ECONOMIC SUBSTANCE REQUIREMENTS REGULATIONS – AN OVERVIEW

1.0 
Introduction

‘Substance
over Form’ is an evergreen debate now tilting in favour of the former. Can a
legal form justify weak substance, or can a strong substance without a legal form be relevant or
practical? Does one score over the other? Are they interdependent or independent
of each other? How does one determine substance in a given transaction or
arrangement? Is it necessary to lift the corporate veil each time to examine
substance? Can a perfectly legal structure within the four corners of the law
be challenged and ignored for want of (or say, apparent lack of) substance? Is
every case of double non-taxation or lower taxation attributable to lack of
substance? There are a host of questions in this arena, some with answers, many
with grey areas and some without an answer. The easiest answer, perhaps, could
be that each case is fact-specific. However, in this uniqueness we need to have
certain rules and regulations and / or patterns to determine substance and give
tax certainty to businesses.

Recently, many jurisdictions introduced
Economic Substance Requirements Regulations (or ESR Regulations) for
enterprises carrying on business activities in / from that jurisdiction in any
form.

In this Article, we shall attempt to
understand what are the provisions of a typical ESR Regulations regime, their
significance and how does one comply with them.

2.0 
Genesis of substance requirements

Way back in 1998, OECD published a Report
on ‘Harmful Tax Competition: An Emerging Global Issue’ expressing
concern about the preferential regimes that lack in transparency and that are
being used by Multi-National Enterprises (MNEs) for artificial profit shifting.
OECD created the Forum on Harmful Tax Practices (FHTP) to review and monitor
compliances by preferential tax regimes with respect to transparency and other
aspects of tax structuring.

One of the twelve factors set out in the
1998 Report to determine whether a preferential regime is potentially harmful
or not was, ‘The regime encourages operations or arrangements that are purely
tax-driven and involve no substantial
activities’.

Fifteen Action Plans to prevent BEPS are
based on the following three main pillars:

(1) coherence of corporate tax at the
international level,

(2) realignment of taxation and substance,
and

(3) transparency, coupled with certainty
and predictability.

BEPS Action Plan 5 dealing with ‘Countering
Harmful Tax Practices More Effectively, Taking into Account Transparency and
Substance,’ intends to achieve the objectives of the second pillar of
realigning taxation with substance to ensure that taxable profits are not
artificially shifted away from countries where value is created. 

FHTP identified many harmful preferential
tax regimes that were providing an ideal atmosphere for profit-shifting with no
or low effective tax rates, lack of transparency and no effective exchange of
information.

To counter such harmful regimes more
effectively, BEPS Action Plan 5 requires FHTP to revamp the work on harmful tax
practices, with priority and renewed focus on requiring substantial activity
for any preferential regime and on improving transparency, including compulsory
spontaneous exchange on rulings related to preferential regimes¹.

3.0 
FHTP’s approaches

FHTP has provided three approaches to
address the issue of substance in an Intellectual Property (IP) regime. They
are as follows:

(i)   Value Creation:
This approach requires taxpayers to undertake a set number of significant
development activities in the jurisdiction to claim tax benefits;

(ii)  Transfer Pricing:
This approach would require a taxpayer to undertake a set level of important
functions in the jurisdiction concerned to take advantage of lower tax regime.
These functions could include legal ownership of assets or bearing economic
risks of the assets, giving rise to the tax benefits.

(iii) Nexus Approach:
This approach has been agreed to by FHTP and endorsed by G20. It looks at
whether an IP regime makes its benefits conditional on the extent of R&D
activities of taxpayers in its jurisdiction. The Nexus Approach not only
enables the IP regime to provide benefits directly to the expenditures incurred
to create the IP, but also permits jurisdictions to provide benefits to the
income arising out of that IP, so long as there is a direct nexus between the
income receiving benefits and the expenditures contributing to that income.

In other words, when the Nexus Approach is
applied to an IP regime, substantial activity requirements establish a link
between expenditures, IP assets and IP income. The expenditure criterion acts
as a proxy for activities and IP assets are used to ensure that the income that
receives benefits does, in fact, arise from the expenditures incurred by the
qualifying taxpayer. The effect of this approach is therefore to link income and
activities.

