Introduction

On 11 September 2019, the UAE issued Ministerial Decision No. 215 of 2019 on the Directives
for the implementation of the Economic Substance Regulations (ESR). The ESR was earlier
published in April 2019 as the Cabinet of Ministers Resolution No. 31 of 2019.

The Ministerial Decision of September 2019 (the “Guidance”) is served as a ‘preliminary’
advice on how the Economic Substance Test (“EST”), could be met for the purposes of
complying, in accordance, with the provisions of the ESR. The Guidance provides various
procedures and functions as to how the Regulatory Authorities wish to enforce and asses the test.

The Guidance may be amended from time to time, revised or expanded
by the appropriate Regulatory Authorities.

Exemption

At the outset, the Guidance confirms that the ESR is not applicable
towards companies where any of the following governmental bodies have at least 51% direct or indirect ownership
in its shareholding. These bodies include:

• The federal government, or;
• Government of any Emirate of the UAE, or;
• Any governmental authority or body of any of them.

How will the Economic Substance Test be determined?

Each Regulatory Authority will have its
own substance and reporting guidelines that the Licensee will need to adhere to in
order to satisfy the EST as per the ESR. The licensees will need to provide a
a notification containing the appropriate information for the Relevant Authority
to determine if the ECT criteria have been satisfied.

For example, for a company registered in DIFC, it is the DIFC
Authority (as Regulatory Authority) who issues the reporting
requirements and who needs to receive the notifications for the EST. Likewise,
for a company registered for instance in mainland Dubai or in DMCC, it will be
the Dubai Department of Economic Development, respectively the DMCC Authority (as
Regulatory Authorities) that will issue requirements and receive
notifications from the companies registered under them. As such, it is the Regulatory
Authorities that determine in each case whether the Economic Substance Test
(EST) is met.

As a first clarification, the ECT requirements apply only to
specific areas of business, which are: Banking, Insurance, Investment Fund
Management, Lease-Finance, Shipping, Headquarters Business, Holding Companies,
Intellectual Property, Distribution, and Service Center Businesses. In the
conditions set forth by the ESR, such businesses are considered to undertake
income-generating Relevant Activities, therefore their activities need to be
notified to the Regulatory Authority.

Secondly, the Guidance mentions that
the Regulatory Authority will collect information from the Licensee in two
ways:

• By way of self-reporting; and
• Pursuant to specific requirements made by the
  Regulatory Authority.

The manner as to how these forms are
to be written and laid out is yet to be given. However, it would seem to be
determined as per each Regulatory Authority.

Thirdly, the
information that needs to be supplied to the Regulatory Authority generally
refers to:

• Whether a Licensee (company) carries out Relevant Activity; and
• Whether or not all or any part of the
  Licensee's gross income in relation to a Relevant Activity is subject to tax in
  a jurisdiction outside of the UAE;
• The date of the end of that Licensee's Financial
  Year;
• Information referring to the relevant
  income and operational expenses of the company, its employees, management,
  board meetings, intellectual property assets and activities, location and place
  of business, outsourced business, as determined in detail by Article 8(4) of
  the ESR. The Regulatory Authorities may require additional documents, in order
  to evaluate whether a company and its activities meet the EST.

Time Frame

The requirements above are in effect from
1 January 2020, meaning that all licensees commenced on or after 1 January 2019
and carrying a Relevant Activitywill need to submit an annual notification
concerning these requirements at the end of their Financial year, which would
be (12) months from the date of commencement.

In the opinion of certain Regulatory Authorities in UAE, the end of
March 2020 would be the first reporting deadline. In this time frame, a
simplified form of reporting will be required, followed by a more comprehensive
report to be notified to the Regulatory Authorities by December 31 2020. The
Regulatory Authorities are expected to issue guidance to their licensees in the
close future.

Article 4.2.3 of the Guidance has clarified that it is not mandatory for the Regulatory
Authority to issue their decision of whether the Licensee has met the prescribed
EST requirements at the end of the relevant financial year instantly. However,
if a decision needs to take place, then as per the ESR, the decision should be executed
no later than six (6) years after the end of that relevant financial year. However,
this time period will not be applicable if the Regulatory Authority cannot
reach a decision due to the Licensee's or any other person's action, deemed as gross
negligence, fraud or misrepresentation.

