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ESR – the BEPS After Burner

Economic Substance Regulation (Reporting) implemented in UAE – a massive change of the shape of business operating environment

(Dubai, 07/08/2019) The United Arab Emirates (UAE) are indeed one of the more prominent NOON (“no or only nominal” tax) countries, which are more and more in the focus of international “tax justice” discussions. Although the UAE constantly implemented US, OECD, EU etc. driven regulations and standards, such as, but not limited to FATCA, CRS, AEOI, BEPS, the country frequently ends up on EU or other grey or even black lists of “non complying jurisdictions” temporarily.

FATCA: Foreign Account Tax Compliance Act is a 2010 US Federal Law requiring all non-U.S. foreign financial institutions (FFIs) to search their records for customers with indicia of U.S.-person status, being indications in records of a U.S. place of birth, prior residency, or similar, and to report the assets and identities of such persons to the U.S. Department of Treasury.

CRS: Common Reporting Standard is an information standard for the Automatic Exchange Of Information (AEOI) regarding bank accounts on a global level, between tax authorities, which the Organization for Economic Co-operation and Development (OECD) developed in2014. Its purpose is to combat tax evasion. The idea of CRS is based on FATCA, sometimes also labelled as “Global FATCA”.

AEOI: Automatic Exchange of Information, long form Standard for Automatic Exchange of Financial Account Information in Tax Matters. The OECD and G20 developed the standard with the input of other jurisdictions and in consultation with the financial industry. AEOI is very similar to Model 1 IGA, used by many countries to implement FATCA.

BEPS: Base Erosion and Profit Shifting is on the one hand an international (white) tax avoidance strategy. But the term became more famous with regards to the OECD / G20 Base Erosion and Profit Shifting Project (or BEPS Project): Aim is to set up an international framework to combat tax avoidance by multinational enterprises ("MNEs") using base erosion and profit shifting tools. Under the OECD/G20 Inclusive Framework on BEPS, already over 130 countries are collaborating to put an end to tax avoidance strategies that exploit gaps and mismatches in tax rules to avoid paying tax.

Reason for the actual (repeated) entry of the UAE on an EU blacklist is the lack of Economic Substance Regulation (ESR) as a logical requirement out of the prior implementation of BEPS. This has now been realized (or resolved) with UAE Cabinet Resolution No. 31/2019: Issued on April 30, 2019, but only published at the end of June 2019.

ESR – what is it about?

Fiscal transparency and regulation became a global priority, thus BEPS and ESR are focusing on fair tax competition. That means for all NOON countries to take measures and tackle the use of their local tax regime to create artificial structures with no substantive economic activities.

Summarizing, the regulation aims on testing, reporting, accepting or rejecting the (domestic) economic (effective) substance of an entity. It is for the concerned entity mandatory to show in a bi- or annual report that displays that:

  • Main Income – is generated inside the UAE (“conducts State Core Income-Generating Activity in the State”);
  • Management – is present and taking decisions within the UAE, while board members must have knowledge and expertise to perform their duties (!!!) (“directed and managed in the State in relation to that activity”);
  • Employees – are working in the entity in appropriate number of full time and qualified employees. Or those are substituted by agreements with providers – which must prove then obviously also economic substance;
  • Expenses – are adequate related to the operational side of the entity business;
  • Assets – are adequate as well (tangible and intangible);

The resolution contains further specifications and requirements for IP (licensing), so-called High-Risk IP Licensees and Holding companies, but remains spongy and blurred regarding any useful parametrization.

Since the regulations apply to Onshore and Free Zone entities as well, it can be expected that ESRR Submissions will be required from each related license authority along with the annual license renewal – as it became already common practice with audited reports.

The Relevant Activities, affected by the ESR Regime?

