The United Arab Emirates (UAE) introduced 'Economic Substance Regulations' (ESR or the Regulation) in April 2019. The primary objective of the Regulation is to restrict the operation of shell/ paper companies in UAE who earn significant profit without carrying out in corresponding activity. In other words, covered licensees are required to demonstrate/ explain that they are genuinely undertaking a certain economic activity, which resulted in income/profits in the UAE.
In the absence of an income tax regime, the UAE was traditionally recognized by multinationals to shift their profits to reduce overall tax for the group. While the UAE is known as a distribution hub, it is also famous amongst the multinationals to carry out financing/ structuring their models. With ESR in place, the multinationals are compelled to re-evaluate their existing operational model in order to be compliant with this Regulation.
Applicability of ESR
The Regulation is very wide in scope and covers almost all UAE licensees/companies undertaking 'relevant activity.' Again, the applicability of the Regulation is comprehensive and does not depend on location (whether onshore or free zone) of business. While initially Regulation included all form of business (including branch or other forms such trusts, foundation, etc, amended Regulation restricted the applicability only to juridical person and partnership firm. The relevant activities specified under the Regulation, which may be subjected to compliance requirements are mentioned below:
- Banking business
- Investment fund management business
- Headquarters business
- Holding company business
- Distribution and Service center business
- Insurance business
- Lease-Finance business
- Shipping business
- Intellectual property business
In this article, we analyze the critical business aspects of Distribution Activity, keeping in mind the requirement of Economic Substance Regulation.
Over the years, the UAE is recognized as a distribution and logistics hub amongst multinational enterprises by virtue of significant progress in infrastructure, the geographical location for ports/shipping industry as well as ease of doing business policies by many free zones of the UAE. However, some organizations had started exploiting the ecosystem for avoiding taxes by setting-up shell companies, just to park all distribution-related profits in UAE, which does not have an Income Tax regime.
The ESR was introduced by the UAE to restrict such harmful tax practices, largely in line with Action Plan 5 of the BEPS project.
Definition of Distribution as provided under the Regulation
While originally, the Regulation was introduced in April 2019, the UAE ministry has recently published the amended Regulation/ Guidelines in August 2020, which will be applicable retrospectively, w.e.f from 1 January 2019. In the section below, we have attempted to analyze the earlier as well as amended Regulation with respect to Distribution Business and consequential impact on businesses.
As per the earlier Regulation, the Distribution Business was defined as a business of "purchasing from a foreign connected person and importing and storing in the state: component parts or materials for goods, or goods ready for sale, and re-selling such component parts, materials or goods outside the state."
Basis the amended Regulation, Distribution Business is defined as a business of "purchasing from a foreign connected person: component parts or materials for goods, or goods ready for sale, and re-selling such component parts, materials or goods."
At this stage, it is important to understand how the above definition of Distribution Activity aligns with the description provided in Action Plan 5 and also some of the other jurisdictions where the Economic Substance Regulation is in place. It may be noted that while Action Plan 5 intends to cover any purchase from group members and re-selling such goods without emphasizing the domestic/ international aspects, the UAE initially decided to restrict its scope to only those purchases which are made from foreign group members and re-selling of those goods outside the UAE. It may be noted that countries like Bahrain, Jersey/Guernsey/ Isle of Man, Bermuda decided to follow the approach of OECD. In order to align with Action Plan 5 and practices followed by few other countries, the UAE has recently made an amendment in the Regulation to eliminate the difference of re-selling aspect to domestic/ international boundaries.
The description of the Distribution Activity in Action Plan 5 does not explicitly refer to the aspect of importing/storing within the country. The UAE Regulation, on the other hand, explicitly mentioned the storing and importing aspects in the definition of 'Distribution Activity,' as provided under the esrwhile Regulation. Now, consider a situation where the licensee is engaged in Distribution Activity but is doing most of its transactions through high sea sales/bill to-ship to model, wherein, the goods do not enter the territory of UAE. In this case, the question arises whether the said transaction would qualify the definition of Distribution Activity and if the consequent compliances under the Regulation would be triggered. Again, in order to eliminate this ambiguity and to achieve broader objective of Regulation, the UAE has amended the coverage of the Distribution Business and therefore, the condition of importing and storing is no longer applicable.
