Economic Substance Regulation (ESR): What You Must Know

Introduction

The United Arab Emirates (UAE) Economic Substance Regulations (ESR) were introduced in 2019 as part of the country's commitment to international tax transparency and alignment with the OECD's Base Erosion and Profit Shifting (BEPS) initiative. Designed to ensure that companies demonstrate genuine economic activity within the UAE, ESR aimed to prevent tax evasion and profit shifting by requiring entities engaged in "relevant activities" to prove substantial presence through core income-generating activities, qualified employees, physical assets, and directed management within the jurisdiction.

However, in a significant regulatory shift, the UAE Cabinet issued Decision No. 98 of 2024, abolishing ESR obligations for all financial periods starting on or after January 1, 2023. This repeal marks a pivotal change in the UAE's regulatory landscape, simplifying compliance while embedding substance principles into broader tax and transparency frameworks. Understanding what happened, why it happened, and what businesses need to know going forward is essential for navigating the current environment.

What Were the ESR Requirements?

Before the repeal, ESR applied to UAE entities engaged in "relevant activities." These activities included:

• Banking: Accepting deposits, making loans, and providing other banking services
• Insurance: Providing insurance coverage and related services
• Investment Fund Management: Managing investment funds on behalf of investors
• Lease-Finance: Providing credit for leasing arrangements
• Headquarters: Providing senior management, assuming or controlling risks, and providing substantive advice
• Distribution and Service Center: Purchasing and reselling goods or providing services to related parties
• Holding Company: Holding shares or equity interests in other entities
• Intellectual Property: Holding, exploiting, or receiving income from intellectual property assets
• Shipping: Operating ships in international traffic

Core Income-Generating Activities (CIGA)

For each relevant activity, entities were required to demonstrate that their Core Income-Generating Activities (CIGA) were conducted in the UAE. These activities varied by sector but generally included the essential operations that generated the entity's income.

Substance Requirements

To demonstrate adequate economic substance, entities had to satisfy several tests:

• Directed and Managed Test: The entity must be directed and managed in the UAE, with board meetings held in the UAE with a quorum of directors physically present, and strategic decisions made in the UAE
• Adequate Employees: The entity must have an adequate number of qualified employees physically present in the UAE
• Adequate Expenditure: The entity must incur adequate operating expenditures in the UAE
• Physical Assets: Where applicable, the entity must have adequate physical assets in the UAE
• CIGA in UAE: Core income-generating activities must be carried out in the UAE

Reporting Obligations

Entities were required to file:

• ESR Notification: Within six months of the end of the financial year, indicating whether the entity conducted relevant activities
• ESR Report: Within 12 months of the end of the financial year, demonstrating compliance with substance requirements (only for entities conducting relevant activities)

Non-compliance could result in penalties ranging from AED 20,000 to AED 50,000, along with potential reputational damage and exchange of information with foreign tax authorities.

The Repeal: What Happened and Why?

In a strategic move to streamline regulations and reduce administrative burdens, the UAE Cabinet issued Decision No. 98 of 2024, abolishing ESR obligations for all financial periods starting on or after January 1, 2023. This repeal:

• Eliminates the need for annual ESR notifications and reports for periods from 2023 onwards
• Retroactively applies exemptions for qualifying entities
• Allows for refunds of previously imposed penalties in certain cases
• Integrates economic substance requirements into the Federal Corporate Tax Law, which took effect in June 2023

Rationale for the Repeal

The primary rationale for repealing ESR was to avoid duplication with the new Corporate Tax regime. The Federal Corporate Tax Law incorporates substance requirements for entities seeking tax benefits, particularly for Qualifying Free Zone Persons (QFZPs) seeking 0% tax on qualifying income. By integrating substance principles into Corporate Tax, the UAE maintains alignment with OECD and FATF (Financial Action Task Force) standards while creating a more business-friendly environment that reduces administrative complexity.

This approach allows businesses, particularly startups, SMEs, and multinationals in free zones, to redirect resources toward growth rather than maintaining separate ESR compliance frameworks.

What Businesses Must Know in 2025

Historical Periods Still Require Compliance

For businesses with financial years prior to 2023, outstanding ESR filings must still be completed. The Federal Tax Authority (FTA) may conduct reviews of historical periods, and entities should ensure all required notifications and reports are filed for periods ending before January 1, 2023.

Record Retention Requirements

Even though ESR reporting is repealed for new periods, entities must retain ESR-related records for six years. This includes:

• Board meeting minutes and resolutions
• Employment contracts and payroll records
• Office lease agreements
• Financial statements and expenditure records
• Evidence of core income-generating activities
• Historical ESR notifications and reports

The FTA may request these records during audits or reviews of historical periods.

Substance Principles Live On in Corporate Tax

While ESR reporting is gone, its underlying principles - demonstrating real operational substance - continue to influence compliance strategies under the Corporate Tax regime. Entities seeking tax benefits, particularly free zone companies seeking 0% tax on qualifying income, must demonstrate:

• Core activities conducted in the UAE
• Adequate staff and assets in the UAE
• Directed and managed operations in the UAE

These requirements echo the former ESR framework, ensuring that substance principles remain embedded in the UAE's tax system.

Integration with Other Regulatory Frameworks

Substance requirements also align with other regulatory obligations, including:

• Ultimate Beneficial Owner (UBO) Requirements: Ensuring declared beneficial owners are tied to genuine, verifiable operations
• Anti-Money Laundering (AML) Laws: Demonstrating legitimate business operations and preventing the use of "shell companies"
• Tax Residency: Proving substance to claim UAE tax residency benefits

Practical Considerations for 2025

For Entities with Historical ESR Obligations

If your entity has financial periods ending before January 1, 2023, you should:

1. Complete any outstanding ESR notifications and reports
2. Maintain comprehensive documentation supporting your substance position
3. Retain all ESR-related records for six years from the end of each relevant period
4. Be prepared for potential FTA reviews or audits of historical periods

For Entities Operating Under Corporate Tax

For financial periods from 2023 onwards, focus on:

1. Ensuring substance requirements are met for Corporate Tax compliance, particularly if seeking free zone tax benefits
2. Conducting gap analyses of operations against Corporate Tax rules
3. Maintaining documentation that demonstrates substance for tax purposes
4. Integrating substance considerations into broader compliance frameworks

Strategic Opportunities

The repeal of ESR presents opportunities for businesses to:

• Reduce administrative burdens and redirect resources toward growth
• Streamline compliance by focusing on integrated Corporate Tax requirements
• Leverage the UAE's simplified regulatory environment for competitive advantage
• Focus on operational excellence rather than separate regulatory filings

Common Misconceptions

Some businesses may still face outdated advice or confusion about ESR. Key points to remember:

• ESR is not completely gone: Historical periods still require compliance, and substance principles remain in Corporate Tax
• Substance still matters: While reporting is eliminated, demonstrating genuine operations remains important for tax and regulatory purposes
• Records must be kept: Six-year retention requirements apply to historical ESR documentation
• Free zones are not exempt: Free zone entities must still demonstrate substance for Corporate Tax benefits

Conclusion

The repeal of ESR for periods from 2023 onwards represents a significant simplification of the UAE's regulatory landscape. However, businesses must remain vigilant about historical obligations, record retention, and the continued importance of substance principles under Corporate Tax. By understanding what changed, why it changed, and what remains relevant, companies can navigate the current environment effectively, turning regulatory simplification into competitive advantage.

For entities with complex structures, multiple jurisdictions, or specific tax planning objectives, consulting with local experts can help tailor compliance strategies to your specific setup and ensure alignment with all applicable requirements in 2025 and beyond.