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The requirement to ensure adequate substance for taxation purposes appeared in article 18(1)(a) of the Corporate Tax Law.[1] It stipulates that taxpayers in the UAE’s free zones which “maintain adequate substance” in the UAE may apply a 0% tax rate to qualifying income.
The Cabinet in its Decision No. 55/2023 ordained QFZP to “undertake its core income-generating activities in a Free Zone and, having regard to the level of the activities carried out, have adequate assets, an adequate number of qualified employees, and incur an adequate amount of operating expenditures… Activities can be outsourced to a Related Party in a Free Zone or a third party in a Free Zone, provided the Qualifying Free Zone Person has adequate supervision of the outsourced activity”.
Except for these rules, there’s no specific regulation on ‘adequate substance’, and no special definition of it.
Therefore, the attributes of substance shall be determined by other rules if they don’t contradict CT regulations[3].
The OECD Report on the Action 5 of the BEPS Plan emphasizes that to perform the functions of buying and holding shares and similar rights in other companies, to receive dividends and income from an increase in the value of shares, the same level of substance is not required as for other relevant activities. The main problem of holding structures was identified when they were used to conceal ultimate beneficial owners[4].
Therefore, the OECD proposed to reduce the substance test to compliance with the requirements for the transparency of transactions and the presence of a minimum of employees and premises that would allow the functions of ownership of other companies. This was intended to assure that such a holding company is a real entity, and not a “letter box” (“brass plate”) company[5].
Having this in mind, the Cabinet established in Art. 6(5) of Resolution No. 57 that a holding company ‘meets the Economic Substance Test if it meets the following conditions:
In order to pass the substance test, a holding company is not required to comply with conditions that:
The requirement for having tangible assets is reduced to having premises.
Does this mean that a holding business’s CIGA is not required to be located in the UAE?
Certain other jurisdictions exempt holding business from the CIGA requirement, for example:
This is not the case in the UAE ESR. Article 3(2) of Resolution No. 57 determines CIGA separately for every relevant activity. Holding business is not excluded. Para ‘g’ describes CIGA for Holding Company Business as ‘all activities related to that business’.
Para 2.7 of Ministerial Decision No. 100 directly addresses CIGA for a Holding Company Business and includes in it ‘all activities related to acquiring and holding shares or equitable interests in other companies…’.
In this respect, the UAE regulation is like Qatar’s. The MoF of this State in its Decision No. 20/2021 stipulated that:
Bahrain has some differences (from the UAE and Qatar) in terms of details but in essence handles the issue in a similar way. Art. 3(c) of the Kingdom’s ESR[8] requires holding companies (“Traders”) ‘to confirm they … have an adequate level of qualified full-time employees resident in Bahrain, have adequate physical offices and/or premises in Bahrain to hold and manage equity participations’.
Thus, unlike in certain other jurisdictions, neither the UAE nor other GCC states[9] exempt holding business from the CIGA test. However, this makes no actual difference with other jurisdictions because all of them require the localization of all activities required for this business (except for directing and managing a holding company). The difference is theoretical rather than practical: one state treats this requirement as part of the CIGA test, and another deems it a replacement for CIGA test.
Para 2.7 of Ministerial Decision No. 100 determines CIGA for a Holding Company Business as ‘all activities related to acquiring and holding shares or equitable interests in other companies…’.
Unfortunately, there are no other specifics either in the UAE’s economic substance, or in tax regulations.
The BVI Rules on ESR have much more details. What is required for compliance with the “employees and premises” condition ‘will be a fact sensitive question, dependent on the nature of the activity being carried on’:
Section 4.14 of Bahamas ESR Guidelines elucidates that ‘to have adequate human resources… compliance depends on the nature of the activity carried on’:
In the UAE, neither Cl. 2.7 of the Relevant Activities Guidance, nor Art. 3(2)(g) of Resolution No. 57, all cited above, specify the content of the CIGA ‘activities related to acquiring and holding shares or equitable interests in other companies’.
However, CIGAs for the Investment Fund Management Business states that ‘taking decisions on the holding and selling of investments … involves the independent consideration, deliberation and making of investment and divestment decisions. A licensee that is merely implementing decisions of another entity with respect to the holding and selling of investments without independent evaluation before taking steps or decisions to effect the investment or divestment decisions taken, does not perform the CIGA’.[12]
As you may see, the Investment Fund Management Business comprises elements of the Holding Business, as the latter is defined under Article 1 of the ESR Regulations as a business that:
Thus, the regulatory description of certain CIGAs from the Investment Fund Management Business is relevant for the Holding Company Business, in particular: ‘independent consideration, deliberation and making of investment and divestment decisions’.
