There is a multitude of companies in the UAE that are owned by entities incorporated in “no or only nominal tax” jurisdictions (referred to herein as “noons”) such as the British Virgin Islands (BVI), Cayman Islands, Isle of Man, Jersey, Guernsey, Mauritius, Bahamas, Seychelles, Bermuda and the UAE (to name a few). Except for using these entities only to hold shares in UAE entities, these companies in the noons often also hold intellectual property rights and enter into licensing agreements, franchise agreements, management agreements and other similar agreements with UAE entities, aimed at reducing the perceived risks of retaining these funds in the UAE and/or to take advantage of the no or nominal tax regimes of these jurisdictions from which dividends are distributed internationally. The European Union has however, with effect from 1 January 2019 changed, the playing fields regarding the conduct of business in this way as is explained below.
What exactly are “Economic Substance Rules”
The European Union Code of Conduct Group, after assessing the tax policies of jurisdictions with no or only nominal tax, has prescribed certain criteria which need to be followed resulting in the implementation of laws by these noons for the purpose of eliminating the facilitation of corporate structures or arrangements aimed at attracting profits which do not reflect real economic activity in these jurisdictions. As a result, entities incorporated in noons which conduct certain identified business activities need to show “real economic activity” in these jurisdictions or face fines, penalties and possible de-registration by the relevant authorities in the jurisdiction in which they are incorporated. The European Union has further imposed certain measures in order to obtain cooperation from the noons which include “blacklisting” non-complying jurisdictions. In order to avoid “blacklisting”, all affected jurisdictions were required to promulgate “Economic Substance Rules” into law within their respective jurisdictions by 1 January 2019. In the UAE, economic substance regulations have been introduced by the Cabinet of Ministers Resolution No. 31 of 2019 which came into effect on 30 April 2019.
Essentially all the jurisdictions that have passed “economic substance rules” into law have followed the same criteria in that they have defined which entities are affected, which economic sectors and/or economic activities are affected and have devised certain tests to establish if an entity complies with the criteria for “economic substance” within that jurisdiction. Although all the laws passed by these noons are not exactly the same, the general criteria imposed by the European Union Code of Conduct Group have been applied by all jurisdictions.
In general, all legal entities that are resident for tax purposes in accordance with the laws of the particular noon must comply with the economic substance requirements, the only exception being if the entity is resident for tax in another jurisdiction from which a tax residency certificate must be obtained to this effect. A number of the noons have also provided particular provisions relating to the determination of tax residency in their economic substance laws.
Affected Sectors & Relevant Activities
Generally, the relevant jurisdictions have made the economic substance laws applicable to the following sectors and/or activities, namely banking, insurance, shipping, fund management, financing and leasing, headquarters, equity holding entities, head offices entities, intellectual property holding and distribution and service centers.
Economic Substance Tests
To show that sufficient economic substance exists within the noon, an entity must pass the following “substance tests”, namely that the entity must from within the noon be (i) effectively directed and managed, (ii) conduct core income generating activities, and (iii) show adequacy in respect of qualified employees, expenditure and physical presence.
Directed & Managed
For an entity to be directed and managed from within the noon it will have to show that regular board meetings are held, the required quorum of directors are present at such board meetings, that the directors have adequate experience and knowledge of such responsibilities, that the minutes of the board meetings are kept, all within the noon itself.
Core Income Generating Activities
The entity must show that core income generating activities (“CIGA’s”) are conducted within the noon with due consideration to the level of income being generated by the entity’s activities. The extent of the CIGA’s may also be dependent upon the economic sector within which the entity falls and/or the economic activity of the entity as certain entities may be an equity holding company and license intellectual property in which case it must pass the test for both activities. The important feature in complying with the CIGA’s is that the income subject to tax in the noon is “appropriate” to the CIGA’s conducted in that jurisdiction.
