Transfer Pricing Compliance in UAE Free Zones

Transfer pricing compliance in the UAE Free Zones ensures transactions between related entities reflect fair market value, aligning with international tax standards and the UAE’s Economic Substance Regulations.

By Giulia Interesse

The UAE Free Zones regime has long been a cornerstone of the nation’s strategy to attract foreign investment and stimulate economic growth. These Free Zones offer businesses various benefits, including tax exemptions, 100 percent foreign ownership, and simplified customs procedures. However, with the increasing complexity of international tax regulations, ensuring compliance with transfer pricing rules has become a critical aspect for companies operating within these zones.

Transfer pricing compliance involves setting and documenting prices for transactions between related entities in a manner consistent with the arm’s length principle, which dictates that such transactions should reflect the pricing that would occur between independent entities. This principle is central to preventing profit shifting and ensuring that taxable income is appropriately allocated across different jurisdictions.

The UAE Federal Tax Authority’s (FTA) webinar on Corporate Tax and Business Taxation for Free Zones held on June 27 and the recently released Corporate Tax Guide (CTGFZP1, May 2024) provides key insights on and illustrative examples of how transfer pricing concepts apply to the UAE Free Zones regime. The importance of linking reporting obligations under the UAE Economic Substance Regulations (ESR) with transfer pricing compliance has also been highlighted in this technical guidance.

Transfer pricing in the UAE: Definition and scope

In the UAE like other tax jurisdictions, transfer pricing rules govern how transactions between related parties or connected persons should be priced. It ensures that these transactions reflect fair market values, preventing artificial profit shifting and enabling an equitable distribution of taxable profits across jurisdictions. This principle is integral to maintaining transparency and fairness in business operations, aligning with international tax standards.

Transfer pricing rules in the UAE are broad-reaching, applying to all taxpayers engaged in transactions with related parties or connected persons. This includes entities operating within the Free Zones, despite the preferential tax treatments they may receive. Compliance with transfer pricing regulations is mandatory for these entities to uphold the arm’s length principle.

Core transfer pricing concepts relevant to the UAE Free Zones

Arm’s length principle

Central to transfer pricing is the arm’s length principle, which mandates that transactions between related parties or connected persons must mirror those that would occur between independent entities under similar circumstances. This principle is crucial in ensuring that prices and terms in such transactions are fair and impartial, reflecting what would be agreed upon in a competitive market.

By adhering to the arm’s length principle, businesses can prevent the manipulation of prices to shift profits across different jurisdictions for tax benefits.

Functional intensity

Functional intensity refers to the degree and extent to which a business entity performs key operational functions, assumes risks, and utilizes assets in the value creation process. It is a critical concept in transfer pricing used to assess the economic substance of an entity’s activities.

Documenting functional intensity through a Functional Analysis Report helps accurately allocate profits based on the actual economic contributions of each entity within a multinational enterprise (MNE). This documentation ensures that profits are assigned where the substantive business activities occur, following the substance over form approach.

Comparability analysis

Comparability analysis involves evaluating the degree of similarity between controlled transactions (those between related parties) and uncontrolled transactions (those between independent entities) to ensure compliance with the arm’s length principle.

This analysis is typically conducted through benchmarking, which measures profitability, expenses, and other relevant financial metrics against functionally comparable and independent companies. By providing a market reference, comparability analysis helps quantitatively assess the economic substance of transactions and supports the determination of fair transfer prices.

Significant people functions

Significant people functions (SPFs) encompass the activities and decisions made by individuals that meaningfully impact a business’s operations, strategic direction, and financial outcomes. Identifying and analyzing SPFs is essential for determining where and how value is generated within an MNE.

Key components of SPFs include:

• Strategic decision-making;
• Operational control;
• Financial management;
• Intellectual property management; and
• Human resources processes.

Identification of related parties and connected persons

Related parties

In transfer pricing, “related parties” refer to entities and individuals with close associations, such as familial connections, ownership interests, control, and partnerships. These relationships are crucial to identify as they significantly impact pricing and specific tax deductions. For instance, companies within the same group, those with common shareholders, or entities controlled by the same individuals are considered related parties.

In the table below, we provide a visual representation of related parties:

Recognizing these associations is essential for businesses to ensure compliance with transfer pricing regulations, as transactions between related parties must adhere to the arm’s length principle. This ensures that prices reflect what would be agreed upon in a competitive market, preventing profit shifting and tax avoidance.

Connected persons

Under the UAE’s Corporate Tax Law, “connected persons” include owners, shareholders, directors, and their relatives. These individuals have a direct impact on business operations and financial decisions.