Another example is distribution involving sales to foreign connected persons. From the plain reading of the language in the law, it appears that if the licensee re-sells the goods to its foreign connected persons, such activity would not be covered under the definition of Distribution Activity. It may be highlighted at this stage that a distribution arrangement involving buying from a related party for the purpose of re-selling to another related party is a perfect recipe for tax avoidance.
Further, the Regulation seeks to cover pure Distribution Activity wherein goods were re-sold 'as is' basis and without any value addition activity performed on it. In this case, the question arises, whether a simple assembling/re-packing activity would be considered as value addition and thus, out of the definition of distribution as per the Regulation.
Overall, the UAE Regulation (with regards to Distribution Activity) seems to be aligned with the global standards on ESR. However, few clarifications from the Ministry would provide much-needed certainty to the licensees for the issues mentioned above.
Economic Analysis of Distribution Activity
Given the modern day dynamics of trade in a digitalized economy, it is difficult to pool the distribution function into 2-3 buckets. However, if we go by the traditional approach (which can be a good starting point), the distributors may be classified as follows:
|Limited risk distributor||
|Indenting/ Commission Agent||
What Businesses are required to do?
The businesses are required to re-assess the applicability of the Regulation to their Distribution Business considering the extended coverage enunciated in the amended Regulation. While many of the businesses have already filed the notification before 30 June 2020, it would be imperative to analyze if the position adopted earlier needs to be revised. In case the amended Regulation is applicable to a business, the relevant licensee is required to submit notification and, thereafter, prepare for a detailed substance report.
The Regulation intends to restrict businesses to artificially attract profits which are not commensurate with economic activity undertaken by them. In order to achieve this objective, licensees are required to demonstrate the economic substance test. In other words, licensees are required to justify their operational as well as management-related activities undertaken in the UAE, which resulted in a profit. Broadly, there are three pillars to demonstrate substance test –
- Management and control within the UAE;
- Adequacy of expenses/assets/employees;
- Performing core income-generating activities.
While the Regulation requires the licensee to perform certain core activities for distribution business such as transporting and storing goods, managing inventories, taking orders, etc., the licensee may perform certain additional activities having regard to its business model. One needs to document the activities/ functions appropriately to justify the substance.
On the other side, Regulation does not provide much guidance on the directed/managed test and adequacy test. These tests are quite subjective in nature, and the licensee may need to consider their professional judgment to demonstrate the reasonableness of this aspect. Again, one business may vary from another in terms of business/operational model, size, functions, etc. Thus, it is crucial to adopt a pragmatic approach while assessing the substance test.
Given the fact that ESR Return is due in December 2020 (for the accounting year ended in December 2019), the licensees need to be pro-active in their approach of collating all the necessary documents to avoid last-minute chaos. The contents of the ESR report, as prescribed under the Regulation appear to be more analytical and includes details such as-
- Analysis of the nature of the relevant activity and identifying the relevant category as specified under the Regulation
- Whether the UAE entity has performed Core Income Generating Activities (CIGA) as specified under the Regulation
- Employee details which include information such as full time/ part-time, qualification, personnel responsible for the relevant activity, etc.
- Details of the outsourcing arrangement, if any
- Details of how the licensee has been managed and directed within the UAE. E.g., Board meetings, records of minutes, etc
- Examining the nature of income and expenses (if required, benchmarking of such items basis the peer/competition)
With ESR in place, the multinationals are compelled to re-evaluate their existing distribution model in order to be compliant with this Regulation. It is also recommended to examine their existing policies with respect to maintaining adequate documentation such as minutes of the board meetings, appropriate contractual agreements, employee records, etc. to mitigate the potential risk of non-compliance.
This being the first year of the compliance, businesses may face difficulties in examining the applicability of Regulation as well as collating the requisite fact-specific information, especially to set the right precedent. The detailed ESR return (due in December 2020) will possibly see more challenges given the experience with stage 1 compliance (i.e., notification filing), and more so, having regard to the contents of the ESR return.
Additionally, travel restrictions on account of COVID-19 measures have increased the challenges for foreign directors to visit/ be physically present in the board meeting. Therefore, despite guidance from the Ministry, a licensee would require a lot of judgment in a professional capacity to determine if their activities meet the substance test.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.