Related Parties

Transfer Pricing rules apply to Related Parties, which are defined under Article 35 of the Corporate Tax Law as any associated Persons, according to a specified degree of association. This association means pre-existing relationship with another Person through kinship (in case of natural persons), ownership or Control, regardless of whether that other Person is resident or not in the UAE.

The criteria for determining association between Related Parties have been categorised and detailed below:

Kinship or affiliation

The definition of kinship or affiliation covers the relationship of two or more individuals who are related up to the fourth degree of kinship or affiliation, including by way of adoption of guardianship.

In the context of the UAE ^[8], kinship includes common blood ties as determined by the ancestors or common ancestors of the individual, where an ancestor or common ancestor may include guardians or adoptive parents, and affiliation covers relationship by marriage, or if one natural person’s spouse is related by kinship to the other Natural Person.

Degrees of kinship or affiliation include:

• The first-degree of kinship and affiliation: a Natural Person’s parents and children, as well as the parents and children of their spouse.

• The second-degree of kinship and affiliation: additionally, includes a Natural Person’s grandparents, grandchildren, and siblings, as well as the grandparents, grandchildren, and siblings of their spouse.

• The third-degree of kinship and affiliation: additionally, includes a Natural Person’s great-grandparents, great-grandchildren, uncles, aunts, nieces and nephews, as well as the great-grandparents, great grandchildren, uncles, aunts, nieces and nephews of their spouse.

• The fourth-degree of kinship and affiliation: additionally, includes a Natural Person’s great-great-grandparents, great-great-grandchildren, grand uncle, grand aunt, grandniece, grandnephew and first cousins, as well as the great-great- grandparents, great-great-grandchildren, grand uncle, grand aunt, grandniece, grandnephew and first cousins of their spouse.

Ownership

A Natural Person and a juridical person are Related Parties by way of ownership where the individual, or one or more Related Parties of the individual, are shareholders in the juridical person, and the individual, alone or together with its Related Parties, directly or indirectly owns a 50% or greater ownership interest in the juridical person.

Two or more juridical persons are Related Parties by way of ownership if:

• A juridical person, alone or together with its Related Parties, directly or indirectly owns a 50% or greater ownership interest in the other juridical person; or

• Any Person, alone or together with its Related Parties, directly or indirectly owns a 50% or greater ownership interest in such two or more juridical persons.

• As per Article 35(1)(b)(1) of the Corporate Tax Law, the Natural Person or one or more Related Parties of the Natural Person are shareholders in the juridical person, and the Natural Person, alone or together with its Related Parties, directly or indirectly owns a 50% (fifty percent) or greater ownership interest in the juridical person. Likewise, as per Article 35(1)(c)(1); one juridical person, alone or together with its Related Parties, directly or indirectly owns a 50% (fifty percent) or greater ownership interest in the other juridical person.

Control

Persons may also be considered as Related Parties through direct or indirect ‘Control’. Control is the direction and influence over one Person by another Person and can be determined in several ways including but not limited to instances where: ^[9]

• A Person can exercise 50% or more of the voting rights of another Person;

• A Person can determine the composition of 50% or more of the board of directors of another Person;

• A Person can receive 50% or more of the profits of another Person; or

• A Person can determine, or exercise significant influence over, the conduct of the Business and affairs of another Person.

Most of these determinants, in particular the 50% threshold, are indicators of common parent-subsidiary relationships. However, the ability of a Person to exercise ‘significant influence’ over another Person consists of the exercise of influence and direction on the conduct of a Business and may require consideration of different factors and circumstances that are specific to the scenario being tested.

The following examples illustrate how a Person can have Control by exercising significant influence over the actions of another Person, however, the underlying facts and circumstances need to be considered on a case-by-case basis when determining the existence of Control.

Related Parties – additional criteria

“Related party” also means any of the following ties:

• A Person and its Permanent Establishment (“PE”) or Foreign PE, ^[10] meaning that Transfer Pricing rules apply to transactions between a Person and their PE or Foreign PE;

• Two or more Persons that are partners in the same Unincorporated Partnership; and

• A Person who is the trustee, founder, settlor or beneficiary of a trust or foundation and the trust or foundation, including the trust’s or foundation’s Related Parties.

Connected Persons

Where a Person is considered to be a Connected Person of a Taxable Person, all payments or benefits provided by the Taxable Person to the Connected Person are deductible for Corporate Tax purposes only to the extent that they correspond to the Arm’s Length Price of the service or benefit provided and they are incurred wholly and exclusively for the purposes of the Taxable Person’s Business.

A Person is considered a Connected Person of a Taxable Person if that Person is: ^[11]

• An individual, who directly or indirectly owns an ownership interest in the Taxable Person or Controls such Taxable Person, or a Related Party of such individual;

• A director or officer of the Taxable Person, or a Related Party of the said director or officer; or

• A partner in an Unincorporated Partnership, and any Related Parties of such partner.

Article 36(6) of the Corporate Tax Law specifies the categories of Taxable Persons where the deduction of payments or benefits provided to their Connected Persons is not restricted to the Arm’s Length Price. These Taxable Persons would include any of the following:

• A Taxable Person whose shares are traded on a recognised stock exchange;

• A Taxable Person that is subject to the regulatory oversight of a competent authority in the UAE; and

• Any other Person as may be determined in a decision to be issued by the Cabinet.

International agreements for the avoidance of double taxation

The domestic legislative basis for Transfer Pricing in the UAE can be found under Articles 34 to 36 of the Corporate Tax Law. In addition, the UAE also has a well- established double taxation agreement network.

Under the terms of certain agreements entered by the UAE for the avoidance of double taxation, reference is made to “Associated Enterprises”. The OECD Model Convention defines the term and sets out the conditions that should be observed in transactions that include these “Associated Enterprises”. ^[12]In particular, the OECD Model Convention states that the transactions between those parties are to be conducted in a manner that is similar to those that would occur amongst independent parties in comparable circumstances.

In the event of differences between the UAE Transfer Pricing regulations and an international agreement in force in the UAE, the provisions of the international agreement will prevail.

Contractual terms of the transaction

A transaction or arrangement is the expression of the commercial or financial relations between parties. Independent parties generally formalise transactions through written contracts which reflect the intention of the parties at the time the contract was concluded. Contracts typically include a description of responsibilities of the parties, its obligations and rights, assumption of identified risks, the pricing arrangements as well as terms and conditions associated with the goods or services covered.

When a Controlled Transaction has been formalised by Related Parties or Connected Persons through written contractual agreements, the agreement provides a starting point for delineating the transaction and determining how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract.

In general, the written contracts alone may not provide all the information necessary to perform a Transfer Pricing analysis, or may not provide information regarding the relevant contractual terms in sufficient detail. In addition, the intention of the parties and key features of the intercompany arrangements may also be found outside of written contracts, for example, in emails, meeting notes, and other written correspondences between the parties. In such cases, the economically relevant characteristics in the other four categories listed above (functions performed, characteristics, economic circumstances and business strategies) will provide an important understanding of the actual conduct of the Related Parties or Connected Persons in relation to the Controlled Transaction under review.

In certain cases, no written contract exists or there may be a conflict between the written contract and actual conduct of the Related Parties or Connected Persons. In such cases, the below needs to be taken into consideration to identify the commercial and the financial relations between Related Parties or Connected Persons:

• Where a transaction has been formalised by Related Parties or Connected Persons in a written contract, the starting point of any analysis should begin with the contract.

• Where the conduct of the Related Parties or Connected Persons is not consistent with the terms of the written contractual agreement, further analysis of the actual conduct should be undertaken. Where there are material differences between the contractual terms and the actual conduct, the actual transaction should be determined based on the actual conduct.

• Where no written contractual agreement exists, the actual transaction is determined from the evidence of actual conduct of the Related Parties or Connected Persons provided by identifying the economically relevant characteristics of the transaction, including what functions are actually performed, what assets are actually used, and what risks are actually assumed by each of the Related Parties or Connected Persons. This analysis is further described in Section 5.1.1.2.

In the event taxpayers decide to maintain written inter-company agreements, they may consider adopting a simplified approach of maintaining them based on certain materiality thresholds, criticality of transactions and arrangements, etc. such that the cost and administrative burden do not outweigh the benefits. Contractual terms that are specifically related to risks are further described under step 2 of the six-step risk framework for analysing the risks in a Controlled Transaction (see Section 5.1.1.2 below).

Functional Analysis

In transactions between two independent parties, compensation usually reflects the functions that each enterprise performs, the assets it uses, and the risks it assumes. The same principle needs to be applied to transactions between Related Parties or Connected Persons. As such, a comprehensive Functional Analysis of the Controlled Transaction is required as part of a comparability analysis to delineate the transaction and determine comparability between the Controlled Transaction and uncontrolled transactions.

A Functional Analysis seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the Related Parties or Connected Persons in a Controlled Transaction. The Functional Analysis focuses on the functions performed by the parties and the capabilities they provide to the Controlled Transaction. These functions and capabilities will include operational activities such as procurement, marketing, sales as well as decision- making (for example, business strategy and risks).

The analysis also considers the type of assets, ^[13]as well as the nature of the assets used. ^[14]

Further, the Functional Analysis will also consider the material risks assumed by each Related Party. Usually, in an open market, the assumption of increased risk would also be compensated by an increase in the expected return. Similarly, the actual assumption and allocation of risks between two Related Parties or Connected Persons would likely affect the pricing of the transaction, so the comparable transactions would also need to reflect the increased risk.

