Holding company, offshore, abuse of rights, capital gains, tax reassessment, finance, wealth management, dividend distribution, etc. These are all terms we hear when discussing economic substance.
Why have economic substance in Dubai?
The concept of economic substance in the UAE has only become popular in recent years. The scope of this concept was introduced through practice and case law to combat certain arrangements considered abusive. These arrangements would have the sole purpose of benefiting from the advantages of an agreement signed between two states. Thinking that abuse of rights is unpunishable is a misconception.
The UAE benefits from a dense network of double-taxation treaties.
Like OECD and EU countries, the UAE announced the
Economic Substance Regulation (
Economic Substance Regulation - ESR) in 2019, which came into force in 2020. It should also be noted that the UAE has signed tax treaties with France, Belgium, Switzerland, etc.
What is economic substance?
There is no strict definition. It can be viewed as a concept assessed on a case-by-case basis.
If you have a foreign subsidiary that is also a tax resident, its substance will be defined by human resources (it has an adequate number of qualified employees) and material resources (employees and physical offices), management autonomy, legal reality, etc.
Certain French companies and many French corporate groups have, in the past, created subsidiaries in foreign countries solely to benefit from treaties between those countries and France. In doing so, they were able to benefit from reduced tax rates, exemptions, etc.
This is the French approach, but each country has different definitions and obligations. Each situation is assessed on a case-by-case basis according to the context, and any risk of reclassification must, of course, be avoided. This is closely monitored, particularly when the company is located in a country with no taxation. It is therefore important that the creation of a company abroad is not motivated exclusively by tax considerations. It must have objectives other than tax purposes. Parent companies are highly exposed to this issue, so it is important that their subsidiaries have adequate substance.
The criteria under the Economic Substance Regulation
Several factors help establish whether a company has economic substance and assess the beneficiary's motivation. One of the essential criteria is determining whether the establishment actually conducts operational activities in the country where it is established.
If your company in the UAE meets certain requirements, its substance will be demonstrated:
- If the organization has offices in Dubai or the UAE, which it can prove through commercial leases (EJARI), electricity bills, etc.;
- The absence of significant material and human resources, particularly if the transaction involves substantial sums (such as significant turnover), would be catastrophic;
- From an organizational standpoint, the manager and employees must be residents of the UAE;
- The existence of general meetings, etc.;
- The existence of company expenses consistent with your activity (contracts, etc.).
Whether it is a subsidiary or subcontracting, all these conditions must be met, and your legitimacy cannot be challenged, allowing you to benefit from tax optimization and preferential taxation. Conversely, if you do not meet these conditions, economic substance will not be demonstrated.
In summary, a company must be given substance through a genuine presence in the country, as well as an economic and legal purpose. Its existence must also not be motivated solely by purely tax-related reasons. If it has no economic utility, it may be subject to penalties.
Abuse of rights is not necessarily established in the absence of evidence, in particular.
Why prove that your company has substance to your country of origin?
Proving your company's substance in the country where you have expatriated is essential and helps you avoid penalties. This will enable your company and its activities to be recognized in the country where you reside. This point is very important because the application of international treaties is at stake. There must be consistency between a company's presence in a jurisdiction and its economic and operational activity.
If the transaction has purely tax-related objectives, you will put your expatriation at risk.
Indeed, if you cannot prove your company's substance in its country of registration (the foreign country), the country in which you are resident could consider that the company is managed from the country of residence and is therefore liable for tax in the country of residence.
In summary, this concept was introduced to monitor foreign companies and verify that they actually conduct business activities locally and have not simply established themselves there in order to defraud the tax authorities.
How can you prove economic substance and avoid the highest tax burden?
There is no fixed list of criteria to follow to prove it. It is assessed on a case-by-case basis. However, a foreign company within a group may be considered to have substance when it has premises in the country of incorporation, qualified employees to manage the company's activities, local accounting, a board of directors, etc. These elements should be substantiated where applicable.
Meeting these criteria does not mean that you will be untouchable in the eyes of the tax authorities. These elements will help limit the risks of a tax reassessment, for example. If the tax authorities seek to demonstrate that the transaction has objectives other than economic and commercial ones, you may face penalties.
What penalties apply in the event of insufficient substance?
If this company cannot demonstrate genuine activity and a real presence in the foreign country, the tax authorities could consider that the company is not resident in the foreign country where it is registered, but in the country of origin of the shareholder(s). This would make it impossible to apply the tax treaty concluded between the two countries.
If it is not applicable, this means that the tax authorities are entitled to apply domestic law. Consequently, the same tax administration could impose penalties on the basis of abuse of rights.
Creating or maintaining substance in a company has a cost, and many groups have been unwilling to make this investment. Today, in the face of the resurgence of reassessments on this basis, it is important to treat this concept with the utmost seriousness.
What does Merritt recommend to ensure substance in the countries where you establish yourself?
A shell company or mailbox company is no longer adequate, since you must prove economic substance to avoid disputes with the tax authorities in your country. From now on, you will absolutely need a local office, a director, and employees on site. Being devoid of any substance could be disastrous.
Our firm can only advise you to comply with these new requirements and genuinely conduct business in Dubai in order to benefit from the advantages between the UAE and your country of origin. It should be noted that the UAE is not on the blacklist of tax havens. There is therefore real added value in creating a company in Dubai.
We invite you to
contact us to validate your project and your needs regarding economic substance.