As we established above, decision-making activity in terms of acquiring and holding shares (to set-up a subsidiary) is a part of CIGA. It’s clear that this must be adopted in a free zone to facilitate the 0% corporate tax rate. Having this in mind, a taxpayer should put it in place from the beginning of the 1st tax period and thereafter. But what about acquisitions performed earlier? Should a taxpayer have evidence that decision-making activity for such acquisitions has been performed in a free zone and not in another part of the UAE or the rest of the world? And what if there’s evidence of the contrary?
Let’s start with an easy aspect and exclude the issue of transition from the equation. We have 2 periods covered by ESR and CT. In one year, we buy shares and then in the second year we sell them with capital gains earned. In the 1st period, we have no assets and staff in the UAE, while in the second we have everything in a UAE free zone. In the first period, we have no need to file an ESR report as no income is earned. In the second period, we earned a capital gain and have all possible presence and links with the UAE. Does this mean we passed the test in the 2nd year?
In my opinion, we didn’t. A capital gain may not be earned without purchasing activity having been conducted in a previous period. The sale and the purchase are inextricably linked. Their separation would have been artificial and formal. But a formal approach is incompatible with the pivotal idea of economic substance.
Let’s now introduce factor of transition into our example. The shares had been acquired before the 1st corporate tax period commenced. We’re tempted to wonder why a taxpayer should suffer for non-compliance with the CT adequate substance rule which was either not in effect or was inapplicable to the taxpayer. Wouldn’t this be a retrospective application of the tax law? In my opinion, it wouldn’t.
Indeed, Article 112 of the UAE Constitution provides that laws apply only from the date they come in force without retrospective effect. When necessary and in matters other than criminal ones, the law may provide otherwise.
The taxable event here is the sale of shares, which occurred after the 1st tax period began. To apply the appropriate rate, we need to choose a rule which corresponds to this sale. There are different rules for a Qualifying Free Zone Person and a non-qualifying one. The receipt of income from a shareholding derived from CIGA conducted outside of a Free Zone disqualifies the shareholder. All the calculation hinges on income earned after the beginning of the 1st tax period. Hence, I do not see substantial arguments to prove that application of 9% tax rate to this income is retrospective and not allowed.
For example, Immovable Property and Financial assets owned by the Taxable Person prior to the Taxable Person’s first Tax Period might fall within transitional period relieve under Ministerial Decision No. 120/2023 but only if they have been earlier (before the 1st tax period) ‘measured in the Financial Statements on a historical cost basis’. Clear that MoF doesn’t see discern here retrospective application of the new rules.
One more example we may find in Art. 61(1) of the Corporate Tax Law: ‘The opening balance sheet referred to in Clause 1 of this Article shall be prepared taking into consideration the arm’s length principle in accordance with Article 34 of this Decree-Law’. There’re no doubts that applying of the Arm’s length rule to measure expenditure deductible after the beginning of the 1st tax period to the transaction occurred before it began is not retrospective.
I do not see why we should use different approach to tax income brought about after the tax period began by the assets purchased earlier. So, let’s proceed.
The model envisaged for a free zone’s 0% corporate tax rate doesn’t permit the use of a pro-rata approach (i.e. taxing income earned without adequate substance at 9% and the rest at 0%). Hence, a combination of holding activity with shares purchased from a free zone and shares purchased from a free zone disqualifies both from the 0% rate being applied.
Therefore, in my opinion, the FTA may disqualify a holding of shares with respect to which the acquiring part of CIGA is conducted outside of a free zone. At least, the risk of such a claim exists. The acquisition of the shares is a prerequisite for dividends. There’s a causal link between the two: no dividend or capital gains may come from shares which haven’t been acquired.
The company may object, referring to Art. 18(1)(a) of the Corporate Tax Law and the heading of Art. 7 of Cabinet Decision No. 55/2023. They mention the ‘maintenance [of] adequate substance in the State’. It is perfect wording to say that a company is to keep substance created earlier rather than to create it from scratch. This seems especially reasonable for shares acquired before the 1st CT period.
However, Article 7 of Cabinet Decision No. 55/2023 specifies ‘maintenance’ as the obligation of a Qualifying Free Zone Person to ‘undertake its core income-generating activities in a Free Zone’. Thus, the FTA has enough rationale to allege that adequate substance does not exist where a decision to acquire pertinent shares is taken outside of a FZ. Therefore, dividends for shares that ensued from activity conducted outside of a FZ do not qualify for a 0% CT rate.
To mitigate the risk, a company may compile evidence to prove that acquiring activity (or a subsidiary’s formation) has been performed from a free zone.