Based on the above approach for the IP
regime, the Action Plan suggests applying this method to non-IP regimes as
well. Thus, a preferential regime should provide the substance requirement with
a clear link between income qualifying for benefits and core activities
necessary to earn the income.

What constitutes a Core Activity depends
upon the type of regime. However, the Action Plan has given certain indicative
Core Income Generating Activities (CIGA) for different types of preferential regimes,
such as Headquarters regimes, Distribution and service centre regimes,
Financing or leasing regimes, Fund management regimes, Banking and Insurance
regimes, Shipping regimes and Holding company regimes. (Paragraphs 74 to 87
of the BEPS Action Plan 5.) 

Under each of these regimes the Plan
identifies how preferential regimes give benefits and related concerns arising
from these regimes. Two common concerns under each regime are: (i)
‘Ring-fencing’, whereby foreign income is ring-fenced from domestic income to
provide tax exemption to the foreign-sourced income, and (ii) ‘Artificial
definition of the tax base’, whereby a certain fixed percentage or amount of
income is taxed, irrespective of the actual income of the taxpayer.

In order to address the above concerns, the
Action Plan provides CIGA in respect of each of the regimes mentioned above. A
taxpayer is expected to undertake CIGA commensurate with the nature and level
of activities. The idea underlying this is to tax income where value is
created. And value creation is determined by looking at the CIGA and also the
expenditure incurred to earn relevant income. 

Another major concern about preferential
regimes is lack of transparency. This concern is addressed through Automatic
Exchange of Information through Common Reporting Standard (CRS)².
Besides this, when information is sought on request, the international standard
on information exchange covers the provision not only of exchange of
information, but also availability of information, including ownership,
banking, and account information. The Global Forum on Transparency and Exchange
of Information for Tax Purposes monitors implementation of international
standards on transparency and exchange of information for tax purposes and
reviews the effectiveness of their implementation in practice.

4.0  Economic Substance Requirements Regulations
(ESR Regulations)

ESR Regulations require economic substance
in a jurisdiction where an entity reports relevant income. The underlying
objective of ESR Regulations is to ensure that entities report profits in a
jurisdiction where economic activities that generate them are carried out and
where value is created.

In December, 2017, the European Union Code
of Conduct Group (EU COCG) assessed preferential tax regimes with nil or only
nominal tax to identify harmful practices and enforce substance requirements.
The EU COCG also published a list of ‘non-co-operative jurisdictions for tax
purposes’ which were engaged in harmful tax practices such as ring-fencing
(through offshore tax regimes), artificial definition of tax base and lacked
transparency. Many countries promised to revamp their tax systems to curb
harmful tax practices and introduce substance requirements to avoid being
blacklisted. The work of EU COCG has been strengthened by BEPS Action Plan 5,
with similar objectives and wider applicability.

BEPS Action Plan 5 is also a Minimum
Standard which requires all G20 Nations and countries in the inclusive group
(over 135 countries) who are signatories of the BEPS Project to mandatorily
implement the same. 

To comply with the above, the following
countries enacted legislation to introduce the Economic Substance Regulations
for tax purposes with effect from 1^st January, 2019 or an accounting
period commencing thereafter:

(i)    Bahamas

(ii)   Bermuda

(iii)  British Virgin Islands (BVI)

(iv)  Cayman Islands

(v)   Guernsey

(vi)  Jersey

(vii)  Isle of Man

(viii) Mauritius

(ix)  Seychelles

(x)   United Arab Emirates (UAE) (implemented with
amendments effective from 10^th August, 2020).

In this Article we shall look closely at
the ESR Regulations as implemented in the UAE. However, it may be noted that
ESR Regulations as introduced by the above-mentioned countries are by and large
similar as they are based on the guidance and requirements issued by the EU as
well as by the OECD; the requirements of CIGA for different regimes are almost
identical. 

Broadly, ESR Regulations in every
jurisdiction would require resident entities to prove economic substance with
respect to the following criteria:

4.1 
Management test

The entity should be directed and managed
from the jurisdiction concerned. This can be proved by having physical board
meetings at regular frequency, maintaining minutes and accounts in the tax
jurisdiction concerned, directors having domain expertise of the activities of
the company, handling day-to-day operations and banking transactions, etc.