Six-step risk framework

There is a six-step process for analysing the risks in a Controlled Transaction, in order to accurately delineate the actual transaction in respect to those risks. This process is summarised as follows:

Before detailing this six-step process, the following terms need to be defined and understood:

• Risk management: This refers to the function of assessing and responding to risk associated with a commercial activity. Risk management comprises three elements:

  1. The capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function,

  2. The capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function, and

  3. The capability to mitigate risk, that is, the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation.

• Financial capacity to assume risk: This can be defined as having the capital or funding to take on the risk or to lay off the risk, to pay for the risk mitigation functions and to bear the consequences of the risk if it materializes. Access to funding by the party assuming the risk takes into account the available assets and the options realistically available to access additional liquidity, if needed, to cover the costs anticipated to arise should the risk materialise.

• Control over risk: This involves the first two elements of risk management, that is (i) the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function, and (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function. Therefore, in order to exercise control over a risk, a party requires both capability and functional performance.

The six-step risk framework is further detailed below.

Step 1: Identify economically significant risks with specificity

There are many definitions of risk, but in the Transfer Pricing context it is appropriate to consider risk as the effect of uncertainty on the objectives of the business. In all of a company’s operations, in every step taken to exploit opportunities, uncertainty exists, and risk is assumed. A company is likely to direct much attention to identifying uncertainties it encounters, in evaluating whether and how business opportunities should be pursued in view of their inherent risks, and in developing appropriate risk mitigation strategies which are important to shareholders seeking their required rate of return. No profit-seeking business takes on risk associated with commercial opportunities without expecting a positive return. The downside impact of risk occurs when the anticipated favourable outcomes fail to materialise. For example, a product may fail to attract as much consumer demand as projected in practice.

Risks can be categorised in various ways, but a relevant framework in a Transfer Pricing analysis is to consider the sources of uncertainty. Examples of these risk categories include strategic, operational, financial, transactional or hazard risks.

It is important to ensure that risks are not vaguely described or undifferentiated in the contract or arrangement as this may lead to difficulties in making appropriate allocations of these risks in a Transfer Pricing analysis.

Step 2: Identify the contractual assumption of risk

The identity of the party or parties assuming risks is generally set out in written contracts between the parties to a transaction. A written contract typically sets out an intended assumption of risk by the parties, but some risks may be explicitly assumed. For example, a distributor might contractually assume accounts receivable risk, inventory risk, and credit risks associated with the distributor’s sales to unrelated customers. Other risks related to that particular type of transaction might be implicitly assumed. For example, in the case of a contract that guarantees a certain level of remuneration to one of the parties would also implicitly pass on the outcome of some risks to that other party, such as unanticipated profits or losses.

The assumption of risk has a significant effect on determining the Arm’s Length Price between Related Parties or Connected Persons, and it should not be concluded that the pricing arrangements adopted in the contractual arrangements alone determine which party assumes risk. The remaining steps of the risk framework focus on determining how the parties actually manage and control risks, which determines the assumption of risks by the parties, and impacting the selection of the most appropriate Transfer Pricing method to be applied in a particular transaction.

Step 3: Functional Analysis in relation to risk

In this step, the focus is on the functions relating to the risk undertaken by the Related Parties or Connected Persons. The analysis provides information about how the Related Parties or Connected Persons operate with respect to the assumption and management of the specific, economically significant risks, and in particular which parties perform control functions and risk mitigation functions, encounter upside or downside consequences of risk outcomes, and have the financial capacity to assume the risk in the context of the Controlled Transaction.

Step 4: Risk analysis

Carrying out steps 1-3 above involves gathering of information relating to the assumption and management of risks in the Controlled Transaction. The next step is to analyse the information collected and to determine whether the contractual assumption of risk is consistent with the actual conduct of the parties and the other facts of the case by evaluating whether:

1. The Related Parties or Connected Persons follow the contractual terms; and

2. The party assuming risk, as analysed under (i), exercises control over the risk and has the financial capacity to assume the risk.

The significance of step 4 will depend on whether the risk analysis leads to significant findings that have not been identified before. Where a party contractually assuming a risk applies that contractual assumption in its conduct, and also both exercises control over the risk and has the financial capacity to assume the risk, then the next step to consider is step 6 (disregarding step 5 on allocation of risk).

Where differences exist between contractual terms related to risk and the actual conduct of the Related Parties or Connected Persons which are economically significant and would be taken into account by third parties in pricing the transaction, the Related Parties’ or Connected Persons’ actual conduct should generally be taken as the best evidence concerning the intention of the Related Parties or Connected Persons in relation to the assumption of risk. In such a case, it is necessary to review the allocation of risk (step 5 of this risk framework).

Step 5: Allocation of risk

If it is established that the Related Parties or Connected Persons contractually assuming the risk do not exercise control over it or do not have the financial capacity to assume such risk (under step 4(ii)), then the risk should be allocated to the party exercising control and having the financial capacity to assume it. If multiple Related Parties or Connected Persons are identified as exercising control and having the financial capacity to assume the risk, then the risk should be allocated to the Related Parties or group of Related Parties exercising control over the risk in a predominant manner. When allocating the risk, the other parties performing risk control activities should be remunerated appropriately, considering the importance of the risk control activities performed.

Step 6: Pricing Controlled Transactions considering the consequences of risk allocation

Once the above steps are completed, the Controlled Transaction should then be priced in accordance with the tools and methods set out in the following sections of this Guide and considering the financial and other consequences of risk-assumption, and the remuneration for risk management. In order to be commercially reasonable, the assumption of a risk should be compensated with an appropriate return, and risk mitigation should be appropriately remunerated. Thus, a Person that both assumes and mitigates a risk will be entitled to greater anticipated remuneration than a Person that only assumes or only mitigates a risk but does not carry both.

Overall, when analysing risks, the FTA expects Persons to observe the following:

1. Conduct a thorough Functional Analysis to determine what risks have been assumed, what functions are performed that relate to or affect the assumption or impact of these risks and which party or parties to the transaction assume these risks. This is important even in cases where the effect of the risks assumed are not apparent in the financial statements as this does not necessarily indicate that the risks do not exist, but rather, it could mean that the risks have been effectively managed.

2. The pricing of the actual transaction should take into account the financial and other consequences of risk assumption, as well as the remuneration for risk management. A Person who assumes a risk is entitled to the upside benefits at the same time it incurs the downside costs.

3. To assume a risk for Transfer Pricing purposes, the Person needs to control and have the financial capacity to assume the risk.

Contribution to the value chain

Entities in a Group will generally conduct various activities and collaborate to deliver the relevant product or service to the Group’s customers. Some of the activities are more impactful and contribute greater value to the overall profit or success of the business, whereas other activities may be more routine or supportive in nature. As an example, activities that contribute to the intellectual property of a Group and to its value creation will typically be higher value functions than the back-office support functions. The manner in which value is added at each stage in creating a product or service is known as the value chain.

Different industries and business models will have different value chains and key value drivers. As part of the Functional Analysis, it is, therefore, important to understand the relative value and contributions of each Related Party to the overall value chain of a business and the relevant product or service.

The findings of the Functional Analysis define the roles of each Related Party and assign a functional characterisation, ranging from entrepreneurial to low or no-risk entities based on the functions performed, assets employed, and risks assumed by each party.

Practical guidance for undertaking a Functional Analysis

Understanding the functions performed, assets used, and risks assumed by the parties to the transaction through a Functional Analysis assists in understanding the contribution of these parties to the value chain and, therefore, in arriving at the appropriate compensation for their activities (see Section 5.3 for further details).

As a practical guide when conducting a Functional Analysis, a functional organisation chart could be prepared for each of the parties involved in the Controlled Transaction. This functional organisation chart should identify the relevant departments and personnel within the organisation together with the functions that they perform. For the personnel, stating the title is not sufficient; information is required on the functions performed (for example, via a job description) and the actual conduct of such personnel, and on how the compensation is structured etc.

A Functional Analysis may begin by undertaking an interview with the relevant departments and personnel, and questionnaires are generally used as an indicative guide to the interviews.

Below is an example of a high-level Functional Analysis of a manufacturer whose products are distributed by a Related Party. This example is illustrative and simplified (as compared to a full Functional Analysis) in order to highlight the key areas that are important in undertaking such an analysis.

Characteristics of property or services

Differences in specific characteristics of property or services often account for the differences in their value in the open market. Comparisons of these features may be useful in delineating the transaction and determining the comparability of Controlled and uncontrolled transactions. Nevertheless, the importance given to this comparability factor depends on the Transfer Pricing method used.

In general, similarity in characteristics of the property or services will matter most when comparing prices of Controlled Transactions and uncontrolled transactions using the Comparable Uncontrolled Price (“CUP”) method, which is a traditional transaction Transfer Pricing method and one of the five internationally accepted Transfer Pricing methods (see further in Section 5.2.2) and less when comparing profit margins in other Transfer Pricing methods. This is because profit margins generally correlate more with the functions performed, assets used and risks assumed by the tested party. The tested party is the party chosen in the Controlled transaction to which a Transfer Pricing method is applied in the most reliable manner.

Characteristics of property or services that may be important to consider in a comparability analysis include the following:

• For tangible property, the physical features, quality and reliability, and the availability and volume of supply;

• For provision of services, the nature and extent of the services; and

• For intangible property (for example, patents, trademarks, know how), the type and nature of the intangible property, the duration and degree of protection, and the anticipated benefits from the use of the intangible property.

The fact that the specific characteristics of property or services have a more significant weight when applying some of the Transfer Pricing methods than others does not mean that these characteristics can be ignored when applying methods that measure profit margins, because it may be that product differences entail or reflect different functions performed, assets used and/or risks assumed by the tested party.

Economic circumstances

Arm’s length prices may vary across different markets even for transactions involving the same property or services. Therefore, to achieve comparability, it is required that the markets in which the independent and Related Parties or Connected Persons operate are comparable and that differences do not have a material effect on price or that appropriate adjustments can be made. As a first step, it is essential to identify relevant markets taking into account available substitute goods or services.

