How to “maintain adequate substance” in a free zone to enjoy a 0% Corporate Tax rate?


Adequate substance in the UAE’s tax regulations

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 expendituresActivities 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”.

  • The FTA adds to the above[2] that:
  • CIGA means “the activities that are of central importance”. As you may see below, this may have come to the FTA Guide from ESR Regulation. The Cabinet determined in Art. 3(2)(g) of the Resolution No. 57 that CIGA constitutes ‘activities that are of central importance to a Licensee for generating income from a Relevant Activity and may include the following’;
  • The Qualifying Free Zone Person (or its outsourced party) must be able to demonstrate that it has adequate staff and assets, and that it incurs adequate operating expenditures within the Free Zone”.

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]


Adequate substance for a holding in the ESR

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:

  • Complies with the requirement to submit any documents, records or information to the relevant Regulatory Authority…; and
  • Has adequate employees and premises for holding and managing the Holding Company Business’.

In order to pass the substance test, a holding company is not required to comply with conditions that:

  • the management and direction of its activity is located in the UAE;
  • expenses corresponding to this type of activity and its scale are borne by the company in the UAE.

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:

  • The ITA in BVI determined in the Rules on ESR that ‘a legal entity which carries on one or more relevant activities must conduct core income generating activity (“CIGA”) in the BVI relating to each such activity... This requirement does not apply to a holding business (ie the business of a pure equity holding company)’. Para. 8.2 stipulates that ‘for a pure equity holding entity there is no … requirement that the entity carries on CIGA in the BVI (there is no CIGA relating to holding business), although it remains necessary to have in the BVI adequate employees and premises for holding or managing its equity participations;
  • Section 12 of the Bahamas MoF’s ESR Guidelines[6] sets out that ‘an included entity that only carries out holding business is subject to a reduced economic substance test but the Act does not specify core income generating activities. There is no requirement for CIGA to be conducted in The Bahamas’.

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:

  • For holding companies that own a variety of assets and generate different types of income (such as interest, rents and royalties), the Basic Income Generating Activities shall be those related to the income generated by the holding companies.
  • For pure holding companies that only own capital contributions and earn only dividends and capital gains, the Basic Income Generating Activities shall be those related to holding and managing capital contributions, and for this purpose, pure holding companies shall provide the people and premises needed to carry out those activities and to respect all applicable reporting requirements’. [7]

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.     


How exactly do employees and assets contribute to the Holding Business?

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’:

  • ‘At one extreme, the requirement for being a pure equity holding entity is simply holding equity participations. If this is all the legal entity does during a given financial period, the relevant activity will be entirely passive in nature and the requirements for adequate and suitably qualified employees and for appropriate premises will be applied accordingly. Any legal entity will of course retain the services of a registered agent, and the performance of those services will be taken into account when assessing economic substance for pure equity holding entities’. [10]
  • On the other hand, the entity may actively manage its equity participations, in which case it should have adequate and suitably qualified employees, and appropriate premises, in the BVI to carry out this function’. [11]

Section 4.14 of Bahamas ESR Guidelines elucidates that ‘to have adequate human resources… compliance depends on the nature of the activity carried on’:

  • The requirement for being a pure equity holding entity is simply holding equity participations. If all the commercial entity does is passively hold equity participations, the nature and the requirements for adequate human resources and for adequate premises will be determined accordingly, and in these cases the appointment of a registered agent may be sufficient. The registered agent’s employees would be counted as the Entity’s employees in its substance filing, but in each case no employee shall be double counted’.
  • ‘… if the included entity actively manages its equity participations, it should have adequate human resources, and adequate premises, in The Bahamas to carry out this function. In the case of an “active” holding business, the services provided by the Entity’s Registered Agent may be taken into account but the adequacy of those resources would depend on the size, scope and complexity of the activities…’.

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:

  • Has as its sole function the acquisition and holding of shares or equitable interests in other companies; and
  • Only earns dividends and capital gains from its equitable interests.

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’.


What if part of a Holding’s CIGA is performed outside of the UAE before the 1st Corporate Tax Period?

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.


Mitigating risk

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.


Efforts to “add more substance in a free zone” may cause harm

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:

  • Establish other (undeclared) staff and assets involved in CIGA, and
  • Verify whether or not these resources are used in CIGA any longer, or the Licensee is continuing to use them.

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:

  • Identifying the real CIGAs, i.e. processes relating to specific holding business within the specific holding company;
  • Identifying the actual people involved;
  • Adjusting the resources that these people use for CIGA, i.e. where, when and what they do.

Therefore, it is prudent:

  • To have internal guidance which enshrines how these processes are conducted in a FZ;
  • To institute regular control over compliance with such guidance.



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.


[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”.

[4] Para 87 of the Report

[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).

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