Accepted Transfer Pricing Methods in the UAE: Guidelines from the Federal Tax Authority

We discuss the main transfer pricing methods accepted by the UAE government under the Corporate Tax Law and aligned with OECD guidance. This article is based on guidance issued by the Federal Tax Authority.

By Melissa Cyrill

There are five internationally recognized Transfer Pricing (TP) methods outlined in the OECD Transfer Pricing Guidelines, which are also incorporated under Article 34(3) of the UAE’s Corporate Tax Law.

The Comparable Uncontrolled Price (CUP) Method, the Resale Price Method (RPM), and the Cost Plus Method (CPM) are considered traditional transaction methods. These are often viewed as the most straightforward way to determine if the conditions in the commercial and financial relationships between related parties align with arm’s length principles. This is because any deviation in the price of a Controlled Transaction from that of a Comparable Uncontrolled Transaction can usually be directly attributed to the underlying commercial and financial relations. Arm’s length conditions can be established by directly substituting the price from the Comparable Uncontrolled Transaction for the Controlled Transaction.

The Transactional Net Margin Method (TNMM) and the Profit Split Method (PSM) are categorized as transactional profit methods. These methods are particularly useful in scenarios where both parties to a Controlled Transaction make unique and valuable contributions or engage in highly integrated activities. They are also applicable when there is limited or no publicly available data on third parties. In such cases, where both parties contribute distinct and valuable functions, a two-sided method like TNMM or PSM may be more appropriate than a one-sided method.

Selecting the appropriate TP method

The selection of the most appropriate Transfer Pricing method involves:

• Assessing the strengths and weaknesses of the five recognized methods.
• Evaluating the suitability of each method based on the nature of the Controlled Transaction, as determined through Functional Analysis.
• Ensuring the availability of reliable information, particularly on uncontrolled comparables, including whether commercial databases or other sources can provide necessary data.
• Considering the degree of comparability between Controlled Transactions and independent transactions, including the need for accurate adjustments to address differences.

The UAE Federal Tax Authority prefers applying Transfer Pricing methods at the transactional level, but methods like TNMM may sometimes be used on an aggregated basis to assess overall profitability.

In some cases, using a single Transfer Pricing method may not fully capture the Arm’s Length Price due to inconclusive results or difficulties in applying adjustments. In such instances, combining methods can provide a more accurate assessment. The goal is to reach a conclusion that reflects the facts, circumstances, and evidence available.

For example, if the Resale Price Method is challenging due to issues with adjustments, the Transactional Net Margin Method might be used alongside RPM. This combination allows for a corroborative analysis to ensure the transaction aligns with the Arm’s Length Principle by comparing net margins under appropriate profit level indicators.

READ: Updates To UAE Transfer Pricing Documentation

Determining the Arm’s Length Price

To determine the Arm’s Length Price, the selected Transfer Pricing method is applied to the tested party and compared with data from Comparable Uncontrolled Transactions.

Choosing the Tested Party:

• Reliability: Select the party where the Transfer Pricing method can be applied most reliably and where the best comparables are available.
• Functional Analysis: The tested party should generally be the one with less complex functions and operations, as this allows for a more straightforward application of the method.

The choice must align with the Functional Analysis of the Controlled Transaction, focusing on the party with simpler operations for reliable results.

Selecting the most appropriate point in the Arm’s Length range

Under Article 34(7) of the Corporate Tax Law, any point within the arm’s length range is acceptable for determining the Arm’s Length Price. When selecting this point, the FTA evaluates:

• Reliability: The credibility of the arm’s length range used.
• Functional Profile: The specific functions, assets, and risks associated with the Taxpayer/Controlled Transaction. For instance:
  • A point closer to the lower interquartile range may suit a company with limited functions, no assets, and minimal risk.
  • A point closer to the upper quartile may be appropriate for a company with high-value functions, significant risk-bearing, and substantial asset usage.

Traditional TP methods

The Comparable Uncontrolled Price (CUP) Method

The CUP method compares the price of property or services in a Controlled Transaction (between related parties) to the price of similar property or services in a Comparable Uncontrolled Transaction (between independent parties). If the prices are similar, it indicates the Controlled Transaction is at arm’s length. Significant price differences suggest that the Controlled Transaction’s price should be adjusted to match the uncontrolled transaction price.