Economic circumstances that may be relevant to determining market comparability include geographic location; the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability of substitute goods and services; and the levels of supply and demand in the market as a whole and within regions.

Business strategies

Business strategies outline the actions and decisions a company plans to take to reach its goals and objectives and must be examined when determining comparability for Transfer Pricing purposes. Business strategies take into account many aspects of an enterprise, such as innovation and new product development, degree of diversification, risk aversion, assessment of political changes, input of existing and planned labour laws, duration of arrangements, and other factors bearing upon the daily conduct of business.

Business strategies could also include market penetration schemes. A Person seeking to penetrate a market or increase its market share might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market. Furthermore, a Person seeking to enter a new market or expand its market share might temporarily incur higher costs and, hence, achieve lower profits levels than other Persons operating in the same market.

An additional consideration is whether there is a plausible expectation that following the business strategy will produce a return sufficient to justify its costs within a period of time that would be acceptable in an arm’s length arrangement. It is recognised that a business strategy such as market penetration may fail, and the failure does not in itself allow the strategy to be disregarded for Transfer Pricing purposes. However, if such an expected outcome was implausible at the time of the transaction, or if the business strategy is unsuccessful but nonetheless continues to run beyond what an independent party would expect, the arm’s length nature of the business strategy may be questioned.

Following the guidance provided above, the Transfer Pricing analysis will identify the substance of the commercial or financial relations between the Related Parties or Connected Persons, and will accurately delineate the actual transaction by analysing the economically relevant characteristics or comparability factors.

The Comparable Uncontrolled Price 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 comparable circumstances. Similar pricing between the Controlled Transaction and uncontrolled transaction(s) would indicate that the Controlled Transaction has taken place at arm’s length. On the other hand, if there are material differences in the pricing, this would likely indicate that the price of the Controlled Transaction should be adjusted to align with the price of the uncontrolled transaction between independent parties.

Given that the CUP method involves a comparison of prices charged in Related Party transactions and in comparable third-party transactions, it is typically the most direct way to apply the Arm’s Length Principle where such data is available. However, the method is reliant on the comparability of available data relating to comparable transactions to ensure its effectiveness.

There is no absolute hierarchy in relation to applying traditional transaction methods. However, traditional transaction methods are regarded as the most direct way of establishing whether transactions and arrangement between Related Parties and Connected Persons are in accordance with the arm’s length standard.

While undertaking comparability analysis of the Controlled Transactions, if it is found that the Comparable Uncontrolled Price (“CUP”) method and another Transfer Pricing method can be applied in an equally reliable way, the CUP method should be the preferred Transfer Pricing method for determining the arm’s length result.

Where the CUP method is applied, the Controlled Transaction may be compared to an internal or an external Comparable Uncontrolled Transaction, depending on the circumstances:

• Internal CUP: where the Arm’s Length Price of a Controlled Transaction is determined by the price of a similar transaction between one of the Related Parties or Connected Persons and a third party(ies).

• External CUP: where the Arm’s Length Price of a Controlled Transaction is determined by the price of a similar transaction between two or more third parties.

An uncontrolled transaction is considered comparable to a Controlled Transaction where one of the following conditions is met:

• None of the differences that may exist between the Controlled Transaction and uncontrolled transaction or the parties undertaking those transactions could materially affect the market price of the transaction in the open market; or

• Where such differences exist, reasonably accurate adjustments can be made to eliminate any material effects on the price of the transaction resulting from such differences.

In this sense, a number of factors should be considered when determining the comparability of Controlled and uncontrolled transactions, which may include, but is not limited to:

• The type of good or service being transacted;

• The timing of the transaction; and

• The contractual terms of the transaction.

As indicated in the earlier example material differences between the Controlled Transactions and the Comparable Uncontrolled Transactions may be addressed through adjustments. However, if a reasonably accurate adjustment cannot be made, the reliability of the CUP method would be reduced, and it might be necessary to select another method instead.

Depending on the facts and circumstances of the Controlled and uncontrolled transactions, certain differences such as geographical market, existence or utilisation of valuable intangibles, functional differences, and significant contractual differences may make it impossible to reliably make sufficient comparability adjustments. In these cases, it would also be appropriate to consider another direct method to price transactions or perform a corroborative analysis based on a distinct transactional method.

Application of the CUP method for commodity transactions

The CUP method is typically the most widely used Transfer Pricing method for establishing the Arm’s Length Price for the transfer of commodities between Related Parties or Connected Persons.

The reference to commodities encompasses physical products for which a quoted price is used as a reference by independent parties in the industry to set prices in uncontrolled transactions. The term ‘quoted price’ refers to the price of the commodity in the relevant period obtained in an international or domestic commodity exchange market. In this context, a quoted price also includes prices obtained from recognised and transparent price reporting or statistical agencies or from governmental price setting agencies. Such indexes are used as a reference by unrelated parties to determine prices in transactions between them.

In applying the CUP method for commodities, the economically relevant characteristics for comparison include, among others, the physical features and quality of the commodity, the contractual terms of the Controlled Transaction, such as volumes traded, period of the arrangements, the timing and terms of delivery, transportation, insurance, and foreign currency terms. For some commodities, certain economically relevant characteristics (for example, prompt delivery) may lead to a premium or a discount in the price applied. Where there are differences between the conditions of the Controlled Transaction and the conditions of the uncontrolled transactions or the conditions determining the quoted price for the commodity that materially affect the price of the commodity transactions being examined, reasonably accurate adjustments should be made for comparability purposes.

Where the quoted price for the commodity is relied upon in determining the Arm’s Length Price of a controlled commodity transaction, it is critical to examine the extent to which these quoted prices are commonly used in the ordinary course of business in the industry to agree prices for Uncontrolled Comparable Transactions. Other comparability factors and economically relevant characteristics which may impact the price (including physical features, quality, quantity, timing, shipping terms etc.) should also be considered.

In addition, the market prices agreed to in uncontrolled commodity transactions are typically inextricably linked to the specific time or date of the underlying transactions. Therefore, the specific time and date of the quoted price linked to the transaction is a key factor when analysing the price for commodities in Related Party transactions including when applying the CUP method to price a controlled commodity transaction. The Person should provide reliable evidence that the date and time of the quoted prices relied upon for benchmarking purposes are comparable to the date and time of the Controlled Transaction. Such evidence may include proposals and acceptances,

contracts, data downloads from commodity exchanges or other documents setting out the terms of the arrangements.

The Resale Price Method

The RPM is based on the price at which a product, that has been purchased from a Related Party, is resold to an independent party. The resale price would be reduced by the gross “Resale Price Margin”, as well as any other costs associated with the transaction, to provide an Arm’s Length Price for the original transaction between the Related Parties or Connected Persons. The “Resale Price Margin” represents the amount out of which a reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), to make an appropriate profit.

Typically, the RPM is applied to the reseller involved in the Controlled Transaction to compare the margins of the reseller in the Controlled Transaction to the margins earned in a comparable uncontrolled transaction, where the reseller adds relatively little value to the property being transacted. The more value the reseller adds to the property, the less appropriate it would be to apply the RPM to determine the Arm’s Length Price of the transaction. This is especially so where the reseller contributes significantly to creating or maintaining intangible properties, such as trademarks or trade names or other marketing intangibles, in its activities. Thus, when applying the RPM, the tested party would ideally not own valuable intangible property.

Given the above, the RPM is often the most appropriate method where it is applied to distribution and marketing operations.

In applying the RPM, the reseller should select a Comparable Uncontrolled Transaction in which the Resale Price Margin earned by the independent reseller(s) can be reliably identified. The identified margins could serve as a benchmark to determine an arm’s length Resale Price Margin in that Controlled Transaction.

Where the RPM is applied as a one-sided method, the Controlled Transaction may be compared to an internal or an external Comparable Uncontrolled Transaction depending on the circumstances:

• Internal comparable: where the arm’s length Resale Price Margin of the reseller in the Controlled Transaction is determined by the Resale Price Margin of a similar transaction between the same reseller and an independent party.

• External comparable: where the arm’s length Resale Price Margin of a Controlled Transaction is determined by the Resale Price Margin of a similar transaction between two independent parties.

An uncontrolled transaction is comparable to a Controlled Transaction (i.e. it is a Comparable Uncontrolled Transaction) for the purposes of the RPM if one of the two following conditions is met:

• None of the differences that may exist between the controlled and uncontrolled transaction or the parties undertaking those transactions could materially affect the Resale Price Margin in the open market; or

• Where such differences are observed, reasonably accurate adjustments may be made to eliminate any material effects resulting from such differences.

In making comparisons for the purposes of the RPM, generally fewer adjustments are needed to account for differences than under the CUP method, because minor product differences are less likely to have as material an effect on profit margins as they do on price. While less product comparability may be required in using the RPM, it remains the case that closer comparability of products will produce better results.

A Resale Price Margin is more accurate where it is realised within a short time of the reseller’s purchase of the goods. The more time that elapses between the original purchase and the resale, the more likely it is that other factors - changes in market, in rates of exchange, in costs etc - will need to be taken into account in any comparison.

Where the reseller is clearly carrying on a substantial commercial activity in addition to the resale activity itself, then a reasonably substantial Resale Price Margin might be expected. The Resale Price Margin should also be expected to vary according to whether the reseller has the exclusive right to resell the goods. Exclusive rights arrangements are found in transactions between independent parties in practice and tend to influence the margin.