4.2 
CIGA test

The entity will have to clearly demonstrate
that Core Income Generating Activities are undertaken in the relevant
jurisdiction and such activities are commensurate with the level of income
generated therefrom. What is CIGA will depend upon the nature of income or the
regime. CIGA can be outsourced to a corporate service provider in the
jurisdiction, subject to oversight by the entity (e.g., monitoring and
control). In such cases, the relevant resources of the service providers will
be taken into account when determining whether the CIGA test is satisfied.

4.3 
Adequacy test

The entity will have to prove that it has
adequate number of qualified employees and infrastructure to carry out CIGA. It
has to also demonstrate that adequate expenditure is incurred to generate the
relevant income in that jurisdiction. ‘Adequacy’ of expenditure, employees or
infrastructure would depend upon the nature of the CIGA.

4.4  Summary of tests for Economic Substance
Requirements

1. The management and direction of the entity
should be located in the offshore jurisdiction concerned;

2. Core Income Generating Activities with respect to
the relevant activity must be undertaken in the offshore jurisdiction
concerned;

3. The entity should have a physical presence in
the offshore jurisdiction;

4. The entity should have full-time employees with
suitable qualifications in the jurisdiction concerned; and

5. The entity should have incurred operating
expenditure in the offshore jurisdiction concerned in relation to the relevant
activity.

5.0 
ESR Regulations in UAE

On 30^th April, 2019, the Cabinet
of Ministers of the UAE issued Cabinet Resolution No. 31 of 2019 concerning
Economic Substance Requirements Regulations (Resolution 31). On 10^th
August, 2020 amendments were introduced to Resolution 31 by the Cabinet of
Ministers by way of Resolution No. 57 of 2020 (ESR Regulations), which repealed
and replaced Resolution 31.

The UAE ESR Regulations contain 22
articles, a list of which is given below.

Ministerial Decision No. 100 for the year
2020 dated 19^th August, 2020 is intended to provide further guidance
and direction to entities carrying out one or more Relevant Activities. An
entity subject to ESR Regulations shall have regard to this Decision for the
purposes of ensuring compliance with ESR Regulations.

5.1 
Basis of ESR Regulations

The basis of ESR Regulations in UAE as
stated in its ‘Ministerial Decision No. 100 for the year 2020 on the Issuance
of Directives for the implementation of the provisions of the Cabinet Decision
No. 57 of 2020 concerning Economic Substance Requirements’ (hereafter referred
to as ‘Ministerial Directives’) is as follows:

‘The ESR Regulations are issued pursuant
to the global standard set by the Organisation for Economic Cooperation and
Development (“OECD”) Forum on Harmful Tax Practices, which requires entities
undertaking geographically mobile business activities to have substantial
activities in a jurisdiction. In addition to the work of the OECD, the European
Union Code of Conduct Group (“EU COCG”) also adopted a resolution on a code of
conduct for business taxation which aims to curb harmful tax practices. The
Cabinet of Ministers enacted the ESR Regulations taking into account the
relevant standards developed by the OECD and the EU COCG.’

5.2 
Applicability

Article 3 of the Ministerial Directives
deals with the Licensees required to meet the Economic Substance test and
provides that ESR Regulations are applicable to Licensees. The term ‘Licensee’
is defined in Article 1 of the ESR Regulations to mean any of the following two
entities:

‘i. a juridical person (incorporated inside
or outside the State, i.e., UAE); or

ii. an Unincorporated Partnership;

registered in the State, including a Free
Zone and a Financial Free Zone and carries on a Relevant Activity.’

A juridical person is defined to mean a
corporate legal entity with a separate legal personality from its owners.

An Unincorporated Partnership is defined
under ESR Regulations to include those forms of partnerships that may operate
in the UAE without having a separate legal personality and are thereby
identified separately under the ESR Regulations. 

In other words, the regulations cover all
Licensees (natural and juridical person) having the commercial license,
certificate of incorporation, or any other form of permit necessarily taken
from the licensing authority to do business. Going by the spirit of the ESR
Regulations, it is interpreted that entities in Free Zone (including offshore
companies) would also be covered.

