Authors: Brian Conn, Consulting Partner, BDO United Arab Emirates & Ismael Navarro, Senior Manager - Transfer Pricing, BDO Kingdom of Saudi Arabia
When the Ministry of Finance announced that corporate tax would be implemented in the UAE it confirmed that one of the mechanisms underpinning the new tax law would be the introduction of transfer pricing, based on Organisation for Economic Co-operation and Development (’OECD’) principles. This will be something new for the UAE and many businesses will not be familiar with the principles of transfer pricing or the practical implications. In this article we will take a high-level look at how transfer pricing works, who might be affected and what businesses should be doing to prepare.
In due course, legislation will confirm the transactions and entities that are within the scope of transfer pricing, the compliance and reporting requirements, and will define the key features such as when entities are deemed to be connected. However, as yet the final law and regulations have not been released, so this article is based on our experience of the type of measures that have been introduced in other GCC States and around the world. These give a good indication of what to expect in the UAE and provide a guideline for UAE businesses to start their planning for the introduction of transfer pricing.
We will give an update on the final rules once they are released, which is expected to happen around the end of the summer.
What is transfer pricing?
Transfer pricing concerns the value of transactions between connected parties: for example, the provision of management services by a parent company to its subsidiaries or the supply of services by a company to its sister company. The essence of transfer pricing rules for tax purposes is that the transfer price should be at an ‘open market’ or ‘arm’s length’ value. This prevents a group of companies manipulating intragroup prices to reduce the group’s overall tax bill.
What is the OECD’s involvement?
For several years, the OECD has been at the forefront of the movement to combat tax avoidance through its ‘Base Erosion and Profit Shifting’ (‘BEPS’) action plan. The purpose of BEPS is to establish measures that sovereign states can take to prevent international businesses from avoiding tax by artificially shifting profits to exploit gaps and mismatches in tax rules in different jurisdictions. Historically, this type of tax avoidance was very common and although it was perfectly legal, the tax revenue of some countries was severely reduced and distorted. There were reports of groups, particularly online businesses, making sales worth billions and yet paying minimal, or no tax, globally.
BEPS measures have been adopted by most of the world’s developed countries. Transfer pricing is an integral part of these measures, and the OECD lays down a number of minimal standards, based around standard reports, in order to maintain transfer pricing integrity.
The UAE has stated its support for the BEPS program and the adoption of the OECD rules for transfer pricing was a logical step as part of the introduction of corporate tax.
Who will be affected?
It is likely that in principle, all businesses will be within the scope of the transfer pricing rules as it seems reasonable that the Federal Tax Authority (‘FTA’) should be able to invoke the rules in any situation, domestic or international, where the manipulation of transfer pricing appears to impact the amount of corporate tax payable. However, in practice, although domestic trade may be within the scope of transfer pricing, the principal burden of the rules is likely to fall on multinational enterprises that transfer goods or services between group entities. Groups of this kind, in particular, will probably need to maintain the records stipulated by the OECD and might need to make additional annual reports or declarations to the FTA.
It is important to remember that although transfer pricing might be a regular and on-going issue for some groups, it can also affect one-off transactions, such as corporate sales or major asset sales. Such transactions may need to be scrutinized for transfer pricing implications even if the business does not normally undertake transactions that fall within the scope of the transfer pricing rules.
What are the OECD guidelines on Transfer Pricing?
The UAE has said that it will follow the OECD guidelines on transfer pricing, so it is important to have a broad understanding of the OECD requirements. The full guideline is extensive and detailed and for the purposes of the article we will keep to a high-level summary of the key points that are likely to be relevant.
Central to the OECD transfer pricing guidelines is the ‘arm’s length principle’, which the OECD says represents an international consensus on the valuation of cross-border transactions between associated enterprises. A value is considered to be equivalent to arm’s length if it is the same as the price that would be paid between two unrelated parties, with no influence over each other, in the prevailing market conditions.
The OECD provides detailed guidance on allowable methods to test, analyse and compare the transfer price in order to establish the arm’s length valuation. It also prescribes the format of documentation that multinational Enterprises are expected to maintain.
Transfer pricing valuation can be complex and different methods will be appropriate for different types of transaction. It is often necessary to gather information from both external and internal sources in order to evaluate all of the factors that influence price, and unfortunately, there are no shortcuts. Detailed transfer pricing studies are necessary for major transactions and when developing internal policies. If the pricing is incorrect, it might be challenged by the FTA or an overseas jurisdiction and could lead to transfer pricing adjustments, either disallowing deductions (overpriced) or increasing the taxable base. This may result in additional cost and penalties. The OECD Guidelines set out five methods that can be applied for determining the arm’s length price.
These five methods consist of three “traditional transaction methods”: the comparable uncontrolled price method, the resale price method, and the cost-plus method and two “transactional profit methods”: the transactional net margin method and the transactional profit split method.
The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in similar circumstances.