CIGA’s for the different economic sectors and economic activities will vary. A few examples are as follows: (i) “Equity Holding Entities” would require compliance with relevant corporate filing requirements, manage the shareholdings in the various subsidiaries with adequate personnel and an appropriate premises (ii) “Intellectual Property Holding Entities” would require research and development activities to be conducted in the noon, and (iii) in respect of intangible assets such as brands and trademarks, the CIGA’s would have to include the conduct of activities such as branding, marketing and distribution.
It is possible to outsource certain CIGA’s, even to outside the noon however this would be subject to certain conditions. In the event of outsourcing, the resources of the service provider will be taken into account when determining compliance with the required CIGA’s.
Relating to the two criteria mentioned above, the noon entity must have sufficient qualified employees, incur sufficient expenditure and have adequate assets within the noon in order to justify the income generated by the noon entity. The employees must be physically present in the noon, although they do not need to be directly employed by the noon entity and may be employed by another entity and may be also be employed either on a temporary or permanent basis. The determination of “adequacy” will depend entirely on the particularities of the noon entity and its economic activity.
Each noon has its own reporting mechanisms however, reporting will mostly be by the submission of a bi-annual or annual “economic substance return” specifying how the substance rules are being complied by the entity. Failure to comply with the economic substance rules of the particular noon will result in the imposition of penalties or other ramifications as determined by these laws. As the implementation date of the various economic substance laws in some of the noons was 1 January 2019, the reporting obligations relating to compliance with the economic substance rules for entities incorporated prior to 1 January 2019 is as early as 1 July 2019 in some of these noons.
As part of the filing obligations to the relevant company registration offices, the noon entity will be required to submit the following details: (i) business/income types, (ii) amount and type of gross income, (iii) amount of operating expenditure, (iv) details of premises, (v) number of qualified employees, including experience levels, employment terms, qualifications and period of employment, (vi) details of CIGA’s (for each economic activity conducted), (vii) financial statements (viii) details of outsourced CIGA’s (if applicable), (ix) business plans, especially relating to reasons for holding intellectual property in the noon, and (x) evidence of quorate board meetings and resolutions passed.
Penalties for Non-Compliance
Should the economic substance requirements not be met for each financial reporting period, the noons will impose financial penalties on the noon entities and in cases of repeated violation, the noon entity may even be de-registered or placed into liquidation by the competent authorities. The amount of the penalties are determined by the economic substance laws of the noons and are not uniform. By way of example, in the BVI the Economic Substance (Companies and Limited Partnerships) Act of 2018 provides for a penalty up to USD 20,000 for the first year of non-compliance and for repeated years up to USD 400,00 per year. The impact on a local UAE entity by a holding entity is incorporated in a noon could be that unless outstanding penalties are paid, the company registration offices of the noon entity may not issue documents such as certificates of good standing and the like, that may be required for share or property transfers in the UAE, amongst other problems that may be experienced.
De-Registration & Liquidation
In the event of repeated non-compliance with the economic substance laws of a particular noon, the noon entity may be de-registered or placed into liquidation at the instance of the relevant noon’s company registration office. Should the noon entity be de-registered, this will severely impact upon the local UAE company in that, required documentation will not be obtainable from the company registration authorities in the noon as may be required from time to time in the UAE, the transfer of shares in the UAE entity will be refused, the transfer of property owned by the local UAE entity will be blocked through the lack of documents, bank accounts of the noon entity may be blocked or even closed, the agreements between the local UAE entity and the noon entity may be unenforceable or terminated, and intellectual property rights may be seriously affected.
Action To Be Taken
Where UAE entities are owned by noon entities, the economic substance laws of the particular noon must be complied with to avoid possibly serious implications on the operations of the UAE entity. As the reporting deadlines are close in a number of noons, the necessary action should be taken immediately to establish both the necessity and thereafter the requirements of the particular noon in order to comply with the economic substance rules. In the event that the economic substance laws of the noon applicable to your business require action, immediate corrective action should be implemented to avoid unnecessary penalties. If actions have been taken, it may also be worthwhile to undergo a “health check” to ensure complete compliance.