On 30 April 2019, the UAE Cabinet issued the Cabinet of Ministers Resolution No.31 of 2019 concerning economic substance regulations in the UAE, requiring all in-scope UAE entities that carry on certain activities to have demonstrable economic substance in the UAE from 30 April 2019.
Background
On 1 December 1997, the Council of the European Union and the Representatives of the Governments of the EU Member States, meeting within the Council of the European Union, adopted a resolution on a Code of Conduct for business taxation. This resolution provides for the establishment of a group (the Code of Conduct Group on Business Taxation, or “COCG”) within the framework of the Council of the European Union, which was established on 09 March 1998, to assess tax measures. On 05 December 2017, the EU Council adopted conclusions on the EU list of non-cooperative jurisdictions for tax purposes, which created the so-called EU’s “blacklist”, as well as a list of jurisdictions being monitored to commit to implement good tax governance principles, the so-called EU’s “greylist”. Although the UAE had initially been put on the EU’s blacklist, the UAE was delisted in January 2018 and placed on the EU’s greylist following the COCG receiving commitment letters.
However, the UAE was re-listed on 12 March 2019, following COCG’s conclusions that the: “United Arab Emirates facilitates offshore structures and arrangements aimed at attracting profits without real economic substance and has not yet resolved this issue.”
The main repercussions for being listed on the EU blacklist are twofold – (a) EU funding restrictions, and (b) reporting requirements, as well as reputational damage. EU funding under the Financial Regulation and in the European Fund for Sustainable Development (EFSD), the European Fund for Strategic Investment (EFSI) and the External Lending Mandate (ELM) cannot be provided to countries featured on the EU blacklist. Furthermore, being listed on the EU blacklist creates a number of reporting requirements, which include amongst others, the need for intermediaries to report to tax authorities in case a tax scheme is routed through a blacklisted country.
The UAE effectively committed to the EU to introduce economic substance legislation before 01 January 2019. The UAE provided a concept paper on 17 December 2018, followed by the first draft legislation on 12 February 2019. Even though some EU Member States (in particularly Italy) commended the UAE's efforts, most delegations held the view that the delay (of introducing the above mentioned law) was not justified. The UAE was therefore re-listed on the EU’s blacklist. In light of the ESRs issued by the UAE, the EU finally removed the UAE from its blacklist on 10 October 2019.
The UAE’s New Economic Substance Regulations
Overview
Relevant Activities include banking, insurance, fund management, financing and leasing, headquarter companies, shipping business, investment holding (i.e. holding companies), IP activities and distribution and service centres. Companies owned directly or indirectly by the UAE Government or any subordinate government authority are exempt from the ESRs.
The economic substance requirements under the ESRs include:
- conducting the relevant “core income generating activities” (“CIGAs”) in the UAE;
- being “directed and managed” in the UAE; and
- with reference to the level of activities performed in the UAE:
- having an adequate number of qualified full-time employees in the UAE
- incurring an adequate amount of operating expenditure in the UAE, and
- having adequate physical assets in the UAE.
Meaning of “directed and managed”
The test for whether activities are “directed and managed” in the UAE, as outlined at Article 6(3) of the ESRs, states that the following conditions must be met:
- the Relevant Entity’s board of directors meets in the UAE at an adequate frequency having regard to the amount of decision-making required at that level;
- at such board meetings there is a quorum of directors physically present in the UAE;
- the board meetings are recorded in written minutes and signed by the attending directors;
- the minutes of such board meetings record the making of strategic decisions of the Relevant Entity at the board meeting;
- the directors of the Relevant Entity have the necessary knowledge and expertise to discharge the duties of the board;
- the minutes of all board meetings and the records of the Relevant Entity are kept in the UAE; and
- in the case of branch offices and representative offices of foreign companies and other commercial companies that do not have a board of directors, but rather are managed and operated by a single manger, such manager shall be physically present in the UAE when taking key decisions relating to the management and operation of the Relevant Entities.
