Introduction

Key commercial hub in the region, the UAE will introduce Corporate Tax (CT) in the middle of 2023, which contains transfer pricing regulations in order to be in par with international entities, as well as waiving red flag to Base Erosion and Profit Shifting (BEPS).

The application of transfer pricing with the introduction of CT will play a significant role within all the businesses in the UAE. This article discusses basic principles of transfer pricing and core concepts as regulated by Organization for Economic Cooperation and Development (OECD) guidelines to have better understanding of the compliances for the UAE businesses.   

What is transfer pricing?

Arm’s length principle, which is the international transfer pricing (TP) standard that OECD member countries have agreed should be used for tax purposes by organizations and tax administrators. Per Horngren (professor of accounting at Stanford University) and Sundem (Professor Emeritus of Accounting), transfer pricing is “The amount charged by one segment of an organization for a product or service that it supplies to another segment of the same organization”. Simply, transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control.

Transfer pricing applicable parties

The applicability of TP regulations solely depends on the significance of the business relationship between other associated parties, the significance can be an assessed overview of commercial and financial relations between the associated enterprises. The UAE proposed CT will include two parties to cover TP compliance and they are related parties and connected parties. The related parties are attached to the entity’s ownership (Ex. A legal entity owned more than 50% of voting shares of the associated enterprise) and connected parties (Ex. A director or an officer of the taxable person).

Arm’s length principle

The authoritative statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD member countries and an increasing number of non–member countries. Article 9 provided:

[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profit which would be, but for those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

By seeking to adjust profits by reference to the conditions which would have been obtained between independent enterprises in comparable transactions and comparable circumstances, the arm’s length principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. Because the separate entity approach treats the members of the MNE groups as independent entities, attention is focused on the nature of the transactions between those members and whether the conditions thereof differ from the conditions that would be obtained in comparable uncontrolled transactions. Such an analysis of the controlled and uncontrolled transactions referred to as a “comparability analysis, ” is at the heart of the arm’s length principal application. The application of the arm’s length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances. There are two key aspects in such analysis:

1. Identify the commercial and financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated.
2. Compare the condition and the economically relevant circumstances of the controlled transactions as accurately delineated with the condition and the economically relevant circumstances of the comparable transaction between independent enterprises.

The typical process of identifying the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attached to those relations requires a broad-based understanding of the industry in which the MNE group operates (e.g. mining, pharmaceutical, luxury goods) and of the factors affecting the performance of any business operating in that sector. The understanding is derived from an overview of the particular MNE group which outlines how the MNE group responds to the factors affecting performance in the sector, including its business strategies, market, products, supply chain, and the key functions performed, material assets used, and important risks assumed. This information is likely to be included as a part of the Master file as described in OECD guideline chapter V.

A practical difficulty in applying the arm’s length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake. Such transactions may not necessarily be motivated by tax avoidance but may occur because in transacting business with each other, members of an MNE group face different commercial circumstances than would independent enterprises. Where independent enterprises seldom undertake transactions of the type entered into by associated enterprises, the arm’s length principle is difficult to apply because there is little or no direct evidence of what conditions would have been established by independent enterprises. The mere fact that a transaction may not be found between independent parties does not of itself mean that it is not at arm’s length.

Why does the transfer pricing should arm’s length?

There are several reasons why OECD member countries and other jurisdictions have adopted the arm’s length principle. A major reason is that the arm’s length principle provides broad parity of tax treatment for members of MNE groups and independent enterprises. Because the arm’s length principle puts associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity. In so removing these tax considerations from the economic decision, the arm’s length principle promotes the growth of international trade and investment.   

As per the OECD transfer pricing principles, tax administration should not automatically assume that associated enterprises have sought to manipulate their profit. There may be genuine difficulty in accurately determining a market price in the absence of market forces or when adopting a particular commercial strategy.

World tax leakage in value

Base erosion and profit shifting (BEPS) describes what happens when multinational enterprises exploit gaps and mismatches or loopholes in the international tax rules to artificially shift profits to lower the amount of tax they pay, by artificially shifting profits to low or no-tax jurisdictions.

However, BEPS is bad for everyone: governments, citizens and businesses alike. Governments lose much needed tax revenues from some of the largest companies in the world: conservatively estimated at around from 4% to 10% of global corporate income tax revenues, or USD 100-240 billion annually; money that could be spent on education, health care, infrastructure, and pensions are lost. Purely domestic businesses have a hard time competing with multinational enterprises that can lower their tax bills by shifting profits offshore.

The OECD/G20 Inclusive Framework members have developed detailed blueprints of a two-pillar approach that provide a solid basis for bringing the process to a successful conclusion by mid-2021.

