property, lease finance, headquarters and holding firms. The regulations have defined what activities constitute relevant activities under these businesses.
All entities in the UAE need to notify the regulatory authority (the authority that has issued the business licence to the entity) of its financial year-end and whether or not it is carrying on a relevant activity. A UAE entity undertaking a relevant activity would need to submit a report to the regulatory authority within 12 months after its financial year end.
The report would include details regarding the relevant activity conducted by the entity including information regarding the income from such activity, operating expenses and assets employed, location of premises, details of employees and a declaration as to whether or not the licensee satisfies the economic substance test. Additional information is required to be submitted for high-risk intellectual property businesses.
Consequences of failure to comply
Where an entity fails to meet the economic substance test, an amount of administrative penalty between Dh10,000 and Dh50,000 shall be imposed (between Dh50,000 and Dh300,000 if the test is failed the subsequent year as well). Further, a separate penalty between Dh10,000 and Dh50,000 could be levied for failure to provide any information or providing inaccurate information.
The regulatory authority may also impose suspension, revocation or non-renewal of the licence of a licensee in case of repeated non-compliance. Entities that do not meet the economic substance requirements will also be reported to the Ministry of Finance for onward exchange of information with tax authorities of ultimate parent entity or beneficial owner.
Subjectivity around these requirements
Though the regulations are effective April 30, 2019, additional guidance and regulations are expected in due course. This should clarify concerns regarding practical applicability of the regulations and meaning of terms like "adequate" used extensively in the regulations as adequacy would need to be determined on a case-to-case basis, and it is unlikely to be based on any standard criteria.
Also, as free zone entities are also covered within the scope of these regulations, it will be interesting to note how these requirements will be practically looked upon at, for instance, meeting requirements of "having adequate people or premises" for licenced offshore companies, meeting test for dormant entities not "carrying out" any activities during the year, etc.
While the regulations should not impact UAE headquartered businesses and others with genuine operations in the UAE, there will be reporting and compliance requirements to manage. All UAE entities should analyse the group structure to identify entities in the UAE and other jurisdictions (like the British Virgin Islands and Cayman Islands), which require compliance with their local economic substance regulations. Once it is determined that a UAE/other overseas entity undertakes any relevant activities, businesses would need to assess whether economic substance requirements would be met. Depending on findings of such exercise, remedial options would need to be considered, if necessary.
While the regulations are a welcome move by the UAE that will strengthen the fiscal, corporate governance and reputation of the country, one would need to wait and see how the same is practically applied by authorities.