What is Transfer Pricing and its Methodologies and for Whom it is Applicable under CT?
Transfer pricing in the UAE is the process of determining fair prices for goods, services, and intellectual property exchanged between related parties in a multinational organization. To ensure compliance with UAE Corporate Tax Law and OECD principles, companies engaging in cross-border transactions with affiliates or subsidiaries must adhere to transfer pricing laws. This involves maintaining detailed documentation, conducting transactions on an arms-length basis, and submitting them to the Federal Tax Authority upon request.
What is Arm’s Length Price?
The arm’s length price (ALP) of a transaction is the price that would be paid if the transaction had taken place between two independent and unrelated parties, where the nature of the transaction is only commercial. Businesses operating in the UAE must abide by this principle to ensure fair pricing between related parties. Such an arm’s length price is comparable to the market price of the merchandise or service involved.
Transfer Pricing Methods
The five TP methodologies required by the UAE to determine the arm’s length price are under the OECD TP Guidelines.
The Comparable Uncontrolled Price (CUP) Method
The CUP technique determines a price based on the prices of comparable transactions that transpired between third parties.
The Transactional Profit Split Method
The profit split method is a fair way to divide profits when two parties work closely together on a project or product. It takes into account each organization's contribution and potential profitability, making sure everyone gets their fair share.
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The Cost-Plus Method
Using the cost-plus transfer pricing method, businesses can establish a price when there is no market price to use as a benchmark. This is accomplished by calculating the standard cost of the goods and then adding the standard profit margin. This figure can then be used as a TP for the transaction.
For instance, Company A manufactures a product and sells it to its subsidiary, Company B, which distributes the product in a foreign country. There is no market price for this product in foreign countries. Using the cost-plus method, Company A calculates that the standard cost of producing the product is $50 and adds a standard profit margin of 20%. The resulting amount will be the transfer price at which Company B would pay Company A for each unit of the product it receives.
The Transactional Net Margin Method (TNMM)
TNMM is the go-to method for determining if transactions between related parties are at arm's length. By comparing companies' operating or net margins, TNMM quickly analyzes whether the transactions are fair and equitable.
For instance, Company A sells a product to its related party, Company B. To ensure that the transaction is at arm's length, TNMM would compare the operating or net margins of Company A and Company B, which are 10% and 8%, respectively. As the margins are relatively similar, this transaction is considered fair and equitable.
The Resale Price Method
This process determines the price at which a related party will resell products to an unrelated party before adding a markup to get the transfer price. Usually, the price is calculated based on the profit margins of competitors in the same sector.
For instance, Company A sells a product to its related party, Company B, for $100. Company B then resells the same product to an unrelated party for $150. Using the resale price method, the transfer price would be determined based on the resale price of $150, rather than the original sale price of $100.
In the UAE, businesses must decide which transfer pricing methodology is best for their cross-border transactions. The chosen approach must adhere to the arm's length principle and be substantiated by proper documentation.
Applicability of Transfer Pricing under the UAE Corporate Tax Regime
Due to their ability to allocate profits among subsidiaries and affiliates, businesses use transfer pricing to lower the total tax burden on the parent company. However, to prevent potential price bias and unfair practices, legislation has established guidelines for international transactions. These guidelines ensure a fair and unbiased price for goods and services exchanged between parties with close relationships.
The UAE Transfer Pricing Rules apply to transactions involving:
- Two or more Natural Persons who are connected through adoption, kinship, or guardianship.
- A natural person and a legal entity where the natural person directly or indirectly owns at least 50% of the legal entity.
- Two or more legal entities where one of the legal entities directly or indirectly owns at least 50% of the other legal entity.
- Anyone who directly or indirectly owns or is in charge of, two or more juridical persons
- A founder, beneficiary, or administrator of a trust or foundation and its related parties.
- Is the proprietor of the Taxable Person
- Is the Director or Official of the Taxpaying Individual
- Is a Related Party to any of the aforementioned Connected Persons
Transfer pricing has a growing impact in the UAE as tax authorities are cracking down on this practice globally. As tax authorities scrutinize transfer pricing activities all over the world, CDA experts can help you create tax-efficient agreements that optimize compliance with laws and regulations while satisfying all of your transfer pricing requirements.
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