Further, when applying the RPM, the following should be considered:

Operational comparability

When the Resale Price Margin used is that of an independent party in a comparable transaction, the reliability of the RPM may be affected if there are material differences in the ways the Related Parties or Connected Persons and independent parties carry out their business. Such differences could include those that affect the level of costs taken into account (for example, the differences could include the effect of management efficiency on levels and ranges of inventory maintenance), which may well have an impact on the profitability of an enterprise but may not have an impact on the price it buys and sells its goods and services for on the open market. Thus, material operational differences in the way the business is carried out should be analysed in determining whether an uncontrolled transaction is comparable for the purposes of applying the RPM.

Comparability of functions performed, assets used and risks assumed

The nature of the functions performed, assets used, and risks assumed in any transaction can substantially affect the amount of gross margin earned in that transaction. Accordingly, for the purposes of using the RPM, it is recommended to evaluate the comparability of these factors in both the Controlled Transaction and the selected Comparable Uncontrolled Transaction. If any material differences are noted, necessary adjustments should be made to account for such differences.

The impact of accounting practices

Measurement and recognition of the items that impact the way the Resale Price Margin is calculated may differ from one enterprise to another due to varying accounting practices. For example, while an item of cost may be accounted for as an operating expense in the Controlled Transaction, the same item of cost may be accounted for as cost of sales in the uncontrolled transaction. Where such differences exist, using the Resale Price Margin without making the appropriate adjustments is likely to result in miscalculated profit margins. Necessary adjustments should be made to eliminate the effect of any material accounting practice differences.

The Cost Plus Method

The CPM considers the direct and indirect costs incurred by a supplier in supplying goods or services in a Controlled Transaction and applies an appropriate mark-up to these costs based on the functions performed by the supplier and the profit that would have been earned from an arm’s length transaction depending on the market conditions. What is arrived at after adding the cost-plus mark-up to the direct and indirect costs of the supplier is then considered the Arm’s Length Price of the original transaction.

The CPM is most useful where semi-finished goods are sold between Related Parties or Connected Persons, where Related Parties or Connected Persons have concluded joint facility agreements or long-term buy-and-supply arrangements, as well as where the Controlled Transaction is the provision of services.

Where the CPM is applied, the Controlled Transaction may be compared to an internal or an external Comparable Uncontrolled Transaction depending on the circumstances:

• Internal comparable: where the cost-plus mark-up of the supplier in the Controlled Transaction is determined by reference to the cost-plus mark-up that the same supplier earns in a similar transaction with an independent party; or

• External comparable: where the cost-plus mark-up of the supplier in the Controlled Transaction is determined by reference to the cost-plus mark-up that would have been earned in comparable transactions between two independent parties.

An uncontrolled transaction can be considered comparable to the Controlled Transaction for the purposes of applying the CPM if one of the following two conditions is met:

• None of the differences that may exist between the Controlled and uncontrolled transaction or the parties undertaking those transactions could materially affect the cost-plus mark-up in the open market; or

• Where such differences are observed, accurate adjustments to eliminate any material effects resulting from such differences were reasonably performed.

When applying the CPM, the following aspects should be considered:

Product comparability

As with the RPM, fewer adjustments may be necessary to account for product/service differences under the CPM than under the CUP method.

Comparability of functions performed, assets used and risks assumed

Similar to the RPM, for the purposes of the CPM, all comparability factors should be considered to the extent relevant. When there are differences that materially affect the cost-plus mark-ups earned in the controlled and uncontrolled transactions, reasonably accurate adjustments should be made to account for such differences.

Comparability of cost base

Applying the CPM requires the comparability of both the cost-plus mark-up and cost base in the Controlled Transactions and uncontrolled transactions. If the Controlled and uncontrolled transactions are not comparable in all aspects (including the cost base) and the differences have a material effect on the price or margin, adjustments should be made to eliminate the effects of those differences. Where the independent party adopts a definition of cost base or a method to compute cost that is different from that of the Related Party, the cost base of the independent party should be adjusted accordingly to ensure comparability.

In applying the CPM, direct and indirect costs of producing a good or providing a service are normally used to compute the cost base. Such costs are limited to the costs of the supplier of goods or services and should take into account the supplier’s Functional Analysis.

The impact of accounting practices

As applicable for the RPM, a Related Party using the CPM should ensure that the accounting practices followed in both the Controlled Transaction and the selected Comparable Uncontrolled Transaction are consistent. If this is not the case, appropriate adjustments for accounting practice differences in both the Controlled Transaction and the selected Comparable Uncontrolled Transaction may be required.

The Transactional Net Margin Method

The TNMM examines the net profit earned from a Controlled Transaction relative to an appropriate base, such as the costs, sales or assets. In this way, the TNMM operates similarly to the CPM and RPM and should be applied in a similar manner.

In applying the TNMM, the net profit margin earned in the Controlled Transaction should be established by reference to the net profit margin earned in internal or external Comparable Uncontrolled Transactions depending on the circumstances:

• Internal comparable: where the net profit margin in the Controlled Transaction is determined by the net profit margin of a similar transaction between one of the Related Parties or Connected Persons and a third party.

• External comparable: where the net profit margin of a Controlled Transaction is determined by the net profit margin of a similar transaction between two third parties.

Additional guidance on the application of the TNMM is provided below.

The comparability standard applied to the TNMM

A comparability analysis must be performed in all cases in order to select and apply the most appropriate Transfer Pricing method, including the TNMM.

Net profit indicators are the ratio of net profit to an appropriate base (for example costs, sales, assets) and are less adversely affected by differences in products and functions compared to price and gross margins. However, there are various other factors that can significantly influence net profit indicators because of the potential for variation of operating expenses across enterprises. These factors include treatment across enterprises of operating expenses and non-operating expenses, capacity utilisation, threat of new entrants, competitive position, management efficiency and individual strategies, threat of substitute products, varying cost structures (as reflected, for example, in the age of plant and equipment), differences in the cost of capital (for example self-financing versus borrowing), and the degree of business experience (for example whether the business is in a start-up phase or is mature).

The above, and other relevant, factors need to be accounted for in order to achieve reliable comparability.

Any differences between Related Parties or Connected Persons and independent parties resulting from the above factors may have material effects on the profitability of transactions and would require reliable and accurate adjustments for the TNMM to produce a reliable measure of arm’s length net margins.

Profit level indicators

The ratio of net profit and the appropriate base used in the TNMM is commonly known as the net profit indicator or profit level indicator.

In order to apply the TNMM, a net profit indicator should be selected to determine the net profitability of the Controlled Transaction. A net profit indicator expresses profitability in relation to an appropriate base such as:

1. Sales,

2. Costs or expenses, or

3. Assets.

Therefore, when applying the TNMM, the net profitability of the Controlled Transaction is compared to the net profitability of the uncontrolled transaction(s), using a net profit indicator.

In addition to being less affected by transactional differences than is the case with CUP method, net profit level indicators may also be more tolerant to some functional differences between the Controlled and uncontrolled transactions than gross profit margins (used in RPM and CPM). Differences in the functions performed between parties are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net profit level indicators. In addition, there may be lack of clarity in the public data with respect to the classification of expenses as gross or operating profits may make it difficult to evaluate the comparability of gross margins, while the use of profit level indicators may avoid the problem.

The following non-exhaustive examples of profit level indicators that may be considered when applying the TNMM are:

As a general rule, the denominator of the net margin indicator should be set on an uncontrolled base and should reflect the relevant driver or measure of value creation as it relates to the functions performed by the tested party, taking into account the risks assumed and assets used. For example, sales may be an appropriate base for distribution activities, full costs or operating expenses may be an appropriate base for a service or manufacturing activity, and operating assets may be an appropriate base for capital-intensive activities such as certain manufacturing activities. Other bases can also be appropriate depending on the circumstances of the case.

The selection of the most appropriate profit level indicator depends on the facts and circumstances of the Controlled Transaction and the following factors should be considered:

1. Strengths and weaknesses of the various possible net profit indicators;

2. The appropriateness of the profit level indicator in view of the nature of the Controlled Transaction as determined through a Functional Analysis;

3. The availability of reliable information needed to apply the TNMM based on that indicator; and

4. The degree of comparability between Controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate differences between them when applying the TNMM based on that indicator.

Aggregation of transactions and company-wide analysis using TNMM

Although it is preferred that the TNMM be applied at a transactional level, it may be possible to apply the TNMM on an aggregate basis when the aggregate activities / transactions are sufficiently interlinked from economical or commercial standpoints, for example, when similar sales functions are conducted for products in similar product lines.

Applying the TNMM on a company-wide basis becomes less reliable when the party being examined is engaged in various different Controlled Transactions or functions or operates different business segments that cannot be appropriately compared on an aggregate basis with those of an independent party. Therefore, Taxable Persons should seek to apply the TNMM on a transactional basis and not on a company-wide basis whereby the method is used to analyse only the profits of the Related Parties or Connected Persons that are attributable to simpler Controlled Transactions, functions or segments that are not interlinked. Depending on the facts of each case, a company- wide analysis may not be sufficient as a basis for a comprehensive Transfer Pricing analysis. However, Taxable Persons may opt to apply the TNMM, or any other method, on a company-wide basis to corroborate the results obtained from the separate analyses performed on a transactional basis.

The Profit Split Method

The Profit Split Method (PSM) seeks to determine the division of profits that independent parties would have expected to realise from engaging in comparable transactions. This method first identifies the combined profits of the Related Parties or Connected Persons from a Controlled Transaction(s) and splits those profits on an economically valid basis. The resulting split should approximate the division of profits that would have been anticipated and reflected in an agreement made at arm’s length between independent parties.

Further guidance on the use and application of the PSM is provided below. However, this Guide does not seek to provide an exhaustive catalogue of ways in which the PSM may be applied. Application of the method will depend on the facts and circumstances of the case and the information available, but the overriding objective should be to approximate as closely as possible the split of profits that would have been realised had the Related Parties or Connected Persons been independent parties.