A total of 9 activity fields are within the scope of the ESR Resolution:

  1. Banking
  2. Insurance
  3. Investment Fund Management
  4. Finance Leasing
  5. Headquarters
  6. Shipping
  7. Holdings
  8. Intellectual Property Companies
  9. Distribution & Service Centers

Those are, along with other, described in detailed fashion in Art. 1 (Definitions) of the cabinet resolution. Furthermore, also in Art. 4 (Meaning of Relevant Activity and Regulatory Authority) and finally in Art.5 (State Core Income-Generating Activities).

A massive change of the business environment may be seen due to the definition of the 9th activity field – better said with view to “Service Centers”:

Art. 1 stipulates that Service Center means: Providing services to Foreign Connected Persons in connection with a business outside the State. Prior to that is stated what a “Connected Person” is: A natural or juridical person who is related to one or more natural or juridical person(s) through direct or indirect ownership or control, or common control.

And Art. 5 states: Providing consulting or other administrative services.

In such constellations outsourced consulting and managing entities, either as branches of a foreign company and/or independent entity with similar shareholder structure will be, as far as we see it, under increased scrutiny and investigation about their economic substance than various other relevant entities with their activities.

Why should you prepare an ESR Rehearsal or even ‘Cramming’?

UAE Cabinet Resolution No. 31/2019 itself stipulates in Article 6 in all seriousness the term “Economic Substance Test”, not stating who performs this test and how it may be executed. You can expect a three-layer test, consisting of

  • The “Directed and Managed” Test
  • The “Core Income Generating Activities” (CIGA) Test
  • The “Adequate” Test

Starting point should be, especially in case of Free Zone entities, to care for resident management:

  • Either by applying in your capacity as manager / director of the entity for your own UAE residence & work permit (visa) – in case you are able to proof sufficient presence time in-country to fulfill your obligation of in-country decision making. You may fail with often usual flying visits every 8 to 12 weeks!
  • Or by appointing a “truly” resident manager instead.

Based on an entity under demonstrably resident management, an ESR rehearsal or check-up should be considered, so that you know your most probable result of the Economic Substance Test (EST) before the government knows it: better said in a period where you still have the chance to counteract.

The argument for an ESR rehearsal is simple, but absolutely vital at the same time: Failing the EST means not only reporting from the authorities to the other concerned country or just a license cancellation, but also hefty penalties.

Common UAE Practice – Penalty Catalogues!

Article 10 defines all offences and penalties (!) “where the EST is not met”:

  • Failure to meet the EST costs you in the first year between 10,000 and 50,000 AED (2,750 – 13,620 US$).
  • If you deny shutting down your entity after such a disastrous assessment and further fail also the EST in the following year, you get a “membership surcharge”: between 50,000 and 300,000 (!) AED (13,620 – 81,700 US$).
  • Of course, non-provision or inaccuracy of information to the relevant authorities costs you the same penalties between 10,000 and 50,000 AED (2,750 – 13,620 US$), see Article 11.

Scope of MCI CLT’s ESR Rehearsals are in first instance review and evaluation of all relevant substance parameters as described above. We use the term rehearsal instead of check-up, because the check-up has a definite result: pass or fail. But this will be decided neither by the entity, nor by us. By whom – we don’t know yet exactly, but it will be the government. Anyone who is promising at this early stage without knowledge about the detailed procedure a clear (pre)result of an (what we hear more and more in the scene) ESR Health Check, is not telling the truth and can’t deliver a liable result!

A rehearsal leads to a result in form of a chance estimation and should be out of this useful to decide about related consequences. Those could be

  • either adjustment of the consistency of the entity (to be on the safe side with view to EST – or even to reach a status, eliminating the EST burden);
  • or shifting the entity in a similar attractive (maybe even more attractive) jurisdiction with more transparent ES regulation or none of this.

This evaluation of consequences is clearly part of MCI CLT’s ESR Rehearsals.

Since the Cabinet Resolution came into force with publication, the first ESR reports will be due for submission in 2020 already.


Martin Kraeter, CEO


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