The Impact of the UAE’s Economic Substance Regulations on Foreign-Owned Companies

The United Arab Emirates’ efforts to align with global tax standards have been commendable. One of the most impactful changes that has come in recent years has been the introduction of Economic Substance Regulations (ESR) in 2019.

For many foreign-owned companies operating in the UAE, this announcement has come with significant rules and regulations with respect to their operations and financial systems. But what exactly are these regulations, and why should foreign-owned companies pay close attention? Let’s understand it with this blog.

What Are the UAE Economic Substance Regulations?

The UAE introduced the economic substance regulations effective from 1st January 2019 as a way to meet the international standards set by OECD and the EU Code of Conduct Group.

It effectively required UAE entities, including offshore companies and branches of local and foreign companies, to carry out and earn income from certain relevant activities in the UAE to maintain economic substance. These requirements should be filed annually, or the organization will risk penalties for non-compliance.

The relevant activities that are subjected to ESR are:

• Banking
• Insurance
• Investment fund management
• Lease-finance
• Headquarters
• Shipping
• Holding companies
• Intellectual property
• Distribution and service centers

While determining whether an entity is carrying out any relevant activities, a ‘substance over form’ approach must be adopted.

What Does ESR Require?

ESR requires the licensees to show that they have genuine economic presence in the UAE and that the activities they carry out are not solely tax-driven. One of the primary reasons the UAE announced the ESR was to prevent companies from shifting profits to low or no-tax jurisdictions without real business activities there. This means that companies need:

• A physical office or workspace in the UAE
• A sufficient number of full-time employees who reside in the UAE
• Operating expenses that reflect actual local business activity

Impact on Foreign-Owned Companies

Economic Substance Test

All companies, including foreign-owned companies, must satisfy the Economic Substance Test (ES Tests). There are 3 ES tests they need to clear. The following is a brief overview of these:

• Core Income Generating Activity (CIGA) test: Requires the core activities to be performed in the UAE
• Directed and Managed test: Requires the business to be directed and managed from the UAE in relation to the Relevant Activity
• Adequacy’ test: Requires adequate resources (employees, expenses, and assets) in the UAE

The Holding companies are subjected to reduced ES tests. Similarly, High-risk Intellectual Property businesses are subject to enhanced ES Tests. The level of economic substance a licensee is required to demonstrate depends on the type of relevant activity.

Recently, the UAE has begun exchanging this information with relevant foreign authorities regarding the entities that have failed the ES test or fall in a high-risk intellectual property (IP) licensee category.

Operational Changes

International businesses operating in the UAE, particularly those engaged in the relevant activities, face the imperative to make the necessary operational adjustments to avoid penalties. This means that they need staff not only to expand their physical presence but also to increase the activities they conduct in the UAE. These changes reflect a commitment towards actively contributing to the local economy.

Risk of Non-Compliance

If any business fails to comply with the regulations, it poses significant risks and penalties.

• Failure to file a notification will result in an AED 20,000 fine.
• Failure to file the report will result in an AED 50,000 fine and deemed failure to meet ES Tests.
• Failure to offer accurate or incomplete information will result in a fine of AED 50,000 and be deemed a failure to meet ES Tests.
• Failure to meet the ES tests in the first year will result in a fine of AED 50,000 and information exchange with foreign competent authorities. Similarly, failure to meet the test in the second year leads to an AED 40,000 fine, information exchange and suspension, cancellation, or non-renewal of the trade license.

To avoid this, companies need to be extremely vigilant in their operations to maintain continuity.

Need to be More Transparent

The ESR mandates detailed disclosures about important aspects of business, such as:

• Business activity
• Financial performance
• Core income-generating functions

This information provides important insight to stakeholders, regulatory bodies, and the public about the company's contribution and operations. While it helps to build trust and credibility in the business environment, any attempt at providing inaccurate or incomplete information will be met with strict consequences.

Higher Compliance Costs

Investing in legal aid and accounting systems has become necessary to meet the compliance requirements. Additionally, foreign-owned companies that were operating otherwise will have to reconsider their operational structures and processes to meet the regulations. While this increases the compliance costs, it also makes these companies legitimate and sustainable in the long term.

Final Thoughts

Although the ESR adds a compliance burden, the overall impact of ESR is positive. It is a sign that the UAE welcomes businesses that genuinely want to establish themselves in the UAE, and not just have a ‘letter box’ address here or take advantage of the UAE’s tax systems. This benefits the companies that wish to be a part of a global business system that holds its credibility at an international level.

One of the most important aspects of ESR is transparent accounting systems. We at

Alpha Pro Partners is a customer-focused firm of expert chartered accountants and business specialists to help your business grow with our industry-leading accountancy and taxation services.

Reach out to us today.

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