The Economic Substance Regulations (ESR) were introduced in 2019 as part of the United Arab Emirates’ commitment to international tax standards, particularly to adhere to the OECD’s Base Erosion and Profit Shifting (BEPS) initiative. Further, to maintain economic fairness and transparency, the UAE has implemented ESR to combat tax avoidance by corporations. Thus, it is advisable for Licensees to seek the expert services of trusted ESR Consultants in the UAE to effectively ensure compliance with the Economic Substance Regulations.
Concept of Base Erosion
Base erosion involves strategies used by multinational companies to reduce their taxable income in high-tax countries. One common method is through the use of inter-company transactions.
Example: Transfer Pricing
If Company A, a multinational corporation, operates in several countries, including a high-tax jurisdiction (Country X) and a low-tax jurisdiction (Country Y). Company A sells a patented technology to its subsidiary in Country Y. To determine the price of the technology, Company A might set a transfer price that is lower than its fair market value. This action reduces the profits in Country X, which has higher tax rates, and shifts them to Country Y with lower tax rates. As a result, Company A pays less overall taxes.
Profit shifting involves manipulating where profits are reported for tax purposes, often by exploiting differences in tax rates across jurisdictions.
Example: Intellectual Property Holding Company
Company B, a multinational enterprise, owns valuable intellectual property (IP) such as trademarks, copyrights, and patents. Instead of holding this IP in a jurisdiction where the company conducts substantial business operations, Company B establishes an entity in a low-tax jurisdiction, often referred to as a “tax haven.” The IP is then transferred to this entity, which charges substantial royalties to the operational entities in higher-tax jurisdictions. This reduces profits in the high-tax jurisdictions and artificially inflates expenses, resulting in lower taxable income. The low-tax jurisdiction captures a substantial portion of the company’s profits through royalty payments at a lower tax rate.
In both scenarios, the goal is to minimize the overall tax liability by allocating income and expenses strategically across jurisdictions. This can lead to a reduction in tax revenue for high-tax countries and potentially create an uneven playing field for international business. To address these issues, the UAE took the initiative of Economic Substance Regulations to combat such practices and ensure fair taxation for a sustainable business environment in the country.
Applicability of ESR to Multinational Corporations
Multinational corporations operating in the UAE are subject to ESR if they engage in Relevant Activities. These activities include banking, insurance, shipping, lease finance, investment fund management, intellectual property, headquarters business, holding company business, and distribution and services. Understanding whether their business falls under one of these categories is the first step to complying with the Economic Substance Regulations.
For multinational corporations that claim to be tax residents in a jurisdiction other than the UAE or are a branch of a foreign entity the Relevant Income of which is subject to tax in a jurisdiction other than the UAE, the burden of proof lies in providing documentation that establishes their exemption status. This might include documents issued by the foreign tax authority confirming corporate income tax residency or records of corporate income tax assessments, payments, or demands.
ESR compliance involves the submission of an annual Notification to the relevant Regulatory Authority. Multinational corporations that claim to be exempted from ESR due to tax residency in a foreign jurisdiction or a branch of a foreign entity claiming to be subjected to tax in a jurisdiction outside the UAE must provide sufficient evidence along with their Notification. This evidence may include a letter or certificate from the foreign jurisdiction’s competent authority confirming tax residency or documentation of corporate income tax assessment and payment.
Penalties for Non-Compliance
Entities that cannot prove their exempt status will be treated as Licensees and subjected to the full requirements of the ESR, including the Economic Substance Test. Non-filing of notification will attract a penalty of AED 20,000. Non-filing of ESR Report and not meeting the ESR Test will attract a penalty of AED 50,000, in case the entity fails to provide adequate evidence to substantiate exempted status. If the same violation continues in the subsequent year the entity will attract a penalty of AED 400,000. Moreover, providing inaccurate information will attract a penalty of AED 50,000.
Avail the services of trusted ESR Consultants in the UAE
It is advisable for multinational corporations to consult ESR experts and provide the necessary documentation to substantiate their exempted status if applicable. Therefore, ensuring compliance with the Economic Substance Regulations and contributing to a fair and transparent global business environment. Thus, contact us today and we shall be glad to assist you.
Syed Hassan Ali carries with him an experience of 13 years in providing legal guidance and consultancy. He is a holder of two degrees, one in Business Management and the other in Economics for Engineers and Scientists. He carries an in-depth knowledge of the UAE market and continues to be an asset to businesses, providing clarity regarding applicability of the ESR regulations as well as guide them in making informed decisions.