Economic Substance Regulation(ESR)
Economic Substance Regulation (ESR) in UAE is a regulatory requirement created by the UAE government, that requires entities licensed by the UAE to demonstrate they have a substantial economic substance in the UAE. It is a measure designed to prevent shifted profits outside of the region. The UAE cabinet issued the regulation in April 2019 and it applies with effect from the first financial year commencing on or after 1 January 2019. The regulation applies to activities in 5 broad areas: banking; finance and leasing; insurance; shipping; and holding companies.
ESR set out in three main components including governance, substance, and reporting. Governance involves having adequate decision making, resources and systems in place to demonstrate that UAE licensed entities are managing their own affairs and making decisions contenting their own financial and commercial resources in the UAE. substance requires UAE licensed entities to demonstrate economic activities happening in the UAE by either having adequate employees and material physical assets in the UAE or conducting activities that have high levels of expenditure to support activity taking place in the UAE and related returns received by entities in the UAE.
In addition, the effective management of economic substance requires the access to good quality financial information. For example, the enhanced disclosure and reporting obligations requires the UAE licensed entities to have in place an accurate and complete accounting system to facilitate the production of financial statements, and for their transactions to be timed and recorded correctly. UAE licensed entities are also required to document key assumptions, judgements and policies which are used in determining the financial statements.
The regulation is necessary to comply with international guidelines set out by the Organisation of Economic Cooperation and Development (OECD) and the European Union, who are interested in ensuring that companies pay tax in the jurisdiction where they generate profits. Companies who fail to comply with ESR can be subject to financial penalties of up to 300,000 UAE Dirhams.
Overall, Economic Substance Regulation (ESR) in UAE is an important measure that ensures that entities licensed by the UAE have a substantial economic substance in the UAE and pay tax in the jurisdiction where they generate profits. This regulation is necessary for the UAE to comply with international guidelines set out by the OECD and the European Union. Any entities that fail to comply with the regulation may face severe financial penalties.