Branches

Branch of a foreign entity in the UAE

Since a licensee could be in the form of a
UAE branch of a foreign entity (juridical person incorporated outside UAE is
covered in the definition), Article 3 of the Ministerial Directives
specifically covers them for compliance of ESR Regulations. 

Similarly, a branch of a foreign entity
registered in the UAE that carries out a Relevant Activity is required to
comply with the ESR Regulations, unless the Relevant Income of such branch is
subject to tax in a jurisdiction outside the UAE.

Branch of a UAE entity outside UAE

Where a UAE entity carries on a Relevant
Activity through a branch registered outside the UAE, the UAE entity is not
required to consolidate the activities and income of the branch for purposes of
ESR Regulations, provided that the Relevant Income of the branch is subject to
tax in the foreign jurisdiction where the branch is located. In this context, a
branch can include a permanent establishment, or any other form of taxable
presence for corporate income tax purposes which is not a separate legal
entity.

5.3 Licensees exempted from ESR Regulations

The following entities which are registered
in the UAE and carry out a Relevant Activity are exempt from ESR Regulations:

(a)  an Investment Fund,

(b)  an entity that is tax resident in a
jurisdiction other than the UAE,

(c)  an entity wholly owned by UAE residents and
which meets the following conditions:

      (i)    the
entity is not part of an MNE Group;

      (ii)   all
of the entity’s activities are only carried out in the UAE;

(d)  a Licensee that is a branch of a foreign
entity, the Relevant Income of which is subject to tax in a jurisdiction other
than the UAE. 

(a) Investment Funds

The ESR Regulations define an Investment
Fund as ‘an entity whose principal business is the issuing of investment
interests to raise funds or pool investor funds with the aim of enabling a
holder of such an investment interest to benefit from the profits or gains from
the entity’s acquisition, holding, management or disposal of investments and
includes any entity through which an investment fund directly or indirectly
invests (but does not include an entity or entities in which the fund
invests).’

The above definition would include the
Investment Fund itself and any entity through which the Fund directly and indirectly
invests, but not the entity or entities in which the Fund ultimately invests.
It is clarified that the words ‘through which an investment fund directly or
indirectly invests’ refers to any UAE entity whose sole function is to
facilitate the investment made by the Investment Fund. The exemption for
Investment Funds is distinct from the Investment Fund Management Business as
regulated under ESR Regulations. The Investment Fund itself is not considered
an Investment Fund Management Business unless it is a self-managed fund (the
Investment Manager and the Investment Fund are part of the same entity).

(b) Tax resident in a jurisdiction other
than the State

An entity which is tax resident in a
jurisdiction outside the UAE need not comply with the ESR Regulations. However,
in order for such an entity to avail this exemption, the entity must be
subjected to corporate tax on all of its income from a Relevant Activity by
virtue of being a tax resident in a jurisdiction other than the UAE. It should
be noted that an entity that pays withholding tax in a foreign jurisdiction
will not be considered as tax resident in a foreign jurisdiction other than the
UAE solely on that basis.

(c) An entity wholly owned by UAE
residents

An entity that is ultimately wholly and
beneficially owned (directly or indirectly) by UAE residents is exempt from the
Economic Substance Test only where such entity is: (i) not part of an MNE
Group; (ii) all of its activities are exclusively carried out in the UAE; and
(iii) UAE resident owners of the entity reside in the UAE. The entity must
therefore not be engaged in any form of business outside the UAE. In this
context, ‘UAE residents’ means UAE citizens and individuals holding a valid UAE
residency permit, who reside in the UAE. 

(d) A
UAE branch of a foreign entity the Relevant Income of which is subject to tax
in a jurisdiction other than the State

An entity is not required to meet the
Economic Substance Test if such entity is a branch of a foreign entity and its
Relevant Income is subject to corporate tax in the jurisdiction where such
foreign entity is a tax resident. 

Evidence
to be submitted to claim exemption from ESR Regulations

A Licensee that claims to be exempt on the
basis of being a tax resident in a foreign jurisdiction is required to submit
one of the following documents along with its Notification in respect of each
relevant Financial Year:

(a)  Letter or certificate issued by the competent
authority of the foreign jurisdiction in which the entity claims to be a tax
resident stating that the entity is considered to be resident for corporate
income tax purposes in that jurisdiction; or

(b)  An assessment to corporate income tax on the
entity, a corporate income tax demand, evidence of payment of corporate income
tax, or any other document, issued by the competent authority of the foreign
jurisdiction in which the entity claims to be a tax resident.

