The economic substance requirements are toughening throughout the world and the United Arab Emirates is not an exception. The country remains highly attractive for foreign entrepreneurs but some things have been changing for the worse for them. To be fair, things have been changing for the worse everywhere. Since this year, the UAE has joined other countries in the region such as Saudi Arabia, Oman, Kuwait, and Qatar in levying a profit tax on companies. Establishing economic presence in the region can still be a promising move but you have to learn about the recent changes in the tax regulations as well as corporate legislation.
In particular, the Emirates have changed the requirements to the economic substance that locally registered companies have to have. They have done so under pressure from the OECD and other global regulators. Below we discuss the current state of affairs in this area but we would like to make a short historic note before we get to the core of the issue.
The OECD and G20 launched the Base Erosion and Profit Shifting (BEPS) program in 2013 and drew up an action plan. Among other things, the economic substance requirements were introduced. All companies now had to have economic substance in the countries of their domiciliation if they were to be eligible for tax preferences.
Since 2015, the Forum for Harmful Tax Practices (FHTP) has been publishing annual reports that act as manuals for national governments. The reports give a definition of economic substance. They list the relevant business activities; they describe the procedures of economic substance testing; they provide examples of business operations essential for acquiring profits from relevant activities. In accordance with the standards set by the FHTP, the Cabinet of Ministers issued a Decree on economic substance compliance in the UAE in 2019. The rules set in the Decree are applicable today. The FHTP closely monitors compliance with the economic substance requirements in zero-tax and low-tax jurisdictions.
The UAE is subject to monitoring, among other states. As of 2023, the FHTP acknowledges that the country is in compliance, the necessary laws have been passed, and the required procedures have been implemented.
We must note that economic substance requirements are different from tax residence requirements. To be more precise, you have to meet a larger number of conditions to pass the economic substance test than to qualify for tax residence of the country. Non-compliant countries can give tax residents to those companies that are not physically present in the countries. In accordance with today’s requirements, tax benefits can be granted only to those residents who have passed the substance test. Otherwise, they can avoid paying taxes on profits made in other countries, which is unfair. This is how the OECD and G20 reason.
The place of effective management (POEM) may matter for tax residence. It does matter for the economic substance test. When the POEM is assessed for tax residence purposes, the location of the managers overseeing profit-generating operations is important. For economic substance purposes, the location of the company top managers who control the organization is important. When it is hard to determine the tax residency of a particular company, both factors may play a role.
General economic substance rules in the UAE
The UAE has set the economic substance rules at the federal level. They oblige the companies registered in the country to have economic substance. Besides, they have file annual substance reports to demonstrate that they are in keeping with the rules.
The rules apply only to companies engaged in relevant business activities. These include the following ones: banking; insurance; investment fund management companies; lease-finance; headquarters; ship business; holding activities; use of intellectual property; distribution of goods purchased from other group companies and intra-group service centers. The economic substance requirements do not apply to companies that fall outside these groups.
Tax regulations relevant to economic substance requirements
The UAE Corporate Tax Act has been amended. The zero tax rate applied to companies registered in Free Economic Zones (FEZ) in the country is now conditioned by their substantial physical presence in the UAE. It is important to note that the company can be physically present in the entire UAE, not necessarily in the FEZ where it is registered. If it has property on the mainland or uses resources on the mainland, it counts as economic substance too.
Examples of difficult questions that may arise due to the wording of the document
Example 1. Company A is registered in port Khalifa FEZ. It has an office and warehouses there. The company buys goods from group companies and then ships them from the FEZ to buyers from the Middle East and Africa. A subsidiary company located on the mainland accepts orders from the buyers. A substantial part of the overall operational costs is attributable to product promotion. Company A pays independent agents to promote the products in the mainland UAE. The agents’ activities count towards the economic substance that the company has in the UAE. Subparagraph ‘a’ of paragraph 1 of Article 17 of the Corporate Tax Act uses the term ‘adequate substance’ rather than ‘economic substance’ or ‘adequate economic substance’. The fact that the word ‘economic’ is not used does not mean that the substance cannot be economic: it can. At the same time, this fact blurs the meaning of the word ‘substance’ a bit.
Thus, the mentioned subparagraph says that the company has to have adequate substance in the UAE to qualify for the zero tax rate. If it said ‘economic substance’, it would be clear that this applies only to the companies engaged in the 9 relevant types of activities listed above. However, the wording makes the following issue unclear: does the company have to have adequate substance if it is engaged in non-relevant activities to qualify for the zero tax rate?
Example 2. The company provides consultation services to independent entities (non-relevant activities) as well as intra-group services (relevant activities). It has to file reports concerning only the intra-group services. But does it have to have adequate substance to provide services to other clients? If the law is to be interpreted broadly, the economic substance test needs to be passed in all cases, no matter if the company is engaged in relevant or non-relevant activities. This interpretation does not look reasonable. If the law is to be interpreted narrowly, the adequate substance requirements are not applicable to non-relative types of activities. If the law is to be interpreted literally, the company becomes unqualified for the zero-tax rate if it fails to comply with the substance requirements in one of the areas of its operations while it does comply with the requirements in other areas. If the law is to be interpreted liberally, the company pays zero in taxes on the profits obtained from non-relevant activities.
The UAE corporate legislation, however, does not allow local companies registered in FEZs to be ‘partially’ tax-exempt. Thus, things may become complicated if a company is engaged in two types of business activities at a time – relevant and non-relevant.
Too little time has passed since the new regulations on economic substance were adopted. Practice will have to show how the Corporate Tax Act is going to be interpreted in questionable cases. If you find yourself in an unclear situation, you had better seek legal advice. Paying nothing in taxes is an attractive opportunity for many and why not use it when you can do it without breaking any laws?