What is Transfer Pricing, and How it Will Affect the Businesses

Transfer price refers to the prices of goods and services charged on transactions between the related parties and with the connected persons. like A Ltd and B Ltd are owned by Mr. X, and the price charged by A Ltd to B Ltd, or vice versa on the sales of goods and services between them refers to the transfer price.

The key risk associated with the transactions between related parties and with the connected persons is that the owner or the person in control can influence the prices of goods and services for the transactions between them, which will reduce the taxable profits and it will help them to avoid the tax.

In continuation of the above example, if A Ltd is in the United Kingdom (UK) where the corporate tax rate is 19%, and B Ltd is in the United Arab Emirates (UAE) where the announced corporate rate is 9%. If we are further assuming that B Ltd has given a loan of AED 20,000,000 to A Ltd at higher interest rates of 10% instead of 5% which is the market rate. Mr. X being a common owner, has controlled the transaction, which resulted in the tax savings of AED 100,000, and it has been shown as under:

From the illustration, it is evident that through the controlled transaction, interest expense has been overbooked by Dhs 1 million (Dhs 20m*10% - Dhs 20m*5%) as compared to the fair market rate, which eroded the profit of Dhs 1 million from the high tax UK jurisdiction to the low tax UAE jurisdiction, and it helped them to evade tax of Dhs 100,000. This tax evasion through the controlled transaction has increased the profit of the entities by Dhs 100,000 (Dhs 13,350 - Dhs 13,250), and it has be summarized as [{20m (loan amount)}*{(10% (inflated rate)-5%(market rate)}*{(19% (UK tax rate)-9%(UAE tax rate)}].

The other situation may be where the connected person of the entity is taking benefits or salaries which are not as per the market rates, and due to these non-arm length benefits, the taxable profits of the company can be eroded which will result in tax savings to the entity. Like a B Ltd. is giving extraordinary salaries and benefits to one of its officers.

To control such situations, transfer pricing rules have been proposed in the UAE corporate tax regime to ensure that the price of a transaction is not influenced by the relationship between the parties involved, and to achieve this outcome, the UAE will apply the internationally recognized “arm’s length” principle to transactions and arrangements between related parties and with connected persons.

In the guidelines of the Organization for Economic Co-operation and Development (OECD), the arm-length principle has been defined as “where the conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

In the UAE corporate tax regime, it has been mentioned that all related parties’ transactions and transactions with the connected persons will need to comply with transfer pricing rules and the arm’s length principle as set out in the OECD transfer pricing guidelines. In the OECD guidelines following five methods have been proposed to assess the arm-length price, which will discuss in our next articles.

• Traditional transaction methods, which include: (i) Comparable uncontrolled price method, (ii) Resale price method and (iii) Cost plus method
• Transactional profit methods and it comprises: (i) Transactional net margin method and (ii) Transactional profit split method

If the transactions between the related parties, and with the connected persons are not at arm’s length price, then the Federal Tax Authority (FTA) will assess the arm-length price and will calculate the profits that would have been at the fair market value. In case, it has resulted in tax evasion, the penalties would be applicable accordingly.

The taxable persons would be required to maintain the documentation as per the OCED guidelines, which required the businesses should maintain the master file and local file, and we will discuss this in the detail in our next articles. ?

The businesses are proposed to have a proper benchmarking study and apply the arm-length price accordingly to avoid any future complications.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax. For any queries/clarifications, please write to him at?[email protected].