Economic Substance Regulations (ESR) Compliance in UAE

What the UAE Economic Substance Regulations Are

The UAE Economic Substance Regulations (ESR) require UAE-licensed businesses conducting certain specified activities to demonstrate that they have genuine, substantive operations in the UAE proportionate to the income they derive from those activities. The regulations were introduced to align the UAE with international standards on Base Erosion and Profit Shifting (BEPS) developed by the OECD, and to address concerns that businesses were routing income through the UAE without maintaining meaningful operations here.

ESR is governed by Cabinet Resolution No. 57 of 2020 and Ministerial Decision No. 100 of 2020, which together replaced the original Cabinet Resolution No. 31 of 2019. These instruments apply to all UAE-licensed businesses , mainland companies, free zone companies, and branches , that carry out any of the nine Relevant Activities defined in the regulations.

The Nine Relevant Activities Under UAE ESR

A business is only subject to ESR if it carries out one or more of the following Relevant Activities and derives income from them:

• Banking Business
• Insurance Business
• Investment Fund Management Business
• Lease-Finance Business
• Headquarters Business
• Shipping Business
• Holding Company Business
• Intellectual Property Business
• Distribution and Service Centre Business

If a UAE-licensed business does not carry any of these Relevant Activities and does not derive income from them, it is still required to submit an annual ESR notification confirming that it is not in scope. If it does carry a Relevant Activity, it must meet the full Economic Substance Test and submit an annual ESR report.

The Economic Substance Test

A UAE business that carries a Relevant Activity must satisfy the Economic Substance Test for each financial year. The test requires the business to demonstrate all of the following:

• Core Income-Generating Activities (CIGAs) conducted in the UAE: the activities that generate the entity’s relevant income must be performed within the UAE. What constitutes a CIGA varies by Relevant Activity , for a Holding Company, the CIGAs are relatively minimal (compliance activities, managing equity participations); for an Intellectual Property Business or Headquarters Business, the requirements are significantly more demanding
• Management and direction in the UAE: the entity must be managed and directed from within the UAE. In practice, this requires that board meetings be held in the UAE with sufficient frequency, that a quorum of directors is physically present in the UAE at each meeting, and that key decisions are made in the UAE rather than overseas
• Adequate employees: the entity must have a sufficient number of qualified full-time employees in the UAE relative to the Relevant Activity it conducts. Outsourcing CIGAs to a UAE-based third party is permitted, but the entity must monitor and control the outsourced activities
• Adequate expenditure: sufficient operating expenditure must be incurred in the UAE relative to the level of Relevant Activity conducted
• Adequate physical assets: sufficient physical assets or infrastructure must be present in the UAE to support the Relevant Activity

The word “adequate” and “sufficient” are assessed on a case-by-case basis, with reference to the nature and scale of the entity’s Relevant Activity. A Holding Company whose only activity is holding equity participations faces different substance requirements from a business generating IP royalty income, which faces significantly more stringent scrutiny.

Annual ESR Notification and Report Deadlines

Every UAE-licensed business must comply with two annual ESR obligations:

ESR Notification

All UAE licensees , whether or not they carry a Relevant Activity , must file an annual ESR notification with their relevant regulatory authority. The notification confirms whether the entity carries any Relevant Activity and, if so, provides basic information about the activity and income. The deadline for the ESR notification is within 6 months of the end of the entity’s financial year. For entities with a 31 December financial year end, this means the ESR notification is due by 30 June of the following year.

ESR Report

Entities that carry a Relevant Activity and derive income from it must also file an annual ESR report. The report is a more detailed submission demonstrating compliance with the Economic Substance Test and must include:

• The type and nature of the Relevant Activity conducted
• The type and amount of relevant income for the financial year
• The operating expenditure incurred in relation to the Relevant Activity
• The number and qualifications of full-time employees in the UAE
• The physical assets held in the UAE
• Details of the Core Income-Generating Activities conducted and, where applicable, details of outsourced activities
• A declaration of whether the entity satisfies the Economic Substance Test

The ESR report deadline is within 12 months of the end of the entity’s financial year. For a 31 December year end, the report is due by 31 December of the following year.

Which Regulatory Authority Receives ESR Filings

The authority to which ESR notifications and reports are filed depends on the entity’s licensing authority and the Relevant Activity conducted:

• UAE Central Bank: for licensed financial institutions conducting Banking, Insurance, Investment Fund Management, or Lease-Finance Business
• Securities and Commodities Authority (SCA): for entities engaged in Investment Fund Management activities not regulated by the Central Bank
• Ministry of Finance: for most other entities, including those in free zones (other than those in the DIFC and ADGM which have their own regulatory frameworks)
• Free zone authorities and DIFC/ADGM: for entities licensed within their respective jurisdictions for activities falling within those authorities’ supervision

Penalties for ESR Non-Compliance

Failure to comply with ESR obligations attracts administrative penalties under the UAE penalty framework:

In addition to financial penalties, repeated or material ESR failures can result in the entity’s trade licence not being renewed, and information about the failure being shared with foreign tax authorities under the UAE’s international exchange-of-information frameworks.

The ESR and QFZP Connection Under Corporate Tax

Since Corporate Tax took effect under Federal Decree-Law No. 47 of 2022, ESR compliance has taken on an additional significance for free zone businesses. One of the five conditions that must be satisfied in every tax period to maintain Qualifying Free Zone Person (QFZP) status , and access the 0% Corporate Tax rate on qualifying income , is adequate substance in the UAE. This substance requirement is assessed consistently with the ESR framework.

A free zone business that fails the Economic Substance Test is likely to also fail the QFZP substance condition, which triggers loss of QFZP status for that tax period and the following four periods. The financial consequence of ESR non-compliance for a QFZP is therefore not just the administrative penalty , it is the loss of the 0% Corporate Tax rate on all qualifying income for five consecutive years. This connection makes ESR compliance materially more significant for free zone businesses than it was before Corporate Tax was introduced.

Frequently Asked Questions (FAQs)

How Farahat & Co. Can Help

Farahat & Co. assists UAE businesses with ESR compliance , from determining whether a Relevant Activity is being carried out, to preparing and filing annual ESR notifications and reports, conducting substance assessments, and advising on the interaction between ESR and QFZP status under the Corporate Tax framework.

Contact Farahat & Co. today to discuss your Economic Substance Regulations compliance requirements.