Core Income Generating Activities and Outsourcing
Specifically in respect of the ‘Investment Fund Management Business’ (ie SCA-licensed investment/asset managers), under Article 5(3) of the ESRs, the CIGAs include:
- taking decisions on the holding and selling of investments;
- calculating risk and reserves;
- taking decisions on currency or interest fluctuations and hedging positions, and
- preparing reports to investors or any government authority with functions relating to the supervision or regulation of such business.
Under the ESRs, Relevant Entities may outsource CIGAs (with the exception of “high risk IP”, as defined), provided the outsourced activities are carried out inside the UAE and the Relevant Entity retains full control over those activities.
Holding Company Businesses
Pure holding companies (defined as “a business that is: (a) a ‘Holding Company’ in accordance with the law applicable to the [Relevant Entity] carrying out such activity in the UAE; (b) has as its primary function the acquisition and holding of shares or equitable interests in other companies; and (c) does not carry on any other commercial activity”), shall be subject to less stringent substance requirements. The economic test for a ‘Holding Company Business’ that derives its income from dividends and capital gains only, as outlined at Article 6(4) of the ESRs, is that it meets the following conditions:
- complies with the requirement to submit any documents, records or information to the relevant regulatory authority in accordance with the law applicable to the Relevant Entity in the UAE; and
- has adequate employees and premises for holding and managing the ‘Holding Company Business’.
However, for holding companies that derive income from sources other than dividends and capital gains from its equity interests, its CIGAs shall be those activities associated with the income generated.
Reporting Requirements and Penalties
Reporting requirements under the ESRs require all Relevant Entities to report to the authority that issued its trade license (“Regulatory Authority”) (who in-turn will report to the UAE Ministry of Finance), in order to demonstrate that they satisfy the economic substance requirements no later than 12-months after the end of each financial year.
Under the ESRs, non-compliance may result in administrative penalties, for failure to provide information, of up to AED 50,000 in the first financial period and up to AED 300,000 in subsequent financial periods, the requirement to provide information upon request as well as ad hoc investigative/inspection powers to the relevant authorities, and ultimately, potential deregistration.
New Implementing Regulations and Ministerial Guidance Released
Overview
As anticipated under Article 17 of the ESRs, on 11 September 2019 the UAE’s Ministry of Finance issued further executive/implementing regulations and ministerial guidance. Ministerial Decision No. 215 of 2019 on the Issuance of Directives for the Implementation of the Provisions of Cabinet Decision No. 31 of 2019 concerning Economic Substance Requirements (the “Ministerial Guidance”) provides the much needed clarifications in relation to practical requirements under the ESRs.
The Ministerial Guidance fills some of the gaps presented by the ESRs in respect of the key requirements of the economic substance requirements. The Ministerial Guidance provides that Relevant Entities carrying on more than one Relevant Activity are required to satisfy the economic substance requirements in respect of each Relevant Activity and therefore cannot offset certain requirements between Relevant Activities undertaken. The Ministerial Guidance also clarifies that the list of CIGAs is non-exhaustive and the general principle is that the activities which form the CIGAs are regarded to be the most important activities expected to be carried out by the Relevant Entity in the UAE.
Meaning of “directed and managed”
In respect of the “directed and managed” test, the Ministerial Guidance expands on the conditions provided in the ESRs, namely that:
- a determination as to adequate frequency of board meetings is dependent on the level of the Relevant Activity being carried on, but that it is expected that at least one board meeting is held in a financial year in the UAE
- Relevant Entities should consider requirements prescribed by the laws regulating them, as well as their constitutional documents when determining what constitutes an adequate number of board meetings
- the minutes of board meetings must refer to all relevant decisions taken at the meetings and be signed by all directors physically present
- quorum of a board meeting is determined in accordance with the laws applicable to the Relevant Entity and its constitutional documents
- if a Relevant Entity is managed by an individual (for example a general manager or CEO), the requirements apply to that individual, and
- it is imperative that the board or manager have the necessary knowledge and expertise to discharge their duties and are not merely giving effect to decisions made outside the UAE.
