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Understanding the Significance of ESR Compliance

February 25, 2023
Fortius Team
A close-up shot of a businesswoman signing documents at her desk illustrates business compliance with regulations.

Cabinet Decision No. 31 of 2019 mandated ESR (Economic Substance Regulation) compliance in the United Arab Emirates. This choice was made to create a stable national economy and to implement ESR across the country. As per the leading ESR consultation services such as Fortius, the ESR regulations adhere to the international norms established by the OECD and the EU Code of Conduct Group on Business Taxation.

So, companies registered in the country onshore or in a free zone that engages in these activities will now be required to show that they are actively participating in and investing in the country under the provisions of the new laws. In most cases, the three conditions below will suffice for a business or company to satisfy the Economic Substance Requirement:

  • The company should be managed and directed from within the UAE
  • The company's CIGA (Core Income Generating Activity) must occur in the UAE.
  • The corporation needs to have sufficient competent workers, space, and annual operating costs.

Which Businesses Must Comply With ESR? Hear from ESR Consultation Services

Suppose your company engages in a "Relevant Activity" in the United Arab Emirates (UAE). In that case, you may be required to obtain a licence or registration from the Financial Free Zone Authorities, which includes companies based in DIFC and ADGM. Consequently, it is crucial to understand and interpret the definition of the relevant activity described by law to determine whether your business falls within the scope of an ESR.

The following actions qualify as "Relevant Activities":

  • Financial Services
  • Insurance
  • Investment Fund Management
  • Shipping
  • Leasing
  • Distribution and Service Center
  • Corporate Offices
  • Intellectual Property
  • Holding Companies

Here are a few illustrations: If a UAE entity 'X' holds an equity interest and receives dividends and capital gains from that equity interest, then 'X' is engaged in a Holding Company Business, which is a relevant activity under ESR.

If UAE entity 'Y' purchases goods from a Foreign Connected Person and distributes those goods within or outside the UAE, then 'Y' is engaged in a Distribution Business, which is a relevant activity.

How Do Businesses Submit the ESR Notification and Report?

Three steps are required for a company to comply with regulations governing economic substance:

At the outset, the Relevant Activity performed by the Licensee or Exempted Licensee that is categorised as a Business and the submission of Economic Substance Notifications by a Business to the respective Regulatory Authorities is identified and assessed by the National Assessing Authority.

Secondly, an evaluation is done by the National Assessing Authority to determine if the company satisfies the Economic Substance Test.

Finally, submitting an Economic Substance Report to the appropriate Regulatory AuthorityAuthority is the third step for businesses to take in ensuring compliance with the ESR.

Why Does Your Company Need to Act in Accordance With ESR?

The Economic Substance Regulations exist to ensure that businesses in the United Arab Emirates are paying their fair share of taxes, reducing the incidence of illegal tax practices committed by international corporations and promoting openness and trust in the marketplace.

Let's take a closer look at the reasons why a company in the UAE should follow ESR regulations:

  1. Avoidance of Penalties- Misreporting one's income to the government can result in a penalty in the form of additional taxation. All companies operating in the UAE are responsible for ensuring that all company profits are earned per local laws and regulations. Regardless of who the clientele is, the work must be completed by a company with a local presence. Consequently, ESR compliance in the UAE benefits and reinforces the country's economy.
  2. Accessible Tax Data- ESR will ensure that all companies operate lawfully and ethically by making all tax data publicly available. Accounting truthfulness is required, and the companies may be subject to additional taxation. Thus, ESR ensures lawful trade and eliminates tax problems in the UAE.
  3. Renewal of Licences- In some cases, companies must go through liquidation or deregistration if they do not comply with the ESR. The same happens if they repeatedly fail to provide the relevant information or meet any criteria mentioned in the law. It will have a significant impact on the national economy. This will also ensure that the company's leadership is always on their toes so that they can avoid any mistakes or provide any false information that could impede the company's operations.
  4. Growth for Ethical Businesses- The ESR implementation will lessen the prevalence of businesses that engage in unethical or illegal business practices, making room for more successful enterprises that operate lawfully and ethically. It leads to healthy rivalry.

What are the Consequences for Not Following the Rules?

Suppose a company needs to provide all the information required by the Economic Substance Regulations Reporting. In that case, it will be penalised between AED 10,000 and AED 50,000 and will also be considered to have failed to act in accordance with the prevailing law. AED 10,000 to AED 50,000 may be assessed against a UAE-registered company that violates ESR by failing to notify the appropriate regulatory body.

For first-time offenders, the penalty for failing to show sufficient Economic Substance in the UAE for any financial year ranges from AED 10,000 to AED 50,000. Relevant information will also be shared with the appropriate Authority.

If a company fails to provide evidence of Economic Substance for two years running, information will be shared as described above. Also, the company could face a fine of 100,000 to 300,000 UAE Dirhams (AED) and the revocation, suspension, or nonrenewal of its business licence.

Parting Thoughts

In conclusion, businesses in the United Arab Emirates should follow the Economic Substance Regulations so that the country's tax system is more open and fair. It also creates a situation where tax planning strategies employed by business organisations do not exploit gaps in the law to avoid paying taxes. Being one of the leading ESR consultation services at Fortius we advise all clients to adhere to the compliances under ESR. To avail our services give us a call right away!

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