The CUP method is considered the most direct way to apply the Arm’s Length Principle, as it relies on the comparability of available data. Although traditional transaction methods like CUP have no absolute hierarchy, they are preferred when reliable data is available. The CUP method can use either internal or external comparisons: internal CUP involves transactions between a related party and a third party, while external CUP involves transactions solely between independent parties.

For a transaction to be considered comparable, any differences between the Controlled and uncontrolled transactions should not materially affect the market price, or accurate adjustments must be possible to eliminate such effects. Key factors for determining comparability include the type of goods or services, timing, and contractual terms. If adjustments cannot be made accurately, the reliability of the CUP method decreases, and other methods may be considered.

In commodity transactions, the CUP method is commonly used, with quoted prices from recognized sources serving as benchmarks. Comparability in this context considers factors like physical features, quality, contractual terms, and timing. Adjustments may be necessary if differences in these factors affect the price. The timing and date of quoted prices are crucial, and evidence must be provided to show that they align with the Controlled Transaction.

The Resale Price Method (RPM)

The Resale Price Method (RPM) is used to determine the arm’s length price of a product that is purchased from a related party and then resold to an independent party. The resale price is reduced by the gross “Resale Price Margin” and other related costs to establish an arm’s length price for the original transaction between related parties. The Resale Price Margin represents the reseller’s gross profit after covering selling and operating expenses.

RPM is most effective when the reseller adds minimal value to the product. If the reseller significantly contributes to intangible assets, such as trademarks or marketing, RPM becomes less appropriate. This method is often used for distribution and marketing operations where the reseller’s functions are more limited.

In applying RPM, the reseller compares the margins earned in the Controlled Transaction to those in a Comparable Uncontrolled Transaction, which can be either internal (between the same reseller and an independent party) or external (between two independent parties). For a transaction to be comparable, any differences between the Controlled and uncontrolled transactions must not materially affect the Resale Price Margin, or accurate adjustments must be possible.

Fewer adjustments are generally needed in RPM compared to the Comparable Uncontrolled Price (CUP) method, as minor product differences impact profit margins less than prices. However, closer product comparability improves accuracy. The method is more reliable when the resale occurs shortly after the original purchase, as longer time gaps may introduce factors like market changes or exchange rate fluctuations.

Factors such as operational comparability, the nature of functions performed, assets used, and risks assumed should be carefully evaluated when applying RPM. Differences in accounting practices, such as how costs are categorized, must also be adjusted for, as they can impact the calculated profit margins.

The Cost Plus Method (CPM)

The Cost Plus Method (CPM) calculates the arm’s length price of a Controlled Transaction by adding an appropriate mark-up to the direct and indirect costs incurred by a supplier. This mark-up reflects the functions performed by the supplier and the profit that would be earned in a comparable uncontrolled transaction under similar market conditions. CPM is particularly useful for transactions involving semi-finished goods, joint facility agreements, long-term buy-and-supply arrangements, and services.

CPM can use internal or external comparisons:

• Internal Comparable: Compares the cost-plus mark-up in the Controlled Transaction to a similar transaction between the same supplier and an independent party.
• External Comparable: Compares it to a transaction between two independent parties.

For an uncontrolled transaction to be considered comparable, any differences between the transactions should not materially affect the cost-plus mark-up, or adjustments should be made to eliminate those effects.

When applying CPM, product comparability is less stringent than in the Comparable Uncontrolled Price (CUP) method, but the comparability of functions performed, assets used, and risks assumed remains important. Additionally, both the cost-plus mark-up and the cost base must be comparable between Controlled and uncontrolled transactions, with adjustments made if necessary.

Direct and indirect costs of producing goods or services are used to compute the cost base, which should align with the supplier’s Functional Analysis. Consistent accounting practices are essential for accurate comparison, and adjustments may be needed to address any differences in accounting methods between the Controlled and Comparable Uncontrolled Transactions.

The Transactional Net Margin Method (TNMM)

The Transactional Net Margin Method (TNMM) assesses the net profit from a Controlled Transaction relative to an appropriate base, such as costs, sales, or assets. This method is similar to the Cost Plus Method (CPM) and Resale Price Method (RPM) and is applied similarly.