The ESR doesn't set out a time frame regarding the retention of records. In
this respect, the Guidance advises that a Licensee should retain any relevant
information evidencing compliance with the ESR for a period of six (6) years
after the end of each relevant financial year. Therefore, upon questioning from
the Regulatory Authority, the licensee may be able to address those requests.

Key factors concerning the Economic substance test

To get the full transparency as to what comprises the EST, the Guidance has provided additional clarity regarding the information below, as to how the Regulatory Authority would assess the submission. This involves:

• The Licensee portraying that their activities have adequate substance. The ESR has
  pointed out what activities are considered ‘Core Activities', under Article 5
  ESR. However, the guidance mentions that this not an exhaustive list. Meaning,
  the licensee may use that list, but are not limited towards them. Therefore, a Licensee should analyze the
  nature of their Relevant Activity(ies), rather than focusing only on Core Income-
  Generating Activities ("CIGA") list
  under the ESR.
• The Licensee to show whether their entity has satisfied the ‘directed and managed'
  test appropriately, by elaborating that at least one (1) meeting should be held
  per financial year which should be signed by all attendees physically present
  in the UAE. Furthermore, the applicable law under which that entity is governed
  by should be considered regarding meeting requirements.
• The Licensee showing that their Relevant Activity is engaging in a ‘genuine
  business activity', whilst carrying out the relevant CIGA in the UAE with the
  employees, expenditure and premises. The guidance mentions that the EST has no
  intentions to compare a smaller firm's requirements to the same level of a
  medium-large firm. Each EST will be individually assed as per the firm's nature
  and level of the relevant activity, income earned and the firm's size.
• The Licensee proving that outsourcing to third party service providers are not being undertaken with the intention of trying
  to evade compliance with the EST, if brought up. Furthermore, within an agreement
  between the Licensee and the outsourced, the Licensee should consider
  mentioning ECR compliance terms, such as disclosing information to the
  Regulatory Authority, for conformity purposes. The Guidance also notes that
  double counting is not allowed if the services are provided to more than one
  Licensee carrying out a Relevant Activity in the UAE.

Additional Guidance for Holding
Companies and Intellectual Property Business

As per the Guidance, a holding
company business that derives its income from dividends and capital gains only
are subjected to a reduced ECT. However, a Licensee that owns other forms of
assets besides dividends and capital gains (e.g. bonds, government securities,
interest in real property) will not be deemed as a ‘pure equity holding entity',
(even if it also owns equity participation). Therefore, the entity will not be
treated as carrying on holding business and therefore will not be exempted from
the EST requirements.

The Guidance mentions that income which
is derived from Intellectual Property "IP" assets, pose a greater risk due to artificial
profit shifting. Similarly, the ESR notes that certain activities relating to
IP Business are to be considered as ‘High Risk', therefore, more conditions are
needed to be satisfied by a Licensee undertaking these activities as mentioned under
Article 5(8)(e) ESR. The Guidance further mentions that periodic decisions made
by non-resident directors or board members would not qualify to satisfy the EST
due to considered high risk IP Licensee.

Why is the EST a necessity and how
do the Regulatory Bodies use the information provided by companies?

The ESR are issued pursuant to
certain international standards set by OECD and the EU, aimed at curbing
harmful tax practices.

The information collected by the
Regulatory Authorities will be supplied to the Ministry of Finance and, for the
companies that do not meet the EST requirements, such information will be
notified to the Regulatory Body of each company at issue. Similarly, for
companies that do not meet the EST or are High Risk IP businesses, the Ministry
of Finance will disclose such information overseas, to Foreign Competent
Authorities.

Finally, the Regulatory Authorities may impose administrative penalties for licensees who fail to notify their activities or do not otherwise comply with the ESR and the Regulatory Authorities rules in this respect. Conversely, the licensees will have the right to appeal the Regulatory Authority decisions.

Conclusion

The UAE entities will need to analyse carefully whether their business is in line with the ESR. The Regulatory Authority will adopt a "strict yet pragmatic approach" when assessing the SCT. The Guidance acts as a supporting guide
towards the regulations by providing further insight as to what is required.
However, further guidance is expected to be issued for further support and this is expected from the Regulatory Authorities in the close future.

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