It is further provided that where an entity
fails to provide sufficient evidence to substantiate its status as an Exempted
Licensee, the entity will be regarded as a Licensee for the purposes of ESR
Regulations and shall be subject to the requirements of ESR Regulations as
applicable to a Licensee, including the requirement to meet the Economic
Substance Test.

5.4 First reportable Financial Year

It is provided that all Licensees and
Exempted Licensees are subject to ESR Regulations from the earlier of (i) their
financial year commencing on 1^st January, 2019, or (ii) the date on
which they commence carrying out a Relevant Activity (for a Financial Year
commencing after 1^st January, 2019).

5.5 What are the Relevant Activities?

Article 3(1) of ESR Regulations identifies
any of the following activities to be a Relevant Activity: (i) Banking
Business, (ii) Insurance Business, (iii) Investment Fund Management Business,
(iv) Shipping Business, (v) Lease-Finance Business, (vi) Distribution and
Service Centre Business, (vii) Headquarters Business, (viii) Intellectual
Property Business, and (ix) Holding Company Business.

Entities are expected to use a ‘substance
over form’ approach to determine whether or not they undertake a Relevant
Activity and as a result will be considered Licensees for the purposes of ESR
Regulations, irrespective of whether such Relevant Activity is included in the
trade licence or permit of the entity. A Licensee may have undertaken more than
one Relevant Activity during the same financial period. In such a case, the
Licensee would be required to demonstrate economic substance in respect of each
Relevant Activity. 

Any form of passive income from a Relevant
Activity can also bring the entity within the scope of the ESR Regulations.

5.6 Relevant Income

The Economic Substance Test has to be
satisfied by a Licensee having regard to the level of Relevant Income derived
from any Relevant Activity. For the purposes of the ESR Regulations, ‘Relevant
Income’ means entity’s gross income from a Relevant Activity as recorded in its
books and records under applicable accounting standards, whether earned in the
UAE or outside, and irrespective of whether the entity has derived a profit or
loss from its activities. 

For the purposes of ‘Relevant Income’,
gross income means total income from all sources, including revenue from sales
of inventory and properties, services, royalties, interest, premiums, dividends
and any other amounts, and without deducting any type of costs or expenditure.
It appears that even capital gains are to be included while computing gross
income. 

In the context of income from sales or
services, gross income means gross revenues from sales or services without
deducting the cost of goods sold or the cost of services. It is further
clarified that gross income does not mean taxable or accounting income or
profit.

5.7
Liquidation or otherwise ceasing to carry on Relevant Activities

A Licensee and an Exempted Licensee shall
be subject to ESR Regulations as long as such an entity continues to exist.

5.8
The Economic Substance Test – How to substantiate economic substance in the
UAE?

In order for a Licensee to demonstrate that
it has adequate substance in the UAE in a given financial year, an entity must
meet the following tests:

(a) Core Income Generating Activities
(CIGA) Test

The Licensee
should conduct Core Income Generating Activities in the UAE. The CIGAs are
those activities that are of central importance to the Licensee for the
generation of the gross income earned from its Relevant Activity.

The CIGAs
depend upon the nature of the Relevant Activity. The list given in Article 3(2)
of the ESR Regulations is an indicative list and not exhaustive³. A
Licensee is not required to perform all of the CIGAs listed in the ESR
Regulations for a particular Relevant Activity. However, it must perform any of
the CIGAs that generate Relevant Income in the UAE. It is clarified that
activities that are not CIGAs can be undertaken outside the UAE.

(b) Directed and Managed Test

The ‘directed and managed’ test aims to
ensure that a Relevant Activity is directed and managed in the UAE and requires
that, inter alia, there are an adequate number of board meetings held
and attended in the UAE. A determination as to whether an adequate number of
board meetings are held and attended in the UAE will depend on the level of
Relevant Activity being carried out by a Licensee.

Consideration must also be given to more
onerous requirements in respect of board meetings prescribed under the applicable
law regulating the Licensee or as may be stipulated in the constitutional
documents of the Licensee.