When using the TNMM, the net profit margin from the Controlled Transaction is compared to that from internal or external Comparable Uncontrolled Transactions:

• Internal Comparable: Compares the net profit margin in the Controlled Transaction to a similar transaction between the same entity and an independent party.
• External Comparable: Compares it to a transaction between two independent parties.

Key Points:

• Comparability: A comparability analysis is essential to ensure reliable application. Net profit indicators, though less affected by product differences than gross margins, can be influenced by various factors like operating expenses, management efficiency, and market conditions. Adjustments may be needed to address these differences.
• Profit Level Indicators: TNMM uses net profit indicators (e.g., operating margin, return on sales, return on assets) to express profitability relative to a base like sales, costs, or assets. These indicators are generally more tolerant of functional differences than gross margins.
• Application: TNMM is ideally applied on a transactional basis rather than a company-wide basis, especially when the entity is involved in diverse transactions or business segments. A company-wide approach may be used to corroborate results from transactional analyses but is not typically sufficient for comprehensive Transfer Pricing analysis.

The Profit Split Method (PSM)

The Profit Split Method (PSM) aims to divide profits from Controlled Transactions between Related Parties based on what independent parties would have anticipated in similar transactions. It first identifies the combined profits and then splits them on an economically valid basis, reflecting the contributions of each party.

Key Applications of PSM:

1. Highly Integrated Operations: Where parties are so interlinked that their functions, assets, and risks cannot be evaluated separately.
2. Unique and Valuable Contributions: Where each party contributes unique intangibles or resources that are not comparable to those made by independent parties.
3. Shared Risks: Where parties share economically significant risks related to the transaction.

Steps in PSM:

1. Determine Combined Profits: Calculate the total operating profit before interest and taxes from the Controlled Transaction.
2. Split Profits: Allocate the profit based on the relative value of each party’s contributions, considering their functions, assets, and risks.

Methods for Splitting Profits:

1. Contribution Analysis: Profits are divided based on the value of each party’s contributions.
2. Residual Analysis: Profits are split in two steps:
   • Step 1: Allocate an arm’s length return for routine functions.
   • Step 2: Split the residual profit based on non-routine contributions.

Considerations in PSM:

• Comparability: While direct comparables may inform profit division, other approaches (like internal data or market data) can be used to achieve a reliable arm’s length result.
• Profit Measure: The measure of profits to be split (e.g., operating profit or gross profit) depends on the risks shared by the parties.
• Actual vs. Anticipated Profits: Actual profits are split when parties share the same significant risks, while anticipated profits are split when risk-sharing is limited.

PSM is used when one-sided methods are inappropriate or when parties’ contributions and risks are complex and interdependent.

The division of profits under the PSM is determined using one or more profit-splitting factors. This process relies on a Functional Analysis and a contextual analysis of the industry and business environment to identify the key contributions to value in the transaction. The selected profit-splitting factors should accurately reflect these contributions, and their weighting must be carefully considered, especially when multiple factors are used.

The basis for profit-splitting, whether for actual or anticipated profits, should be determined based on the information available at the time the Related Parties entered into the transaction. However, accessing reliable public data on profit splits among independent parties is often challenging. Additionally, measuring the relevant financial data, such as costs or assets, can be difficult, and the choice of splitting factors often involves subjective judgment.

Use of other TP methods

Article 34(4) of the UAE Corporate Tax Law allows the use of alternative Transfer Pricing methods to calculate the Arm’s Length Price when the five recognized methods cannot be reasonably or reliably applied, provided these alternatives satisfy the Arm’s Length Principle. When using an alternative method, sufficient supporting documentation is required to justify the choice, including economic and commercial rationale and detailed empirical analysis.

For example, in a real estate development project under a term lease from a Related Party, if none of the five recognized methods are applicable, a Discounted Cash Flow (DCF) approach might be used to determine the arm’s length nature of lease payments. If the DCF method is deemed appropriate, the Person must keep detailed documentation to support this decision, including the rationale, relevant variables, and quantitative analysis, as required by Article 55(4) of the UAE Corporate Tax Law.

• Previous Article Egypt’s Fiscal Performance in the 2023-24 Financial Year
• Next Article Abu Dhabi’s Office Space: Addressing the Demand for Grade A Assets