In the table below, we provide a visual representation of connected persons:

When it comes to payments or benefits provided to connected persons, these are deductible for corporate tax purposes only if they align with the arm’s length price, representing a fair and impartial value for the services rendered. This requirement ensures that businesses do not inflate payments to connected persons to reduce taxable profits.

However, an exception exists for payments made to connected persons of publicly listed or regulated companies, which are not subject to these restrictions.

Scope of transfer pricing rules in the UAE Free Zones

To be considered as a Qualifying Free Zone Person, according to Article 18 of the UAE Corporate Tax Law, the following criteria need to be met:

• Maintaining adequate substance in the Free Zone;
• Deriving qualifying income;
• Not having elected to be subject of Corporate Tax Rate of 9 percent; and
• Complying with the arm’s length principle and transfer pricing documentation.

Additional conditions may also include:

• De-minimis requirements: Non-qualifying revenues do not exceed the de-minimis requirements rates lower of 5 percent of total revenue, or AED 5 million (US$1.36 million).
• Audited Financial Statements: Preparing audited financial statements.

If a Qualifying Free Zone Person fails to meet any of these conditions, it will cease to qualify as such from the beginning of the relevant tax period and for the subsequent four tax periods.

Transfer pricing rules in the UAE Free Zones apply to a broad range of transactions involving related parties and connected persons, known as “controlled transactions.” According to Article 2 of Ministerial Decision 139 of 2023, qualifying activities include:

• Manufacturing and/or processing of goods or materials;
• Logistics services;
• Ownership, management and operation of ships;
• Distribution of goods or materials in or from a Designated Zone to a customer that resells such goods or materials, or pars thereof or processes or alters such goods or materials or parts thereof for the purpose of sale or resell (not to the end customer);
• Reinsurance services, fund management services and wealth and investment management services that are subject to regulatory oversight;
• Holding of shares and other securities;
• Headquarter services to related parties;
• Treasury and financing services to related parties;
• Financing and leasing of aircraft including engines and components; and
• Any other activities that are ancillary to these.

Application of the arm’s length price

For transactions involving related parties or connected persons, businesses must apply the arm’s length price. This involves a three-step process:

1. Identifying and analyzing: This involves identifying related parties, connected persons, and relevant transactions. Conducting a comparability analysis to assess the fairness of the prices and terms.
2. Choosing the right method: Refers to selecting the most suitable transfer pricing method that aligns with how independent businesses would price similar transactions under normal market conditions.
3. Determining the fair price: That is, calculating the arm’s length price, which represents the price that unrelated parties would agree upon in a comparable situation.

Transfer pricing documentation and reporting obligations in the UAE Free Zones

Entities in the UAE Free Zones meeting either of the following criteria are required to prepare transfer pricing documentation:

• Where the taxable person’s revenue in the relevant tax period is AED 200 million (US$54.4 million) or more; or
• Where the taxable person, for any time during the relevant tax period, is a constituent company of an MNE group.

Required transfer pricing documentation includes:

1. Transfer Pricing Disclosure Form: This form enables reporting on controlled transactions, the related parties involved, and the transfer pricing methods used to determine the arm’s length price. It is filed alongside the tax return. It should be submitted within 9 months from the end of the relevant tax period (together with the tax return).
2. Master File: A comprehensive document ranging from 75 to 150 pages, the Master File provides an overview of the group’s structure, income allocation, intangible assets, financial activities, and tax positions. This document is prepared globally but must be maintained by the local entity and submitted upon request within 30 days.
3. Local File: A detailed document, usually between 50 and 100 pages, the Local File includes information about transactions with related parties, the transfer pricing methods applied, and a comparability analysis. It is prepared and maintained locally and must be filed upon request within 30 days.
4. Country-by-Country Report: In the case of a MNE group, this report, often in table format, provides jurisdictional quantitative data and it is prepared globally and submitted annually.

Impact on Free Zone companies

For UAE Free Zone companies, compliance with transfer pricing rules is particularly critical. These businesses must ensure that all transactions involving related parties and connected persons adhere to the arm’s length principle to maintain their tax benefits and status.

Consequences of non-compliance

Non-compliance with transfer pricing regulations can have severe consequences for Free Zone companies, including the potential loss of their Qualifying Free Zone company status.

This status is crucial for maintaining favorable tax conditions and losing it could result in significant financial and operational repercussions. Therefore, it is imperative for Free Zone companies to meticulously document and report their transactions in accordance with transfer pricing rules to avoid these risks.

Additionally, given the UAE’s growing integration into the global economy, compliance with transfer pricing rules is not merely a legal obligation but also a strategic imperative for businesses. By understanding and implementing these regulations effectively, businesses can navigate international tax complexities with confidence, optimizing their tax positions while meeting regulatory requirements.

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