The issuing of the European Union (EU) blacklist of non-cooperative jurisdictions, and significant changes in the global tax environment, have forced many low-tax and zero-tax jurisdictions to consider implementing economic substance requirements.
Entities in such jurisdictions may need to make changes in their operations to demonstrate more substance, which may include an increased local presence, activities, local expenditure, and recruitment of officers or employees within the country.
Jurisdictions, where substance compliance is required from 2019 include Bermuda, British Virgin Islands, Cayman Islands, Guernsey, and Jersey.
Entities in these jurisdictions may need to increase local presence, engage in relevant activities, incur local expenditure, and recruit local officers in order to comply.
The UAE is one such jurisdiction where more rigorous economic substance requirements have just been released. The UAE Cabinet issued the Resolution No.31 of 2019 on 30th April of this year, requiring all UAE entities that carry on specific activities to demonstrable economic substance in the UAE from 30 April 2019.
What does “economic substance” mean?
The UAE has double taxation avoidance treaties (DTAA) with over 100 countries. This means that any entity established in the UAE can claim relief from taxation in their home country under the provisions of an existing DTAA with that country.
Economic substance describes the economic reality of a corporate entity or structure that has been established because of international tax efficiency reasons.
A large number of international tax-planning structures have been established to benefit from lower tax laws in foreign jurisdictions and claim benefits under DTAAs signed between the countries. These include finance companies, holding companies, Intellectual property structures and trading companies, among others.
For example, consider the case when country X does not have a DTAA with country Y and hence an additional company is setup in country Z, with which both country X and country Y have signed a DTAA. The only objective of the corporate entity in country Z is to benefit from tax efficiencies under the DTAA. But due to the lack of economic necessity these kinds of structures often lack genuine economic activity.
Such entities are thus often setup for financial and tax reasons, but not so much because they are 'economically' necessary in the international operational activities of the company. The term “economic substance”, or “tax substance” refers to the effective role such an entity plays in the larger context of an internationally operating company. Is the company in Cayman Islands (or elsewhere) really necessary from an economic perspective in the overall corporate structure of an enterprise?
The UAE Ministry of Finance released the Economic Substance Rules in April 2019. Consequently, the ADGM, like other free zones, listed additional requirements for the structures offered, including ADGM SPVs. The two main criteria are:
The SPV can only act as a passive holding company, invest in downstream entities and enjoy dividends and royalties. It cannot carry out any trade or service and hence cannot issue invoices or have clients. The SPV will have to demonstrate basic substance within the UAE. Two mandatory requirements are:
a) the authorised signatory will have to be a UAE-resident and
b) the SPV will have to hold some assets within the UAE.
This can be in the form of shares in an underlying UAE-based free zone entity.
These criteria have to be met in order to get authorised. The underlying assets have to be identified, and an undertaking signed that confirms the execution of the stated transaction within 6 months of licensing.
How is it relevant to companies established in the UAE?
Many companies in the UAE are setup with minimal operations but are part of a larger international structure. One of the objectives of such companies may be to qualify for tax residency within the UAE, and hence claim benefits under a DTAA signed with the jurisdiction where the parent company is based.
The new regulations apply to all onshore and free zone companies setup in the UAE, than engage in the “Relevant Activities”. These may also apply to offshore companies that are currently established in the UAE, such as RAK IBCs, JAFZA Offshore companies and Ajman Offshore companies.
3. Fund management
7. Holding company
8. Intellectual property (IP)
9. Distribution and service centre
What kind of requirements will the UAE company have to comply with to demonstrate economic substance?
As per the newly-issued Regulations, the entity in question must conduct its core and income-generating activities from the UAE. They should also be directed and managed from the UAE, which implies that all strategic decisions concerning the entity have to be made within the UAE.
The level of substance required depends on many factors, such as the jurisdiction involved and the activities that the company currently engages in. Generally speaking, here are some points that would need to be considered when establishing an entity in the UAE for tax residency purposes:
1. Maintaining a dedicated physical office. Desk spaces may not qualify.
2. Employing resident officers (Directors, secretaries) and in some cases, employees as well.
3. Maintaining evidence of actual operations – telephone and internet, company website, official email addresses
4. Maintaining an operational bank account in a local bank.
5. Using local service providers – accountants, auditors, law firms etc.
6. Conducting board meetings within the UAE
7. Taking strategic decisions within the UAE – to demonstrate place of effective management
8. Maintaining official records in the physical office – minutes of meetings, accounting records, contracts etc.
Can these tasks be outsourced?
Yes. All these tasks can be outsourced to service providers. At 10 Leaves, we have multiple solutions that can help with the compliance of these economic substance requirements.
Will an offshore company qualify for tax residency in the UAE?
An offshore company does not qualify for tax residency in the UAE, since it is not allowed to operate inside the UAE. It also cannot lease office space or employ staff within the UAE.
Will a free zone company qualify for tax residency in the UAE?
Free zone companies are allowed to carry out operations, lease physical space and employ staff. On this basis, they do stand to qualify for tax residency. However, it may happen that additional substance requirements will be required, considering if the current activities are classified as “Relevant Activities” and also the jurisdiction of the parent company where the UAE company applies for tax relief (under the DTAA).
I have a Tax Residency Certificate for my UAE Company. Is that not sufficient?
Currently, there are certain minimum requirements to qualify for tax residency, and the TRC is issued after the company satisfies these criteria. However, the TRC may be contested when applying for tax relief in the jurisdiction under the DTAA, keeping in mind the new focus on substance requirements.
By when do we have to comply?
Existing entities must comply from 30th April 2019, and new entities should comply upon receipt of their commercial licenses. Penalties for non-compliance include fines ranging from AED 10,000 to AED 300,000, and possible revocation of the commercial license.
How do we go about it?
Contact us to know more about whether the new economic substance regulations apply to your activity and legal structure. We can then discuss on how to address the potential gaps and satisfy these requirements on an ongoing basis
Download the PDF: Economic Substance Regulations in UAE