Application of the PSM

There are two steps in the application of the PSM:

1. The first step is to determine the consolidated total profits earned by the Related Parties or Connected Persons from a Controlled Transaction. The profit to be split is generally the operating profit before interest and taxes.

2. The second step is to split the profit between the Related Parties or Connected Persons on an economically valid basis based on the relative value of their contributions to the Controlled Transaction(s), considering the functions performed, the assets used, and the risks assumed by each Related Party, in relation to what independent parties would have received. In general, the determination of the relevant profits to be split and of the profit splitting factors should be:

• Consistent with the Functional Analysis of the Controlled Transaction under review, and in particular reflect the assumption of the economically significant risks by the parties, and

• Capable of being measured in a reliable manner.

Where comparable data does exist, it could be useful in determining the division of profit that would have been achieved between independent parties in comparable circumstances. However, in those cases where there is no direct evidence of how independent parties in comparable circumstances would have split the profit in comparable transactions, the total profit may be split / allocated using one of the following approaches:

• Contribution analysis approach: where the total operating profit earned by the Related Parties or Connected Persons from a Controlled Transaction is divided between the Related Parties or Connected Persons based on the relative value of the contributions made by each of the Related Parties or Connected Persons participating in the Controlled Transaction.

• Residual analysis approach: This approach splits the total profit in two steps:

  • Step 1 - Each Related Party to the Controlled Transaction is allocated an arm’s length return for the routine functions that it performs (for example, routine services or distribution). Typically, the return for routine contributions may be determined based on the TNMM or any other Transfer Pricing method.

  • Step 2 - The residual profit (i.e. the profit remaining after the allocation of the return for routine contributions) is split using a contribution analysis or other allocation approach based on the underlying facts and circumstances of the Controlled Transaction. The relevant non-routine contributions (i.e. the unique and valuable contributions or assets, high level of integration or the shared assumption of economically significant risks) should be identified through a Functional Analysis of each Related Party.

These approaches are not necessarily exhaustive or mutually exclusive. Alternative ways may be used to split profit, as long as there is reasonable evidence that the selected approach produces a reliable arm’s length result.

The approach followed in splitting the profit should be verifiable and based on internal accounting data or on publicly available and measurable market data. In practice, internal data such as relevant assets, costs, and headcount may be used as allocation keys to split the profit. For self-developed assets, which may not be on the balance sheet, valuation techniques such as discounted cash flow may be used. If more than one allocation key is used to split the profit between the Related Parties or Connected Persons, it is necessary to determine the relative contribution of each allocation key in earning the combined profits. The measure of profits to be split will depend on the risks the parties share.

In many cases, operating profit may be the most appropriate measure of profits to be split because the parties share the risks of the entire business. However, if the parties share only the risks associated with the volume of sales and production of the products, and they do not share the risks associated with selling the products in the marketplace, then a split of gross profit may be appropriate.

The profits to be split may include actual profits or anticipated profits, or a combination thereof. Guidance on when it is appropriate to split actual vs. anticipated profits is provided below:

• The splitting of actual profits is appropriate when all the relevant parties share the assumption of the same economically significant risks or separately assume closely related ones. This type of risk assumption may arise if the business operations are highly integrated and / or each party makes unique and valuable contributions.

• A split of anticipated profits, in contrast, would be more appropriate if one of the parties does not share in the assumption of all of the economically significant risks, which might exist after entering into the transaction.

The division of the relevant profits under the PSM is achieved using one or more profit splitting factors. The Functional Analysis and a contextual analysis (for example, of the industry and business environment) are essential to the process of determining the relevant factors to use in splitting profits, including determining the weighting of applicable profit splitting factors, in cases where more than one factor is used. The determination of the appropriate profit splitting factor(s) should reflect the key contributions to value in relation to the transaction. Whether actual or anticipated profits are split, the basis for splitting profits must be determined on the basis of the information known or reasonably available at the time the Related Parties or Connected Persons entered into the Controlled Transaction.

It is generally difficult to access reliable publicly available data on what profit split independent parties would agree upon under comparable facts and circumstances. Further, issues may arise in measuring the relevant financial data (for example, costs or asset base) which are used for the actual application of the PSM. Finally, the splitting factors which could be applied are in principle subject to judgment.

Other Transfer Pricing methods

Article 34(4) of the Corporate Tax Law stipulates that the Arm’s Length Price may be calculated using methods other than the five Transfer Pricing methods listed in the Corporate Tax Law, if none of the five recognised methods can be reasonably or reliably applied, and provided these other methods satisfy the Arm’s Length Principle.

Where an alternative Transfer Pricing method has been used, adequate supporting documentation explaining the reason(s) for selecting the method including reasonable sufficient economical and commercial rationale, as well as clear disclosures of the underlying empirical analysis performed in applying the method must be provided. For example, a Person engaged in a real estate development project obtained under a term lease from a Related Party may opt to apply a Discounted Cash Flow (“DCF”) approach in demonstrating the arm’s length nature of the controlled lease payments if none of the five recognised Transfer Pricing methods can be reasonably applied to determine an arm’s length result. Where the facts and circumstances of the case, as well as the functional and comparability analyses establish that the DCF is appropriate, the Person may proceed to apply the DCF approach. However, supporting documentation should be kept in any case (pursuant to Article 55(4) of the Corporate Tax Law) to corroborate the reason for selection of this approach, relevant variables, presentation of the quantitative analysis and other relevant information and supporting documentation.

Internal comparables

Internal comparables may have a more direct and closer relationship to the Controlled Transaction under review than external comparables. The financial analysis may be easier and more reliable as it will presumably rely on identical accounting standards and practices for the internal comparable and for the Controlled Transaction. In addition, access to information on internal comparables may be both more complete and less costly.

However, internal comparables are not always more reliable and it is not the case that any transaction between the Person and an independent party can be regarded as a reliable comparable for Controlled Transactions carried on by the same Person. However, whenever reliable internal comparables exist, it may be unnecessary to search for external comparables.

External comparables and sources of information

There are various sources of information that can be used to identify potential external comparables. A common source of information is commercial databases which act as repositories for company accounts.

Commercial databases tend to provide access to a wide variety of potential comparables. Therefore, database searches typically start with a wide set of third- party data or companies that may be broadly comparable. These could be companies that operate in the same sector, perform similar broad functions and do not carry economic characteristics that are obviously different based on standard industry codes. The list of potential comparables is then refined using selection criteria and publicly available information (for example, from databases or reliable internet sites). Therefore, it is important that the database searches are systematically designed to develop search strategies that assist in screening the vast list of potential comparables in line with criteria that are relevant to the Controlled Transaction. It is best to seek quality over quantity of potential comparables when performing a database search and selecting comparables.

The information obtained from commercial databases may need to be refined with other publicly available information, depending on the facts and circumstances to enhance the reliability of the underlying data used in the comparability analysis.

A number of limitations to commercial databases are frequently identified. Because these commercial databases rely on publicly available information, they may not be available in all jurisdictions, since not all jurisdictions are aligned on what company data should be publicly available. Moreover, where information is available, the presentation and level of detail may vary from jurisdiction to jurisdiction because disclosure and filing requirements may differ depending on the legal form of the enterprise or the specific requirements of the jurisdiction. It is important that the identification of potential comparables is made with the objective of finding the most reliable data, recognising that they will not always be perfect. For instance, independent transactions may be scarce in certain markets and industries.

A pragmatic solution may need to be found, on a case-by-case basis, to address the limitations of the commercial databases, such as broadening the search and using information on uncontrolled transactions taking place –

• In the same industry and a comparable geographical market, but performed by third parties that may have different business strategies, business models or other slightly different economic circumstances;

• In the same industry but in other similar geographical markets; or

• In the same geographical market but in other industries.

The choice among these various options will depend on the facts and circumstances of the case, and in particular on the significance of the expected effects of comparability defects on the reliability of the analysis. However, even in cases where comparable data is scarce and imperfect, the selection of the most appropriate Transfer Pricing method (as per the guidance above) should be consistent with the Functional Analysis of the Related Parties or Connected Persons.

The FTA does not have a preference for any particular commercial database as long as it provides a reliable source of information that assists Taxable Persons in performing comparability analysis; provided that the order for applying comparables is followed (local, regional (Middle East), then other regions).

Whichever database the Taxable Person chooses to select comparables from, adequate documentation should be maintained to demonstrate the results of the comparability analysis. Where a Taxable Person has used a private database to support its transfer prices, the FTA may request access to the database in line with Article 55(4) of the Corporate Tax Law to review the Taxable Person’s results and to better understand the conclusions reached.

Non-domestic comparables

As far as possible, Taxable Persons should use domestic comparables in their comparability analysis as these comparables generally have a higher degree of comparability in terms of their market and economic circumstances compared to foreign comparables. Where insufficient data is available at the domestic level, Taxable Persons can consider regional or global comparables.

Selection of potential comparables

The search for information on potentially Comparable Uncontrolled Transactions and the process of identifying comparables is dependent upon prior analysis of the Controlled Transaction and of the economically relevant characteristics or comparability factors. A methodical, consistent approach should provide some continuity or linkage in the whole analytical process, thereby maintaining a constant relationship amongst the various steps: from the preliminary analysis of the conditions of the Controlled Transaction and the comparability analysis, to the selection of the Transfer Pricing method, through to the identification of potential comparables and ultimately a conclusion about whether the Controlled Transactions being examined are consistent with the Arm’s Length Principle.