The ‘directed and managed’ test further
requires that:

(i)   meetings are recorded in written minutes and
that such minutes are kept in the UAE;

(ii)  quorum for such meetings is met and those
attendees are physically present in the UAE; and

(iii) directors have the necessary knowledge and
expertise to discharge their duties and are not merely giving effect to
decisions being taken outside the UAE.

The minutes of the board meetings must
record all the strategic decisions taken in relation to Relevant Activities and
must be signed by the directors physically present. The quorum shall be
determined in accordance with the law applicable to the Licensee setting out
quorum requirements, or as may be set out in the constitutional documents of
the Licensee (or both).

It is clarified that for the purposes of
ESR Regulations the ‘directed and managed’ requirement does not prescribe that
board members (or equivalent) be resident in the UAE. Rather, the board members
(or equivalent) are required to be physically present in the UAE when taking
strategic decisions. In the event that the Licensee is managed by its
shareholders / owners / partners, an individual manager (e.g., general manager
or CEO), or more than one manager, the above requirements will apply to such
persons to the fullest extent possible.

(c) Expenditure Test

Having regard to the level of Relevant
Income earned from a Relevant Activity, the Licensee should ensure that it (i)
has an adequate number of qualified full-time (or equivalent) employees in
relation to the activity who are physically present in the UAE (whether or not
employed by the Licensee or by another entity and whether on temporary or long-term
contracts), (ii) incurs adequate operating expenditure by it in the UAE, and
(iii) has adequate physical assets (e.g. premises) in the UAE.

What is adequate or appropriate for each
Licensee will depend on the nature and level of Relevant Activity being carried
out by such Licensee. A Licensee will have to ensure that it maintains
sufficient records to demonstrate the adequacy and appropriateness of the
resources and assets utilised and expenditure incurred.

It is provided that the National Assessing
Authority shall review such records and other supporting documentation
submitted in assessing whether a Licensee has demonstrated the adequacy and
appropriateness of resources and assets utilised and expenditures incurred.

The requirement for adequate employees is
aimed at ensuring that there are a sufficient number of suitably qualified
employees carrying out the Relevant Activity. The requirement for adequate
physical assets is intended to ensure that a Licensee has procured appropriate
physical assets to carry out a Relevant Activity in the UAE. Physical assets
can include offices or other forms of business premises (such as warehouses or
facilities from which the Relevant Activity is being conducted) depending on
the nature of the Relevant Activity. Such premises may be owned or leased by
the Licensee, provided that the Licensee is able to produce the lease
agreement, etc., to prove the right to use the premises for the purposes of
carrying out the Relevant Activity.

__________________________________________________________________________________

3 The indicative list of CIGAs is based on the recommendations of the BEPS
Action Plan 5 (paragraphs 74 to 87).

5.9 Outsourcing

Article 6(2)
of the ESR Regulations provides that a Licensee may conduct all or part of its
CIGAs for a Relevant Activity through an Outsourcing Provider. For the purposes
of ESR Regulations, an Outsourcing Provider may include third parties or
related parties. The substance (e.g., employees and physical assets) of the
Outsourcing Provider in the UAE will be taken into account when determining the
substance of the Licensee for the purpose of the Economic Substance Test,
subject to certain conditions.

5.10 Notification Filings

Every Licensee and Exempted Licensee is
required to submit a Notification to their respective Regulatory Authorities
setting out the following for each relevant financial year:

i.   the nature of the Relevant Activity being
carried out;

ii.  whether it generates Relevant Income;

iii.  the date of the end of its financial year;

iv. any other information as may be requested by
the Regulatory Authority.

A Notification submitted by an Exempted
Licensee must be accompanied by sufficient evidence to substantiate the
Exempted Licensee’s status for each category in which it claims to be exempt.
Failure to provide sufficient evidence to this effect will result in the
Exempted Licensee not being able to avail itself of the exemption and having to
comply with the full requirements of the ESR Regulations, including meeting the
Economic Substance Test.

The time frames for compliance with the
requirement to submit a Notification are different from the time frames to
submit an Economic Substance Report as discussed in paragraph 5.11 below.

The Notification must be submitted within
six months from the end of the financial year of the Licensee or Exempted
Licensee. The Notification must be submitted electronically on the Ministry of
Finance Portal.

