Historic Overview – Economic Substance Regulations (ESR)
These regulations aimed to ensure that companies conducting certain “Relevant Activities” within the UAE maintain substantial economic activity. Compliance required companies to meet three core tests: the Core Income Generating Activity (CIGA) test, the Adequate Local Substance test, and the Directed and Managed test.
Key Amendments to the Economic Substance Regulations
The UAE recently introduced significant changes to the ESR, marking a major regulatory shift for businesses in the region.
Issued under Cabinet Decision No. (98) of 2024, these changes amend the provisions of Decision No. (57) of 2020 and aim to reduce the compliance burden, particularly in light of the new UAE Corporate Tax (CT) Law. Under this new law, effective for taxable persons’ financial years beginning on or after 1 June 2023, businesses across all Emirates (with some exceptions) are subject to federal tax. Consequently, ESR will no longer apply for financial years starting on or after 1 January 2023, though it remains applicable for the period from 1 January 2019 to 31 December 2022.
Key Changes to the ESR
- Abolition of ESR Reporting Requirements
The UAE Ministry of Finance announced that entities are no longer required to submit ESR notifications or reports for financial years ending after 31 December 2022. This aims to simplify compliance by removing the administrative reporting burden for more recent financial periods. - Cancellation of Administrative Penalties
Administrative penalties related to ESR compliance for financial years ending after 31 December 2022 have been abolished. The Federal Tax Authority (FTA) will issue refunds to businesses that have already paid these penalties, significantly reducing costs associated with ESR compliance. - Applicability Period
The ESR now applies solely to the financial years spanning 1 January 2019 to 31 December 2022. Any reporting obligations or penalties applicable to periods after 2022 are no longer in effect. - Impact on Free Zone Entities
Although ESR reporting requirements have been lifted, Free Zone entities aiming to benefit from a 0% corporate tax rate must still demonstrate adequate economic substance within the UAE. This entails maintaining sufficient assets, employees, and operational expenditures within the Free Zone to qualify for tax incentives.
Practical Considerations
- Administrative Penalties
Licensees facing penalties for non-compliance with ESR during financial years beyond the ESR Period (2019-2022) will benefit from the cancellation of these penalties. Refunds can be requested through the e-refund portal on the Ministry of Finance website. - Status of Previous Filings
For filings submitted by Licensees for periods after the ESR Period, guidance from relevant authorities is awaited. It is anticipated that these filings will be disregarded, but further instructions are expected. - Document Retention and ESR Portal Access
Licensees are required to retain supporting documentation for six (6) years following the end of each reportable period, as the FTA retains a six-year audit window to review substance compliance for the ESR Period. - Increased Audit Activity
With the limited timeframe for ESR compliance audits, there may be increased audit activity by the FTA to assess Licensees’ compliance with ESR requirements during the ESR Period.
Implications for Businesses
These updates are intended to streamline the compliance process and reduce regulatory burdens on UAE businesses. However, it remains crucial for companies to confirm that all ESR obligations for the relevant periods (2019-2022) are fully met to avoid potential penalties. Businesses operating in Free Zones should remain vigilant regarding substance requirements to benefit from Tax incentives, including maintaining adequate local resources and conducting core income-generating activities within the UAE.
Recommendations for Businesses
To ensure compliance and optimize the benefits of these regulatory changes, entities should consider the following actions:
- Ensure Reporting Compliance for 2019-2022
For entities with ESR obligations for financial years between 2019 and 2022, confirm that all ESR notifications and annual reports have been accurately submitted. - Review ESR Applicability and Take Necessary Actions
Evaluate your entity’s operations in relation to the ESR and confirm any obligations that applied during the ESR Period. - Evaluate Adequate Substance for Free Zone Entities
Free Zone entities should review their operational structures to ensure alignment with UAE Federal Corporate Tax compliance standards. - Confirm Eligibility for Penalty Waivers
Verify if your entity qualifies for a refund or waiver of any administrative penalties paid during the relevant periods. - Stay Informed of Further Guidance
Monitor updates from authorities for further clarifications on ESR compliance, particularly regarding refunds and the treatment of previous filings.
Conclusion
The amendment aims to enhance efficiency and tax compliance across the country, ensuring accurate application of tax legislation by all entities subject to it. This step is also part of the Ministry’s ongoing efforts to improve the tax system’s efficiency and attract further investments,” By removing the need for ESR reporting and associated penalties for recent financial years, the UAE government aims to support business growth and simplify regulatory compliance.
For further details on how these changes may impact your business, contact Motei & Associates for a personalized legal consultation.