Broadly, there are two ways in which the identification of potentially comparable Uncontrolled Transactions can be conducted:

• Additive approach: This starts with identifying a list of independent parties that are believed to carry out potentially comparable transactions. Information is then collected on transactions conducted by these independent parties to confirm whether they are in effect acceptable comparables, based on the predetermined comparability criteria. In practice, the additive approach may include both internal and external comparables.

• Deductive approach: This starts with a wide set of companies that operate in the same sector of activity as the tested party, perform similar broad functions as the tested party and do not present economic characteristics that are obviously different. The list is then refined using selection criteria and publicly available information (for example from databases, internet sites, information on known competitors of the tested party). In practice, the deductive approach typically starts with a search on a database.

Once the potential comparables are identified, both quantitative and qualitative criteria are used to include or reject potential comparables identified. Qualitative criteria can be found in product portfolios and business strategies. Quantitative criteria includes:

• Size criteria in terms of sales, assets or number of employees,

• Intangible-related criteria such as ratios of net value of intangibles/total net assets value, or ratio of R&D/sales, where available,

• Criteria related to the importance of export sales, where relevant,

• Criteria related to inventories in absolute or relative value, where relevant, and

• Other criteria to exclude independent parties that are in particular special situations such as start-up companies, bankrupted companies, etc. when such peculiar situations are obviously not appropriate comparisons.

The choice and application of selection criteria depends on the facts and circumstances of each particular case and the above list is neither limitative nor prescriptive.

The process followed to identify potential comparables is one of the most critical aspects of the comparability analysis and it should be transparent, systematic and verifiable. In particular, the choice of selection criteria has a significant influence on the outcome of the analysis and should reflect the most meaningful economic characteristics of the transactions compared. Complete elimination of subjective judgments from the selection of comparables would not be feasible, but much can be done to increase objectivity and ensure transparency in the application of subjective judgments.

Taxable Persons should maintain appropriate supporting information that describe the criteria used to select potential comparables and the reasons for excluding some of the potential comparables. Such information can be used by the FTA to assess the reliability of the comparables used.

Application of statistical measures to determine arm’s length range

If the identified range of financial results or indicators includes a sizeable number of observations, statistical tools that take account of central tendency to narrow the range (for example, the interquartile range or other percentiles) would be useful to enhance the reliability of the analysis. The use of statistical measures also prevents the impact of outliers and exceptional circumstances.

In this respect, the acceptance of the interquartile range is considered an appropriate approach to determine an arm’s length range of financial results or indicators because it provides a more robust measure of central tendency and variability compared to other statistical measures like the arithmetic mean or median. The interquartile range is obtained by dividing the dataset in four (4) equal parts. By doing so, three unique points amongst the dataset are derived, namely the lower quartile (the middle number/figure between the lowest value and the median), the median (the middle value of all observations) and the upper quartile (the middle number/figure between the median and the highest value). The interquartile range then represents all data between the lower quartile and the upper quartile.

A substantial deviation among points in the arm’s length range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm’s length range.

Selecting the most appropriate point in the arm’s length range

As per Article 34(7) of the Corporate Tax Law, any point within the arm’s length range is acceptable in establishing the Arm’s Length Price of the Controlled Transactions of a Taxable Person.

The FTA will consider the reliability of the arm’s length range when assessing the appropriateness of the selected point in the range.

The FTA will also take into consideration the functional profile of the Taxpayer/Controlled Transaction when assessing the most appropriate point within the range. A point closer to the lower interquartile may be appropriate for a company performing very limited functions, holds no assets and assumes no risks. A point closer to the upper quartile may indicate high value functions, ability to assume risk and employ assets.

Extreme results

Extreme results could be produced in case the benchmarking brings about figures that fall in the extreme ends of the interquartile range. Extreme results might consist of losses or unusually high profits and can affect the financial indicators. Where one or more of the potential comparables have extreme results, further examination would be needed to understand the reasons for such extreme results. The reason might be a defect in comparability such as losses not reflecting normal business conditions, losses reflecting a level of risk that is not comparable to the one assumed in the Controlled Transaction, or exceptional conditions met by an otherwise comparable third party. An extreme result may be excluded on the basis that a previously overlooked significant comparability defect has been brought to light, not on the sole basis that the results arising from the proposed “comparable” merely appear to be very different from the results observed in other proposed “comparables”.

Generally, a loss-making uncontrolled transaction or loss-making company should trigger further investigation in order to establish whether or not it can be comparable to the Controlled Transaction. Circumstances in which loss-making transactions/ enterprises should be excluded from the list of comparables include cases where losses do not reflect normal business conditions, and where the losses incurred by third parties reflect a level of risks that is not comparable to the one assumed by the Taxable Person in its Controlled Transactions.

Timing of origin

In principle, information relating to the conditions of Comparable Uncontrolled Transactions undertaken or carried out during the same period of time as the Controlled Transaction (contemporaneous uncontrolled transactions) is expected to be the most reliable information to use in a comparability analysis. Such transactions better reflect how independent parties have behaved in an economic environment that is the same as the economic environment of the Taxable Person’s Controlled Transaction.

Timing of data collection

Taxable Persons may prepare Transfer Pricing documentation to demonstrate that they have made reasonable efforts to comply with the Arm’s Length Principle at different points of time. There are two general approaches:

• Arm’s length price-setting approach: where Transfer Pricing documentation is prepared at the time the Controlled Transactions were undertaken, or based on information that was reasonably available to the Taxable Person at that point. Such information includes not only information on comparable transactions from previous years, but also information on economic and market changes that may have occurred between those previous years and the year of the Controlled Transaction.

• Arm’s length outcome-testing approach: where the actual outcome of the Controlled Transactions is tested to demonstrate that the conditions of these transactions were consistent with the Arm’s Length Principle. Such a test typically takes place as part of the process for preparing the Tax Return at the end of the Tax Period.

It is recommended for Taxable Persons to ensure that the approaches are applied consistently and result in the same outcome for all the Related Parties or Connected Persons to the Controlled Transaction.

Multiple year data

In practice, examining multiple-year data is often useful in a comparability analysis. In order to obtain a complete understanding of the facts and circumstances surrounding the Controlled Transaction, it may be useful to examine data from both the year under examination and prior years. Looking at multiple years can reveal factors that may have influenced (or should have influenced) the determination of the transfer price. For example, the use of data from past years will show whether reported losses on a Controlled Transaction are part of a history of losses on Comparable Uncontrolled Transactions. Further examination may then reveal that this is the result of particular economic conditions in a prior year that increased costs in the subsequent year.

Multiple-year data can improve the understanding of long-term arrangements, provide insights into relevant business and product life cycles of the comparables and improve the process of selecting third-party comparables.

Use of multiple-year data and averages generally improves the reliability of the range of financial results, especially where transactional profit methods are applied. As the use of multiple-year data may produce a broader set of financial results and indicators, statistical tools will be useful in analysing the results for purposes of determining the arm’s length range.

The examination of multiple-year data is typically done for 3 years inclusive of the year in which the transaction is undertaken. When using a 3-year period, at least 2 years of data should be available in order to accept the comparable company.

Frequency of updating the search for comparables

Searches for comparables should be fully updated every three years with an annual financial update of the comparables in the interim years as a minimum requirement. In case of a change in circumstances of the Controlled Transaction or Related Parties (or Connected Persons), the full analysis on the selection of comparables needs to be undertaken in the year of the change in circumstances.

Master File information

The Master File content follows the requirements under Annex I to Chapter V of the OECD Transfer Pricing Guidelines.

The Taxable Persons in scope should present the MNE Group information in a Master File in a consolidated format. The Master File must include information on:

Organisational structure:

• A chart illustrating the MNE Group’s legal and ownership structure and geographical location of operating entities.

Description of MNE Group’s business(es):

• A general written description of the MNEs business including:

  • Important drivers of business profit.

  • A description of the supply chain for the group’s five largest products and/ or service offerings by turnover plus any other products and/or services amounting to more than 5% of group turnover. The required description could take the form of a chart or a diagram.

  • A list and brief description of important service arrangements between members of the MNE Group, other than research and development (R&D) services, including a description of the capabilities of the principal locations providing important services and Transfer Pricing policies for allocating services costs and determining prices to be paid for intra-group services.

  • A description of the main geographic markets for the group’s products and services that are referred to in the second bullet point above.

  • A brief written functional analysis describing the principal contributions to value creation by individual entities within the group, i.e. key functions performed, important risks assumed, and important assets used.

  • A description of important business restructuring transactions, acquisitions and divestitures occurring during the fiscal year.

MNE Group’s intangibles:

• A general description of the MNE Group’s overall strategy for the development, ownership and exploitation of intangibles, including location of principal R&D facilities and location of R&D management.

• A list of intangibles or groups of intangibles of the MNE Group that are important for Transfer Pricing purposes and which entities legally own them.

• A list of important agreements among identified associated enterprises related to intangibles, including cost contribution arrangements, principal research service agreements and license agreements.

• A general description of the group’s Transfer Pricing policies related to R&D and intangibles.

• A general description of any important transfers of interests in intangibles among associated enterprises during the fiscal year concerned, including the entities, countries and compensation involved.

MNE Group’s intercompany financial activities:

• A general description of how the group is financed, including important financing arrangements with unrelated lenders.

• The identification of any members of the MNE Group that provide a central financing function for the group, including the country under whose laws the entity is organised and the place of effective management of such entities.

• A general description of the MNE Group’s general Transfer Pricing policies related to financing arrangements between associated enterprises.

MNE Group’s financial and tax positions:

• The MNE Group’s annual consolidated financial statements for the fiscal year concerned if otherwise prepared for financial reporting, regulatory, internal management, tax or other purposes.

• A list and brief description of the MNE Group’s existing unilateral advance pricing agreements (APAs) and other tax rulings relating to the allocation of income among countries.