5.11 Submission of Economic
Substance Report

Every Licensee shall be required to meet
the applicable Economic Substance Test requirements and submit an Economic
Substance Report containing the requisite information and documentation
prescribed under the ESR Regulations within 12 months from the end of the
relevant financial year.

The Economic
Substance Report of the
Licensee will be assessed by the National Assessing Authority within a
period of six years from the end of the relevant financial year. The
National
Assessing Authority will issue its decision as to whether a Licensee has
met
the Economic Substance Test. This six-year limitation period shall not
apply if
the National Assessing Authority is not able to make a determination
during
this period due to gross negligence, fraud, or deliberate
misrepresentation by
the Licensee or any other person representing the Licensee.

5.12
Exchange of information with foreign authorities

The Competent Authority will spontaneously
exchange information with relevant Foreign Competent Authorities under the ESR
Regulations pursuant to an international agreement, treaty or similar
arrangement to which the UAE is a party in the following circumstances:

i)   where a Licensee fails to satisfy the
Economic Substance Test;

ii)  where a Licensee is a high-risk IP Licensee;

iii)  where an entity claims to be tax resident in a
jurisdiction outside the UAE; and

iv) where a branch of a foreign entity claims to be
subject to tax in a jurisdiction outside the UAE.

Every Licensee that is carrying out a
Relevant Activity must identify the jurisdiction in which the Parent Company,
Ultimate Parent Company and Ultimate Beneficial Owner claim to be tax resident.
An Exempted Licensee that is either (i) tax resident in a jurisdiction other
than the UAE; or (ii) a UAE branch of a foreign company of which all the income
of the UAE branch is subject to tax in a jurisdiction other than the UAE must,
in addition to identifying the foregoing, also identify the jurisdiction in
which such Exempted Licensee claims to be (a) a tax resident or (b) the
jurisdiction of the foreign company of the UAE branch (as may be relevant).

5.13 Penalties

Stringent penalties are prescribed for
non-compliance with ESR Regulations, which are as follows:

5.14
Summary of the Relevant Activities, related CIGAs and the Regulatory Authority⁴

One may refer to the Text of ‘Schedule 1 –
Relevant Activities Guide’, of the Ministerial Directives referred to in
Paragraph 5.1 infra, for detailed explanations and examples.

_____________________________________________________________________

                      5.15  Flow-chart of the Applicability of ESR
Regulations⁵

 ________________________________________________________________________

5.Source: https://www.mof.gov.ae/en/StrategicPartnerships/Pages/ESR.aspx

6.0.
Relevance of ESR Regulations for Indian Entities

Many Indian companies have their
subsidiaries, branches, project offices or other forms of entities operating in
the UAE. Every such entity needs to strictly follow the ESR Regulations as
stringent penalties are prescribed. The provisions of the ESR Regulations are
stricter than Limitation of Benefits under a Tax Treaty. Therefore, each structure
would need a reassessment, review and restructuring if need be. As the
Regulations are applicable to each type of Licensee, including Free Trade
Zones, Proprietorships, etc., even individual investments need to be examined
and should comply with ESR Regulations.

7.0 Epilogue

There is a well-known saying, ‘Don’t judge
a book by its cover’. It means, a beautiful cover cannot determine the worth of
a book. It can enhance its visual appeal but not the underlying (inherent)
value. In a lighter vein, an old Bollywood song also gives us some guidance… Dil
ko dekho, chehera na dekho, chehere ne lakhon ko loota… Dil sachcha aur chehera
jhutha.

So, there is no doubt that one needs to
have a substance and purpose in whatever structure one enacts, whichever
jurisdiction one chooses or whatever business activities / transactions one
undertakes. One has to justify every action from the perspective of non-tax
evasion, while one can always take benefits and advantages of favourable tax
treaties / regimes with good business substance.

It is equally important for Indian
entrepreneurs to bear in mind the ESR Regulations in different jurisdictions,
their reporting requirements while structuring or undertaking any outbound
investments / activities. They may also need to revisit their existing
structures to fall in line with the stringent substance requirements of various
jurisdictions. It may be noted that genuine businesses need not worry, but they
will have to prove their bona fides.