If it doesn’t do so, you may obtain certainty via a clarification request. Generally, the FTA doesn’t consult on ESR issues, but clarifies ESR penalty provisions (see details here). The FTA‘s 2022 Annual Report says that the FTA responded "to 2,348 enquiries relating to Economic Substance Regulations". You may try seeking clarification in terms of the application of an ESR penalty to a specific business case, e.g. “Whether the penalty for non-compliance with the ESR is applicable in the case described below?”.
Later, you may apply for a private clarification of adequate substance for the purpose Corporate Tax. Currently, clarifications are only available for VAT and Excise Tax. As far as Corporate Tax is concerned, only registration issues may be clarified at present. The FTA will announce the date from which a wider scope will be accepted for clarification requests.
You may also consider the option of passing over the shares to another free zone group entity[13]. This other entity should concentrate on acquiring part of the CIGAs in a free zone to fix the issue.
With a view to improving their position in potential tax or ESR disputes, companies often hire additional employees or providers who are located in a free zone.
This approach proceeds from an idea of ‘creating’ substance in a FZ, which may be considered adequate to the activity, bringing about a certain income (dividends).
This approach is quite popular. However, we believe it is not correct.
Art. 4.2 of Ministerial Decision No. 100 clarifies that “the CIGAs listed in Clause 2 of Article 3 of the ESR Regulations are examples of activities commonly associated with each Relevant Activity, but are not an exhaustive list of all CIGAs associated with a particular Relevant Activity. 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”.
Therefore, economic substance is not something to be created in a free zone. Adequate substance is a feature, which is inherent to income generated. In other words, it is activity that is conducted naturally and organically. An activity that is specifically arranged to demonstrate substance should not create adequate substance.
The CIGAs related to acquiring shares (setting-up a subsidiary) and subsequently holding them have previously been performed somewhere and somehow. Plans to add employees or to outsource the conduct of this activity to certain providers do not excuse the rest (the existing CIGAs) from being performed outside of a free zone. If existing CIGAs are already being conducted within the boundaries of a free zone, there’s no need to hire or outsource additional functions (if they are not actually necessary for business and are designed only to demonstrate free zone substance).
Hence, the FTA may question a Licensee (a taxpayer) on how a Group (or a Company) has conducted CIGA before hiring new employees or providers. Indeed, the holding existed before; therefore, CIGA has been conducted earlier by somebody somewhere. Thus, this question is relevant as it allows one to:
In the latter case, the FTA should verify the venue where CIGA continued to be performed.
Such scenario of an ESR audit is especially probable if, in its previous ESR reports, a Licensee declared staff and assets located outside of a FZ.
Companies have to be ready for such scenario and secure evidence addressing their previous practice.
To compile evidence, we advise:
Therefore, it is prudent:
Pursuant to the MoF’s press-release issued on 19 May 2023 “a number of posts circulating on social media and other platforms that are issued by private parties, contain inaccurate and unreliable interpretations and analyses of Corporate Tax”.
The Ministry issued a reminder that official sources of information on Federal Taxes in the UAE are the MoF and FTA only. Therefore, analyses that are not based on official publications by the MoF and FTA, or have not been commissioned by them, are unreliable and may contain misleading interpretations of the law.
See the full press release here.
You should factor this in when dealing with this article as well. It is not commissioned by the MoF or FTA. The interpretation, conclusions, proposals, surmises, guesswork, etc., it comprises have status of the author’s opinion only. Like any human job, it may contain inaccuracy and mistakes that I have tried my best to avoid. If you find any inaccuracies or errors, please let me know so that I can make corrections.
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[1] Decree Law No. 47 of 2022 on the Taxation of Corporations and Businesses
[2] General Corporate Tax Guide CTGGCT1, Section 5.5.4
[3] The relevancy of such approach is indirectly confirmed in the MoF’s Decision No. 139/2023. Art. 2(3) of this Decision sets out that: “Unless otherwise prescribed in this Decision or any other decision issued by the Minister, the activities referenced in Clause (1) of this Article shall have the meaning provided under the respective laws regulating these activities”.
[5] Para 88 of the Report
[6] The Commercial Entities (Substance Requirements) Act, 2023 (“CESRA 2023”).
[7] Article 7(2)(h).
[8] Order of the Minister of Industry Commerce and Tourism No. (106) of 2018 Concerning Economic Substance Requirements in the Kingdom of Bahrain.
[9] The Cayman Islands Economic Substance Guidance, issued by Tax Information Authority on July 2022, has same interpretation of CIGA for holding business.
[10] Section 8.4
[11] Section 8.5
[12] Para 2.3 of the Relevant Activities Guidance.
[13] However, you may not have a tax incentive as the dominant objective in such plan (Art. 50 of the Corporate Tax Law).