Part 1- A conceptual framework of Transfer Pricing for your business

The Federal Tax Authority (FTA) has issued the much-awaited extensive Transfer Pricing (“TP”) Guide which provides an overview or guidance on the TP regulations in the UAE, including insights on TP rules and procedures, determination of the related party transactions, different methodologies for pricing related party transactions and key compliance requirements.

OVERVIEW OF TP

1. Transfer Pricing or TP is primarily a tax concept, but which also has important accounting and risk-related implications.
2. TP refers to the pricing of transactions between Related Parties or Connected Persons, and has become increasingly important due to globalization and cross-border trade activities by enterprises.
3. It refers to the pricing of transactions or arrangements between Related Parties or Connected Persons that are influenced by the relationship between the transacting parties.

Our article, in its two-part series, aims to provide a detailed background on the concept of TP, its scope (i.e., Transactions as well as Persons covered under the ambit of UAE TP regulations) and the manner in which UAE businesses can implement TP policies.

TP APPLICABILITY & SCOPE

1. TP APPLICABILITY

1. The TP provisions introduced in the UAE have their genesis in the OECD Transfer Pricing Guidelines for MNEs’ 2017 (“Amended in 2022”) and the UN TP Manual.
2. Also, the need to introduce TP in the UAE is to align with the principles laid down under the 14 Action Plans of Base Erosion and Profit Shifting (“BEPS”), which emphasize on prevention of shifting excessive profits to low tax jurisdictions.

2. CONCEPT OF RELATED PARTIES AND CONNECTED PERSONS

1. TP rules apply to Related Parties, which are defined under Article 35 of the Corporate Tax Law as any associated Persons, according to a specified degree of association.
2. The criteria for determination of related parties has been defined below:
   1. Kinship – relationship of two or more individuals who are related up-to fourth degree of kinship or affiliation.
   2. Ownership – Natural person and a Juridical person are related parties where the individual along with its related parties owns 50% or more ownership interest in the Juridical person. Two or more Juridical person can also be considered as related parties by way of ownership.
   3. Control – Person may also be considered as related parties through direct or indirect significant influence over the other party. Few of the examples referred in TP Guide are as follows:
      1. Debt constituting of 50% of the total capital of the borrower
      2. Royalty arrangement entitling 50% of profits
      3. Shareholder (shareholding less than 50%) playing a key role in decision making

3. ARM’S LENGTH PRINCIPLE
   1. The Arm’s Length Principle (ALP), as introduced in the UAE under Article 34 of the Corporate Tax Law, requires that transactions and arrangements between Related Parties or Connected Persons are priced as if the transactions or arrangements had occurred between independent parties under similar circumstances
   2. Thus, the CT Law requires Related Parties or Connected Persons to earn their “fair share” of profits based on the ALP.
   3. TP guide emphasizes on the fact that these transactions should be priced at ‘Market Price’ and hence ALP should be applied to determine the appropriate price that would have been agreed by the independent parties in similar transaction.
   4. Common transaction classes generally include the supply or transfer of tangible goods, provision and receipt of services, funding and other financial transactions, and commercial exploitation of intangible assets such as patents, brands and know-how
   5. A “Controlled Transaction” is a transaction or arrangement between Related Parties or Connected Persons.
   6. Controlled Transactions generally include the supply or transfer of tangible goods, provision and receipt of services, funding and other financial transactions, and commercial exploitation of intangible assets such as patents, brands and know-how.
   7. For the purposes of the UAE TP rules, all cross border Controlled Transactions as well as domestic Controlled Transactions (including transactions undertaken between Free Zone Persons) must follow the ALP.
   8. Further, TP rules not only apply to MNE groups but also to domestic groups (including free zone entities) with no presence outside UAE.

4. FUNCTIONAL ASSET & RISK ANALYSIS

1. A Functional Analysis seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the Related Parties or Connected Persons in a Controlled Transaction.
2. The Functional Analysis focuses on the functions performed by the parties and the capabilities they provide to the Controlled Transaction. These functions and capabilities will include operational activities such as procurement, marketing, sales as well as decisions.

5. APPLICATION OF ALP

Further, in addition to the above, with respect to the selection of potential comparables, the following aspects may be taken into consideration:

1. Domestic or foreign comparables:
   1. To the extent practically possible, taxpayers should use domestic comparables in their benchmarking analysis;
   2. In cases where sufficient data is not available at the domestic level, taxpayers can consider regional or global comparables;
   3. Further, geographical order for searching for external comparables is as follows:
      1. comparables in the local market;
      2. comparables in the regional (Middle East) markets, and then;
      3. comparables in other regions’ markets.

2. Consistency in selection of comparables:
   1. Taxpayers should adopt a consistent and analytical process to identify potential comparables;
   2. Furthermore, taxpayers must maintain appropriate supporting documentation that describes the criteria used to select potential comparables and the reasons for excluding some of the potential comparables. Such information can be used by the FTA to assess the reliability of the comparables used.

3. Use of multiple year data: The examination of multiple-year data is typically done to improve the understanding of long-term arrangements. The taxpayers can include a three-year period, and they can deliberate to accept a comparabale post application of all quantitative filters as well as qualitative filters, in case financial data of two out three years is available.

4. Frequency of updating the external comparables search: Searches for comparables should be fully updated every three years with an annual financial update of the comparables in the interim years as a minimum requirement. In case of a change in circumstances of the Controlled Transaction or transacting parties, the full analysis on the selection of comparables needs to be undertaken in the year of the change in circumstances.

5. Extreme Results: It might consist of losses or unusually high profits and can affect the financial indicators. Where one or more of the potential comparables have extreme results, further examination would be needed to understand the reasons for such extreme results. The reason might be a defect in comparability such as losses not reflecting normal business conditions, losses reflecting a level of risk that is not comparable to the one assumed in the Controlled Transaction, or exceptional conditions met by an otherwise comparable third party;

6. TP METHODS