The CUP method is a particularly reliable method where an independent enterprise sells the same product as is sold between two associated enterprises. A comparable transaction would thus mean an uncontrolled transaction where terms and conditions are the same or almost similar to that of the controlled transactions.
This method arrives at an arm’s length price by deducting an appropriate discount for the activities of the reseller from the actual resale price.
The OECD Guidelines recommends the use of RP in cases where the reseller related person does not add substantially to the value of the product. In other words, it is more viable in cases where an entity merely performs the basic sales, marketing and distribution activities.
This method assesses whether controlled transactions or specified domestic transactions between related persons are at arm’s length by comparing the gross profit mark-up of the supplier to that earned by unrelated enterprises in comparable uncontrolled transactions. Gross profit mark-up is the ratio of profits earned in relation to the direct and indirect costs of production incurred. This method can be employed when a taxpayer manufactures products using unrelated party inputs, and then sells those products to related parties without engaging in significant marketing or selling activities.
The profit split method seeks to split combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.
Typical transactions where PSM can be applied are those where integrated services or where valuable non-routine intangibles are involved.
The transactional net margin method compares the net margins earned by a related person from a controlled transaction in relation to a particular factor such as costs incurred, sales, assets utilized, etc.
This method is commonly employed when a taxpayer provides services or when no other method can be employed.
A case-by-case analysis would have to be undertaken to determine the most appropriate method to evaluate the correct application of the arm’s length principle for every intercompany transaction in question.
The key documentation requirements in the OECD guidelines are known as Master File, Local File and Country-by-Country Reporting (CbCR). It seems likely that groups that fall within the scope of UAE transfer pricing will need to maintain the Master and Local Files. CbCR has already been introduced to the UAE.
The Master File is intended to give a global overview of a multinational enterprise’s business operations, its transfer pricing policies for the group, and details of the economic activities of the individual group companies. The Master File covers the multinational as a whole but in some cases, it might be separated into different parts to cover different service lines or activities.
The OECD sets out minimum content for the Master File and this includes:
- Details of the organizational structure
- Description of the group’s business activities
- Information regarding the group’s intangible assets
- Information regarding the group’s financial activities
- Information regarding the group’s financial and tax position. This would include financial statements, lists and details of Advance Transfer Pricing Agreements and tax rulings from around the world.
The Local File comprises details of controlled transactions within the jurisdiction and is supplementary to the Master File. Minimum content for the Local File includes:
- Information on the taxable person such as management structure, organizational chart and reporting lines within the organization, including international reporting lines
- Detailed descriptions of the business and business strategy and an indication of whether the local entity has been involved in or affected by business restructurings or intangible transfers
- Documentation on material controlled transactions including information such as details of intragroup payments and receipts, descriptions of the transactions, identification of related parties, intercompany agreements, detailed functionality and comparability analysis including methods used and factors or assumptions taken into account.
- Industry analysis
- Detailed financial information including financial statements
There are different approaches to compliance that the UAE might take in connection with Local and Master files. For example, these documents must be available upon request from Zakat, Tax and Customs Authority (‘ZATCA’) in Saudi Arabia but are not routinely submitted to the authorities, while in Qatar, these reports must be submitted to the tax authorities.
In addition to the OECD requirements, it is possible the UAE will also introduce some additional annual compliance obligations. As an example, in Saudi Arabia, affected businesses are required to make an annual declaration confirming that the group has a transfer pricing policy, and that the policy has been properly applied to all controlled transactions. The declaration must be signed-off by a qualified auditor. Compliance obligations of this type are not unusual, and the UAE might introduce something along similar lines.
What will this mean for UAE businesses?
As already mentioned, in principle it is likely that transfer pricing will cover all related party transactions. However, the greatest burden will fall on multinational enterprises. For these businesses in particular, transfer pricing is a significant and important issue. Developing or updating a group policy for transfer pricing or preparing transfer pricing studies for large transactions can be a complex and time-consuming exercise, and most businesses require professional assistance with exercises of this kind. The on-going compliance can also be demanding as the Master File and Local File are detailed documents that require time and effort to prepare. There is almost certain to be penalties if compliance is not handled correctly.
What should businesses do now?
Until the final law and regulations are published, businesses will probably not wish to commit to major changes. However, multinationals should start to make an assessment of their current position and current transfer pricing policy (if there is one). This will help to identify if there are transactions that are likely to be affected by transfer pricing, whether those transactions are likely to meet the type of arm’s length test that will be applied in the future, and whether there is adequate and robust documentation to support the valuation. Essentially, this is a question of whether the current pricing policy and business model would stand up in the face of a transfer pricing investigation or examination.
The assessment of transfer pricing should be part of a broader assessment of the likely impact of corporate tax, which all UAE businesses should be undertaking before the tax is implemented. There is time to do this before implementation, but time goes quickly, and we would urge businesses to start the process sooner, rather than later.
If you need assistance or advice with transfer pricing or any other matter connected with tax, please contact our UAE tax team.