Understanding Corporate Tax and Economic Substance Regulations

The UAE has always been known as an international business hub, with enterprises mostly attracted by its tax-friendly environment and its strategic location. In trying to align itself with international requirements to drive out unfair tax practices, the UAE promulgated the Economic Substance Regulations (ESR) and Corporate Tax laws. These laws looked forward to having the UAE entities maintain an adequate relevant substantial economic presence in the country proportionate to their activities. It explains the technicality of ESR and corporate tax in the UAE, especially with regard to businesses that have their place within the UAE Free Zones.

Background on UAE Economic Substance Regulations (ESR)

The UAE introduced its Economic Substance Regulations in April 2019 and was further revised through Cabinet Decision No. 57 of 2020 issued in August 2020. These Regulations mandate that UAE onshore and free zone companies, together with certain other forms of business enterprises, must conduct defined “Relevant Activities” to continue to maintain and be able to demonstrate adequate economic presence in the UAE—the “Economic Substance Test.” 

Scope of Application

According to Article 3 (1) of the Ministerial Decision No. 100 for the Year 2020, the ESR applies to an entity that is:

1. a juridical person (incorporated inside or outside the State); or
2. an Unincorporated Partnership; registered in the State, including a Free Zone and a Financial Free Zone and carries on a Relevant Activity. These activities herein include:

• Banking Business
• Insurance Business
• Investment Fund management Business
• Lease – Finance Business
• Headquarters Business​​
• Shipping Business
• Holding Company Business
• Intellectual property Business (“IP”)
• Distribution and Service Center Business​

Such activities need licensees from the UAE who can show adequate economic presence proportionate to the activities carried out in the UAE.

Compliance and Administrative Requirements

1. Filing Requirements

There are two key filing requirements with which UAE Licensees should comply:

• Economic Substance Notification: This should be filed online with the MoF portal within six months from the end of the relevant Licensee’s financial year in the UAE.
• ES Annual Report: This applies to UAE Licensees that undertake RA(s), generate relevant income from those activities, and do not qualify for exemptions; the report must, within 12 months of the year-end, be submitted.

2. Economic Substance Test (ES Test)

The Licensees required to file the ES Annual Report shall also meet the Economic Substance Test, meaning they need to be able to prove that they have adequate employees, physical assets, and expenditure in the UAE, as well as core income-generating activities (CIGAs) conducted in the State.

3. Exemptions

The ESR Regulations exclude certain forms of entities from the requirement to meet the Economic Substance Test. For the purpose of the ESR Regulations, an Exempted Licensee includes any of the following entities registered in the UAE and which carry out a Relevant Activity: 

• An investment fund;
• An entity that is tax resident in a jurisdiction other than the UAE;
• An entity wholly owned by UAE  residents and meets the following conditions:

• the entity is not part of a MNE group;
• all of the entity’s activities are only carried out in the UAE;

• A licensee that is a branch of a foreign entity the relevant income of which is subject to tax in a jurisdiction other than the State.

Each exemption is subject to the discretion of the relevant authorities and must be claimed for every financial period, if applicable.

UAE Corporate Tax and ESR Interaction

Federal Decree-Law No. 47 of 2022 on Corporate Tax

This law covers corporate income tax in great detail and specifies a 0% rate for “Qualifying Income” of a “Qualifying Free Zone Person” and a rate of 9% for income that is non-qualifying. In order for a Free Zone entity to be eligible for the 0% rate, it must meet the following conditions:

• Minimum substance in the Free Zone
• Derive qualifying income
• Elect not to be subject to corporate income tax
• Comply with transfer pricing
• Ensure any non-qualifying revenue does not exceed the de minimis limit.
• Prepare audited financial statements

Conditions for Qualifying Free Zone Persons

Cabinet Decision No. 55/2023 defined a “Qualifying Free Zone Person” as any person who meets the following requirements:

• Conducting core income-generating activities (CIGAs) within the Free Zone.
• Maintenance of adequate assets, employees, and expenses associated with their CIGAs.
• They can also outsource CIGAs to related or third parties within the Free Zone, subject to appropriate supervision on their part.

Consequences of Non-Compliance

Failure to meet the ‘adequate substance’ requirements, among others, may cause a denial of the person’s status as a “Qualifying Free Zone Person”. That means the 0% tax rate on qualifying income would not apply from the commencement of the tax period, and it will continue till the subsequent four tax periods.

Key Considerations for UAE Licensees in Free Zones

1. Substance Over Form

Businesses must adopt a ‘substance over form’ approach to assess adequate economic substance. This involves:

• Conducting CIGAs within the Free Zone and maintaining documentary evidence.
• Ensuring the UAE Licensee is directed and managed in the UAE, including holding board meetings in the UAE and maintaining records.
• Having an adequate number of qualified employees, assets, and expenditures in the UAE.

2. Outsourcing

Any such outsourcing providers should align with the requirements above, avoiding double counting and performance of the services through written agreements that straightforwardly outline detailed responsibilities, compensation, and supervision terms.

Conclusion

Business enterprises that are set up in the UAE Free Zones should be careful when going through the complexities of the UAE’s Economic Substance Regulations and Corporate Tax laws. Compliance would ensure continued benefits of preferential tax rates and alignment with international standards placed upon them.

In case one requires further clarity on the Economic Substance Regulations and Corporate Tax requirements of the UAE, and the areas in which those might apply, one may seek advice from experts at Farahat & Co. to guide one through the compliance process. Our experienced team takes care of your business compliance procedure and helps to comply with all the laws. Contact us today to ensure the proper and correct positioning of your business within the regulatory framework of the UAE.