Key areas of action to tackle BEPS include:

• Stopping the inappropriate transfer of profits between multinationals’ subsidiaries in different countries
• Helping countries to collect VAT more effectively in today’s digital world
• Providing a template for multinationals to report, country by country, where their profits, sales, employees and assets are located, and where they pay tax
• Eliminating treaty shopping between jurisdictions
• Facilitating swift implementation of the BEPS measures through a new multilateral instrument

More than 135 countries and jurisdictions are taking part on an equal footing in the Inclusive Framework on BEPS, and 90+ countries and jurisdictions have signed the Multilateral Convention to Implement Tax-Treaty Related Measures to Prevent BEPS. The Convention saves governments time by eliminating burdensome one-on-one negotiations, which take years to finalise, and helps countries to effectively implement the recommendations of the BEPS Project in a consistent manner, closing loopholes in thousands of existing tax treaties.

Harmful preferential tax regimes have also been addressed, with legislative changes made to amend/abolish 150+ of these regimes, representing a major step forward in tackling artificial profit shifting.

Methods of transfer pricing and selecting

OECD describes that there are mainly two types of TP methods called “traditional transaction method” and “transactional profit method” that can be used to establish whether the conditions imposed in the commercial or financial relationship between associated enterprises are consistent with the arm’s length principle. Traditional transaction methods are the comparable-uncontrolled price method (CUP), the resale price method, and the cost-plus method. Transactional profit methods are the transactional net margin method and the transactional profit split method.

The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should take into account the respective strengths and weaknesses of the OECD recognise method; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular on uncontrolled comparable) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. No one method is suitable for every possible situation, nor it is necessary to prove that a particular method is not suitable under the circumstances.

Traditional transaction methods are regarded as the most direct means of establishing whether conditions in the commercial and financial relations between associated enterprises are at arm’s length. This is because any difference in the price of a controlled transaction from the price in a comparable uncontrolled transaction can normally be traced directly to the commercial and financial relations made or imposed between the enterprises, and the arm’s length condition can be established by directly substituting the price in the comparable uncontrolled transaction for the price of the controlled transaction.

There are situations where transactional profit methods are found to be more appropriate than traditional transaction methods. For example, in cases where each of the parties makes unique and valuable contributions in relation to the controlled transaction, or where the parties engage in highly integrated activities, may make a transactional profit split more appropriate than a one-sided method. As another example, where there is no or limited publicly available reliable gross margin information on third parties, the traditional transaction method might be difficult to apply in cases other than those where there are internal comparable, and a transactional profit might be the most appropriate method in view of the availability of information.

Transfer pricing in GCC

The subject of transfer pricing (TP) has gained a great deal of momentum globally over years. Most of the OECD and G20 countries had implemented TP legislations even before the BEPS initiative and have issued further regulations following the finalisation of the BEPS Action Plan reports. The Gulf Cooperation Council (GCC) countries Bahrain, Kuwait, Oman, Qatar, Saudi Arabia (KSA) and the United Arab Emirates (UAE) support to global TP developments. Additionally, while Kuwait, Oman, Qatar and KSA contain provisions in their respective income tax laws providing for related party transactions to be at arm’s length.

While detailed TP provisions been issued by KSA and Qatar and GCC-headquartered groups are already filing Country-by-Country (CbC) Reports and preparing Master Files and Local Files in other countries in which they operate, and which have the underlying TP legislation.

How it impacts UAE business with income tax

The consultation paper (public consultation document) brings out a separate discussion on the applicability of TP in the UAE. We might expect the introduction of TP principles embedded in the corporation tax law.  As of now, in accordance with the PCD UAE will follow the guidelines as per the OECD. 

There are certain corporate tax aspects that may impact TP provisions under the new regime. It is to be noted that, their impact on the TP regime shall be assessed once final guidelines are issued. Some aspects are discussed below:

• Tax Grouping

The UAE group companies shall be allowed to form a tax group i.e., a fiscal unity and file a consolidated tax return provided certain conditions are met. However, there is no clarity regarding the applicability of the fiscal unity concept under the TP regime. In other words, it will be seen whether the UAE group companies that file a consolidated tax return will be allowed to maintain consolidated TP documentation as well.

• Withholding tax

No withholding tax is expected to be applicable on domestic and cross-border payments of any nature under the corporate tax regime. Given the same, UAE-based MNC’s payments to related parties (and non-related parties) shall not be subject to withholding taxes which will provide MNCs relief from double taxation. However, from a transfer pricing perspective, no analysis of withholding taxes on related party transactions is required.

• Qualifying intra-group transactions

Qualifying intra-group transactions and reorganizations will not be subject to UAE CT provided the necessary conditions are met. Accordingly, it remains to be seen which category of transactions will fall under the purview of qualifying intra-group transactions and how the same shall be analysed from a transfer pricing perspective.

• Free zone regimes

Considering that applicable free zone businesses will continue to benefit from CT incentives, there could be a requirement for certain TP considerations to be analysed. In addition, the expected TP rules may also need to address situations where the Free Zones-based entities conduct business with mainland UAE-related entities.

How Crevaty can help

The introduction of a transfer pricing regime by the UAE can be considered an important step towards strengthening its position as an attractive investment destination and regional hub.

Transfer pricing is becoming increasingly relevant and important for businesses across the globe due to the rapid expansion of global markets. As experts in the field of tax, our extensive range of transfer pricing services include the provision of transfer pricing planning services, advisory services and compliances.