A presentation by line of business is permitted where well justified by the facts (for example, where the structure of the MNE Group is such that some significant business lines operate largely independently or were recently acquired). Where line of business presentation is used, care should be taken to assure that centralised Group functions and transactions between business lines are properly described in the Master File. Even where a line of business presentation is selected, the entire Master File consisting of all business lines should be available to each jurisdiction in order to assure that an appropriate overview of the MNE Group’s global business is provided.

Local File information

The Local File content follows the requirements under Annex II to Chapter V of the OECD Transfer Pricing Guidelines and must include the following information:

Local entity:

• A description of the management structure of the local entity, a local organisation chart, a description of the individuals to whom local management reports and the country(ies) in which such individuals maintain their principal offices.

• A detailed description of the business and business strategy pursued by the local entity including an indication whether the local entity has been involved in or affected by business restructurings or intangibles transfers in the present or immediately past year and an explanation of those aspects of such transactions affecting the local entity.

• Identification of the key competitors.

Controlled transactions:

For each material category of controlled transactions in which the entity is involved:

• A description of the material-controlled transactions (for example procurement of manufacturing services, purchase of goods, provision of services, loans, financial and performance guarantees, licenses of intangibles) and the context in which such transactions take place.

• The amount of intra-group payments and receipts for each category of controlled transactions involving the local entity (i.e. payments and receipts for products, services, royalties, interest, etc.) broken down by tax jurisdiction of the foreign payor or recipient.

• An identification of associated enterprises involved in each category of controlled transactions and the relationship amongst them.

• Copies of all material intercompany agreements concluded by the local entity.

• A detailed comparability and functional analysis of the taxpayer and relevant associated enterprises with respect to each documented category of controlled transactions, including any changes compared to prior years.

• An indication of the most appropriate Transfer Pricing method with regard to the category of transaction and the reasons for selecting that method.

• An indication of which associated enterprise is selected as the tested party, if applicable, and an explanation of the reasons for this selection.

• A summary of the important assumptions made in applying the Transfer Pricing methodology.

• If relevant, an explanation of the reasons for performing a multi-year analysis.

• A list and description of selected comparable uncontrolled transactions (internal or external), if any, and information on relevant financial indicators for independent enterprises relied on in the Transfer Pricing analysis, including a description of the comparable search methodology and the source of such information.

• A description of any comparability adjustments performed, and an indication of whether adjustments have been made to the results of the tested party, the comparable uncontrolled transactions, or both.

• A description of the reasons for concluding that relevant transactions were priced on an arm’s length basis based on the application of the selected Transfer Pricing method.

• A summary of financial information used in applying the Transfer Pricing method.

• A copy of existing unilateral and bilateral/multilateral APAs and other tax rulings to which the local tax jurisdiction is not a party, and which are related to controlled transactions described above.

Financial information:

• Annual local entity financial accounts for the fiscal year concerned. If audited statements exist, they should be supplied and if not, existing unaudited statements should be supplied.

• Information and allocation schedules showing how the financial data used in applying the Transfer Pricing method may be tied to the annual financial statements.

• Summary schedules of relevant financial data for comparables used in the analysis and the sources from which that data was obtained.

Determining the arm’s length remuneration for the treasury function

Often, the central treasury function is performing routine services without bearing or managing significant risks. In such cases, Taxable Persons may refer to Section 7.2 for further details on remunerating centralised services. However, it is important to separately consider the arm’s length remuneration for cases where the treasury function is acting as an in-house bank that is bearing and managing significant contingent liability risk that may arise from Related Party loans, cash pooling or guarantees (further discussed below).

Determining the arm’s length pricing for intra-group loans

Given the abundance of data on third-party loans, it is often the case that the CUP method can be applied to price intra-group loans. For loans, the CUP method typically involves the following steps:

• Analysis of the terms of the loan relating to factors that may impact the pricing including issue date, tenor, country of the borrower, currency, options (for example, pre-payment option), interest rate type (for example, fixed vs. floating), etc.

• Analysis of the borrower’s credit rating to understand the credit risk borne by the lender in extending the loan (factoring in implicit support from the group as further discussed below).

• Search for third-party loans with a similar credit rating and terms.

• Comparability adjustments if necessary and the calculation of the arm’s length range.

The below sub-sections provide more details on conducting a credit rating analysis as well as performing a search for third-party loans.

Credit ratings

Credit rating is an opinion about an entity’s general creditworthiness and capacity to meet its financial obligations. The creditworthiness of the borrower is one of the main factors that independent lenders take into consideration when the terms of the borrowing are being determined. Credit ratings can serve as a useful measure of creditworthiness and, therefore, help to identify potential comparables or to apply economic models in the context of intra-group loans.

Credit ratings can be determined for the overall creditworthiness of an MNE or the Ultimate Parent Entity of the MNE Group or for a specific issuance of debt. Based on prevailing facts and circumstances and provided there is comparability between the third-party debt issuance and the Controlled Transaction, when both MNE credit rating and financial instrument credit ratings are available, the rating of the particular financial instrument would be more appropriate to be used to price the controlled financial transaction.

Determining credit ratings requires consideration of both quantitative (for example, financial information of the borrower) and qualitative factors (for example, the industry and jurisdiction in which the borrower operates). An approach often used to determine a credit rating for a specific MNE is to replicate the process used to determine the credit rating of the MNE Group by applying the quantitative and qualitative analysis of the individual characteristics of the MNE using publicly available financial tools or independent credit rating agencies’ methodology. This approach also takes into consideration the enhanced creditworthiness that an MNE may receive for being part of an MNE Group.

The credit rating methodology used in publicly available financial tools may differ significantly from the credit rating methodologies applied by independent credit rating agencies to determine official credit ratings and the impact of any such differences should be carefully considered. For instance, publicly available tools generally use only a limited sample of quantitative data to determine a credit rating. Official credit ratings published by independent credit rating agencies are derived from more rigorous analysis that includes quantitative analysis of historical and forecast entity performance, as well as detailed qualitative analysis of, for instance, management’s ability to manage the entity, industry specific features and the entity’s market share in its industry. For these reasons, the reliability of credit rating results derived from the use of publicly available financial tools may be limited when compared to independent credit rating agencies. However, this may be improved if the analysis can demonstrate consistency of ratings using publicly available tools with those provided by independent credit rating agencies. For example, when deciding whether and on what terms to lend, banks and other lenders may rely on independent credit ratings. A third- party lender may take into account independent credit ratings in terms of fixing the level of interest on a particular loan (a higher rating resulting in a lower interest rate). Credit ratings are just one area of consideration when deciding whether and on what terms to provide lending. The same considerations apply equally to Related Party loans.

In general, a lower credit rating will indicate a greater risk of default and be expected to result in higher borrowing costs.

It is important that the MNE Group appropriately documents the reasoning behind the credit rating used when pricing intra-group loans and other controlled financial transactions.

Implicit support

The effect of Group membership is relevant for informing the conditions under which a Taxable Person would have borrowed from an independent lender at arm’s length. In particular:

1. The external funding policies and practices of group management will assist in informing the form and terms and conditions of the debt the MNE would have entered into with an independent lender, including the pricing (i.e. interest rate paid), and all economically relevant characteristics such as the type of loan, its term, currency, security, covenants, business strategies, and so forth.
2. The entity may receive support from the Group to meet its financial obligations in the event of the entity getting into financial difficulty.

In the context of intra-group loans, this incidental benefit that the entity is assumed to receive solely by virtue of its Group affiliation, is referred to as ’implicit support’. The effect of potential Group support on the credit rating of an entity and any effect on that entity’s ability to borrow or the interest rate paid on those borrowings would not require any payment or comparability adjustment.

Implicit support from a Group may affect the credit rating of the borrower or the rating of any debt which it issues. The relative status and strategic importance of an entity within the Group may help determine what impact that potential group support has on the credit rating of a debt issuer. The weaker the linkage of an entity to the Group, the less it would receive support. In the event that there is evidence that an entity is not likely to receive support from its Group, it may be appropriate to consider the entity on the basis of its own stand-alone credit rating only.

Performing a search for third-party loans

The arm’s length interest rate for an intra-group loan can be benchmarked against publicly available data for other borrowers/third-party loans with the same credit rating as well as sufficiently similar terms and conditions and other comparability factors of the loans. In addition to credit quality, in performing a search for third-party loans, it is important to also consider key factors that would impact the pricing of the loan, such as the following:

• The issue date of the loan is an important factor in the pricing of the loan as interest rates may fluctuate significantly over time based on various macroeconomic factors.

• The currency of the debt can impact the risk of the loan due to foreign exchange rate fluctuations. Certain currencies are generally considered lower risk (for example, the US Dollar (“USD”) or those currencies pegged to the USD such as the AED) while other currencies are higher risk (for example, currencies undergoing or at risk of a devaluation).

• The country of the borrower can impact the risk of a loan due to the unique macro-economic factors of that country (for example, recession or high inflation), risk of capital controls being imposed, or political instability that could threaten the capital markets of a country.

• The tenor of a loan will impact the pricing of the loan as it will impact how long the lender’s capital will be tied into this transaction. Under normal economic conditions, loans with a longer duration would typically require a higher interest rate to incentivise the lender to extend the loan for such a time period.

• The options of a loan may grant certain privileges to the lender or the borrower. For example, a pre-payment option that would allow the borrower to pay off the loan before the maturity date could add a premium to the loan due to the potential benefit provided to the borrower (for example, if interest rates are lowered, it would benefit the borrower to pay off the loan early, thereby disadvantaging the lender due to loss of interest income).

• There are different types of rates that may be applied to loans including fixed rate loans and floating rate loans. The interest rate of a fixed rate loan remains ’fixed’ (i.e. constant) throughout the duration of the loan, whereas a floating rate loan will fluctuate based on an underlying market benchmark (for example LIBOR or EIBOR), thereby impacting the riskiness of the loan.