Meaning of “adequate” and “appropriate”
Furthermore, the Ministerial Guidance clarifies the meaning of “adequate” and “appropriate” in relation to employees, expenditures and premises, acknowledging that what is adequate or appropriate for a small business, may not be so for a large or medium sized business. It is explained that the ESRs do not intend to impose requirements on Relevant Entities to engage more employees than required or to incur expenditures beyond what is needed. Rather, the intention is to ensure that the Relevant Entity is engaged in a genuine business activity and carrying out CIGAs in the UAE with the employees, expenditures and premises it has. This assessment will depend on the nature and level of the Relevant Activity being undertaken by the Relevant Entity and the Relevant Entity should maintain sufficient records demonstrating the adequacy and appropriateness of resources utilised and expenditures incurred. The Regulatory Authority will review such records in assessing whether the Relevant Entity has demonstrated the required levels.
The Ministerial Guidance explains the rationale behind the economic substance requirements. It explains that the requirement for adequate employees is designed to ensure employees carrying out the Relevant Activity are suitably qualified to carry on such activity and that the requirement for adequate premises is aimed at ensuring that the Relevant Entity has appropriate premises for carrying out the Relevant Activity. Adequate premises can include offices or other forms of business premises depending on the Relevant Activity being carried out, including warehouses or facilities. The premises can be owned or leased by the Relevant Entity, provided the Relevant Entity provides the Regulatory Authority with relevant documentation evidencing the right to use the premises to carry out the Relevant Activity.
Outsourcing
The Ministerial Guidance provides guidance for when CIGAs can be outsourced by the Relevant Entity in the UAE to a third-party service provider (the “Service Provider”). The Service Provider may be a company related to the Relevant Entity, provided that such arrangements do not contravene existing regulatory requirements to which the Relevant Entity is subjected. The Service Provider must have adequate levels of activities, employees, expenditures and premises in the UAE which are individually and in the aggregate, adequate for the CIGAs being undertaken. These cannot be double counted in relation to services provided to multiple Relevant Entities. The Ministerial Guidance stipulates the need for agreements entered into with Service Providers to meet the economic substance requirements and the disclosures required to be made to Regulatory Authorities. The Ministerial Guidance also states that the Relevant Entity must be able to demonstrate to Regulatory Authorities that the outsourcing arrangements are not being done with the objective of circumventing compliance with the economic substance requirements.
Holding Company Businesses
Moreover, the Ministerial Guidance elaborates when a Relevant Entity can apply the less stringent economic substance requirements by virtue of being a ‘Holding Company Business’. A Relevant Entity which owns assets other than equity interests, for example, bonds, government securities or interests in real property, is not a pure holding company and accordingly is subject to the full economic substance requirements.
Reporting Requirements and Determinations
In relation to Relevant Entities’ reporting obligations towards relevant Regulatory Authorities, the Ministerial Guidance provides that while the ESRs do not prescribe a set period for the retention of information by a Relevant Entity, it is advisable to retain any relevant information evidencing compliance with the economic substance requirements for a period of six years after the end of each financial year. This timeframe aligns to the Regulatory Authorities’ powers to assess Relevant Entities’ compliance.
The Ministerial Guidance provides guidance on how a Regulatory Authority will determine whether a Relevant Entity has met the economic substance requirements, stating that the Regulatory Authority shall adopt a strict but pragmatic approach to the construction and application of the ESRs. The Regulatory Authority may consider various factors in making its determination, including:
- the CIGAs being carried out;
- fluctuations in the levels of CIGAs being carried out having the effect of adequacy levels differing from financial year to financial year;
- timesheets or other evidence when assessing adequacy of employees and time spent by employees with appropriate qualification conducting CIGAs and relevant comparable statistics for the business sector, such as the average revenue per employee;
- the fact that directors of a Relevant Entity may sometimes themselves perform the CIGAs, in addition to their fiduciary duties, thereby reducing/eliminating the need for employees/Service Providers; and
- outsourcing activity.
