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Economic Substance Test: Consequences of Non-Compliance

February 15, 2023
Fortius Team
Businessmen in a meeting with a presentation on penalties for failure to meet the Economic Substance Test.

The amendments in the UAE ESR happened in April, 2019 with a view to create an uniform and fair taxation system pertaining to international standards. Presently, companies in the UAE subject to the Economic Substance Regulations (ESR) must demonstrate economic presence commensurate with the level and type of substantial economic activities they conduct. Newly adopted methods of taxation often require expert help and the ESR consultation services offered by Fortius are ideal for ensuring ESR compliance.

To maintain an economic existence, a company must satisfy the Economic Substance Test by generating income from Core Income Generating Activities (CIGAs). The company must also be directed and managed in the UAE. The company should also have sufficient employees, premises, and expenses within the UAE.

But now, the biggest unknown is what will occur if a licensee or exempt licensee fails the Economic Substance Test. Businesses use the Economic Substance Test to demonstrate their goals are sincere and do not engage in unfair tax practices. If a company fails the economic substance test and is non-compliant with economic substance regulations, the National Assessing Authority will take action and impose ESR penalties.

Here is a brief overview of the specifics.

Conditions to Pass the ESR Test- As Advised by ESR Consultation Services in the UAE

National Assessing Authority determines whether a company complies with the economic substance regulation to pass the Economic Substance Test by analysing its performance concerning the following essential requirements:

1. The Entity must engage in fundamental revenue-generating activities in the UAE.

The companies are required to conduct CIGAs concerning their UAE-relevant activities. The Economic Substance Regulations recognise the following, among others, as relevant activities:

  • Insurance
  • Banking investments
  • Budget administration
  • Shipping
  • Lease financing
  • Intellectual equity firms
  • Holding company business, etc.

2. The company must be directed and managed in the United Arab Emirates.

The second test determines whether or not the companies have held and attended a sufficient number of board meetings in the UAE. The directors must possess the necessary skills and knowledge to fulfil their responsibilities. The companies must keep a written record of the board meetings, and all participants must sign it. All attendees must be physically present in the UAE to fulfil the board meeting's quorum requirements.

3. The company must maintain adequate staff to pass the Economic Substance Test.

Businesses must have a sufficient number of full-time employees competent enough to manage the Core revenue-generating activities. They must be physically present in the UAE while engaging in various activities there.

4. The firm must incur necessary operating expenses

During the Core Revenue-Generating Activities, the businesses should have incurred adequate expenses. If the tasks are outsourced, the third party's expenses must be sufficient to pass the Economic Substance Test.

5. If CIGA is outsourced, the Licensee must be able to monitor and manage the service.

The ESR includes a provision for satisfying the economic substance requirement if the Licensee outsources the CIGAs to a third party. The Licensee must be able to monitor and control the entity to which the CIGAs have been delegated.

What are the Consequences of Failing the Test for Economic Substance?

A company will be deemed to have failed the Economic Substance Test if it fails to demonstrate adequate economic presence in the critical test requirements. In such a case, the National Tax Authority will notify the business via ESR penalty email with the following information:

  • During the applicable Fiscal Year, the company failed the Economic Substance Test.
  • The reasons why the FTA determined that the enterprise failed the examination.
  • The amount of the corporation's penalty for failing the Economic Substance Test.
  • The payment deadline for the fine.
  • The steps required for businesses to pass the examination.

The governing body will impose a fine ranging from 10,000 to 50,000 dirhams on a company that fails the Economic Substance Test during the applicable fiscal year. Companies failing the test for the second year in a row will be subject to fines between 50,000 and 300,000 dirhams. The sanctioned amount will be specified in a notice issued by the National Assessing Authority, and payment is required within thirty days of the notice's issuance.

After determining that a company has failed to meet the Economic Substance Test, the Regulatory Authority will notify the Competent Authority that the company has failed the test. Under pertinent international agreements and treaties, the Competent Authority will exchange company information with the Foreign Competent Authority of the country or territory where the parent company of the Ultimate Beneficial Owner resides.

Can an Organisation Contest the Penalty for Failing the Economic Substance Test?

Businesses have the right to file an appeal against the imposed penalty if it turns out that the alleged penalty is not liable. They may also contest the severity of the sanction. Article 17 of Resolution 57 of the Cabinet of Ministers for 2020 provides for "appeal" as a service related to the Economic Substance Regulation. So, if a business is not satisfied with any of the rulings related to offences or penalties imposed upon them by the Competent Authority, it may challenge the same under the below mentioned situations:

  1. The violation was not committed
  2. The penalty imposed is not proportional to the violation
  3. The administrative penalty imposed exceeds the limited prescribed penalty

Therefore, if any of the three conditions are met, the Licensee may file an appeal through the Ministry of Finance's website.


The Economic Substance Regulations (ESR) were enacted by the United Arab Emirates (UAE) to ensure that the economy conforms to international standards and to prevent unethical tax practices. To comply with the ESR, the companies will be tested to ensure that they continue to maintain sufficient economic substance concerning the relevant activities they conduct in the UAE. Failure to satisfy the Economic Substance Test will result in penalties and actions such as information sharing with the competent authority.

In addition, it creates a negative impression when a company fails ESR regulation tests and is penalised. This can significantly affect the business's reputation in the market and the eyes of its customers. Therefore, companies should always strive to comply with ESR regulations. Our experts at Fortius provide top-notch ESR consultation services and can ensure our clients are always ESR compliant. Give us a call right away!

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