• The industry of the borrower may impact the riskiness of the loan. For example, some industries are considered to be more stable in nature or may involve significant physical capital that could reduce the risk to the lender (for example manufacturing), whereas the opposite may be true for other industries (for example technology).

The above guidance is not meant to be exhaustive, and other factors may also need to be considered in pricing an intra-group loan.

Comparability adjustments for third-party loans

In certain cases, when conducting a loan benchmarking analysis, it may not be possible to match all of the key comparability criteria of an intra-group loan. For example, certain countries do not have robust capital markets and, therefore, may not offer a sufficient number of third-party loans issued in their country or currency. As a result, comparability adjustments may be required to enhance the comparability and reliability of the third-party loan.

Determining the arm’s length remuneration in a cash pooling arrangement

Cash pooling arrangements involve transactions between Related Parties or Connected Persons and hence it is important to ensure that the arrangement is conducted in line with the Arm’s Length Principle.

The appropriate reward of a cash pool leader will depend on the facts and circumstances, the functions performed, the assets used and the risks assumed in facilitating a cash pooling arrangement. In general, a cash pool leader performs routine functions such as co-ordination, forecasting, reporting and basic analysis, and the expectation is that it will receive a commensurate renumeration as a routine service provider. In more complex cash pools, additional responsibilities could include risk management, interest optimisation and external banking relationships. These types of cash pools would expect to receive more than a routine reward. The level of remuneration for a cash pool function should be directly linked to the activities and services, assets used and risks assumed by the cash pool leader, and the appropriate Transfer Pricing method should be adopted after analysing the specific facts and circumstances.

The remuneration of the cash pool members will be calculated through the determination of the arm’s length interest rates applicable to the debit and credit positions within the pool. This determination will allocate the synergy benefits arising from the cash pool arrangement amongst the pool members and it will generally be done once the remuneration of the cash pool leader has been calculated.

Pricing a related party guarantee

Pricing a Related Party guarantee is typically done by estimating the benefit recognised by the guaranteed party in receiving a lower interest rate on its borrowings as a result of the guarantee. This approach is referred to as the “interest savings approach” and is done by calculating the difference in the guaranteed party’s cost of borrowing without the guarantee as compared to its actual cost of borrowing with the guarantee. Estimating the cost of borrowing should be done in line with the guidance in this section on pricing intra-group loans as detailed above in Section 7.1.3.

Determination of Arm’s Length Price of captive insurance

In pricing the captive insurance arrangement, it may be possible to apply the CUP method if there are internal comparables whereby the captive insurer has suitably similar business with unrelated customers, or if external comparables are available.

However, due to the unique nature of insurance arrangements, it is often difficult to apply the CUP method for captive insurance. Thus, it may be more reliable to evaluate the arm’s length profitability of the captive insurance entity following the guidance in Section 5 of this Guide and applying the appropriate profit level indicator. Typically, such an analysis would take into account the profitability of claims and an appropriate return on capital.

Finally, an alternative method may be considered such as an actuarial analysis to determine an arm’s length premium for insuring a particular risk. However, alternative methods come with unique challenges and should only be used where the five Transfer Pricing methods prescribed in Article 34(3) of the Corporate Tax Law are not suitable or inconclusive.

Benefits test

Under the Arm’s Length Principle, the question whether an intra-group service has been rendered when an activity is performed for one or more Group members by another Group member should depend on whether the activity provides a respective Group member with economic or commercial value to enhance or maintain its business position. This can be determined by considering the following non-exhaustive factors:

• Whether the benefits have economic or commercial value such that an independent party in comparable circumstances would be willing to pay for the activity if performed by an independent party or would have undertaken to perform the activity for itself.

• Whether activities are performed for another party which receives, or reasonably expects to receive, benefits from such activities. If so, there may be a service provided even if the expected benefits do not eventually materialise.

• Whether objectively there is any commercial or practical necessity for the activities to be performed for the service recipient and an independent party would be willing to pay the service provider for the performance of those activities. If not, the benefit may be too remote or incidental.

• Whether the benefits are identifiable and capable of being valued. Otherwise, there is no service provided.

Shareholder activities

Sometimes in an MNE Group, an intra-group activity is performed relating to Group members even though those Group members do not need the activity (and would not be willing to pay for it were they independent of the Group). Such an activity may be one that a Group member (usually a parent entity or a regional holding company) performs solely because of its ownership interest in one or more other Group members (i.e. in its capacity as shareholder). It may also be required to perform such activities for regulatory compliance reasons, which would also indicate these activities are performed in the service provider’s capacity as a shareholder.

These types of activities would not be considered to be intra-group services, and thus would not justify a charge to other Group members. Instead, the costs associated with this type of activity should be borne and allocated/retained at the level of the shareholder. This type of activity would be referred to as a “shareholder activity”.

The following are indicative examples of costs that may be associated with shareholder activities and should not be charged:

• Costs relating to the juridical structure of the parent entity itself, such as shareholder meetings, issuing of shares in the parent entity, stock exchange listing of the parent entity and costs of the supervisory board.

• Costs relating to reporting requirements (including financial reporting and audit) of the parent entity including the consolidation of reports, the parent entity’s audit of the subsidiary’s accounts carried out exclusively in the interest of the parent entity, and the preparation of Consolidated Financial Statements of the MNE Group.

• Costs of raising funds for the acquisition of its participations and costs relating to the parent entity’s investor relations such as a communication strategy with shareholders of the parent entity, financial analysts, funds and other stakeholders in the parent entity.

• Costs relating to compliance of the parent entity with the relevant tax laws.

• Costs which are ancillary to the corporate governance of the MNE Group as a whole.

Treatment of pass-through cost / reimbursement of expenses

Sometimes, a Group company may arrange and pay for, on behalf of its Related Parties or Connected Persons, goods or services acquired from various vendors. These are generally called pass-through costs and are subject to reimbursement.

A question may arise as to whether the Group company arranging and paying for such goods or services should add a profit element to the amount paid to the vendors when recharging such costs to Related Parties or Connected Persons.

The Group service provider may pass on the costs from the vendors without a profit element or mark-up provided that:

• The acquired goods or services are requested by and for the benefit of the Related Parties or Connected Persons;

• The Group service provider is merely the paying agent and does not enhance the value of the acquired goods or services in the process whatsoever; and

• The cost of the acquired goods or services is the legal or contractual liability of the Related Parties or Connected Persons. This condition can be met even if the Group service provider is legally or contractually liable to pay for the acquired goods or services through an inter-company agreement.

The Group service provider should nonetheless consider charging an appropriate arm’s length standard margin for its function in arranging and paying for the acquired goods or services on behalf of its Related Parties or Connected Persons. This should be based on (but not limited to) the aggregate costs of performing the function, and reflect the nature of its own services and extent of value-add generated for the Related Parties or Connected Persons.

Duplication

Duplication of services occurs when a service is provided to a Related Party that has already incurred costs for the same activity performed either by itself or on its behalf by an independent provider. There is no commercial or practical necessity for such duplicative service and thus, applying the benefit test, no service is considered provided. While generally this is the case, there could be situations where duplication of service may be allowed:

• Where the duplication of services is only temporary, for example, where an MNE Group is reorganising to centralise its management functions.

• Where the duplication is undertaken to reduce the risk of a wrong business decision. For example, this situation may arise if a company receives in-house accounting advice from a Related Party on an issue but chooses to get a second opinion to minimise the risk of being penalised for failing to comply with accounting standards, the costs of the in-house accounting advice received should be borne by the company.

Any consideration of possible duplication of services needs to identify the nature of the services in detail, and the reason why the company appears to be duplicating costs contrary to efficient practices. The fact that a company, for example, may be performing marketing activities in-house and also is charged for marketing services from a Group company does not in itself determine duplication. In this example there may be differences if the local entity is executing a local marketing strategy and the Group company is executing a global marketing strategy which may be indicative of different marketing activities which are not duplicative.

The FTA expects a clear rationale for suffering any duplicative costs as a result of intra-group services. As such, the Taxable Person should maintain sufficient documentation to support the Taxable Person’s position in suffering costs for what may appear to be duplicative services.

Incidental benefits

In certain situations, an intra-group service relates only to some Group members but incidentally provides benefits to other Group members. For example, comprehensive group-wide studies on structural changes could be made to reorganise the Group, studies exploring the benefits of acquiring new lines of business, or to terminate a division. These activities may constitute intra-group services to the particular Group members who commissioned these studies. These Group members may incorporate the findings of the studies to support or reject key business decisions directly impacting their competitive advantage in the marketplace. As a secondary consideration, these studies may be made available to other Group members for their reference. These types of studies may also provide useful information such as highlighting operational inefficiencies or product lines with growth potential. For the Group entities that have been provided with the studies for their reference, the useful information is an incidental benefit, and it would not be appropriate to raise a charge as a provision of intra-group services. This is because the activities producing the benefits were never intended for them, and would not be ones for which an independent party ordinarily would be willing to pay. However, each case must be determined according to its own facts and circumstances.

Intra-group services rising from several layers of management

An MNE Group can include several businesses and service lines. It can have several layers of management oversight and supervision for, for example, a global business leadership team overseeing business affairs globally at large, a regional business leadership team responsible for a particular region, and a local business leadership team responsible for a country. In other words, not all MNE Groups are vertically integrated and may instead have regional or divisional sub-groups with their own management and support structures.

The MNE Group may decide to perform an allocation of the cost of its global and regional business leadership teams across all the countries of operations.

While performing such an allocation, the MNE Group should apply the principles of the benefits test discussed in Section 7.2.2.1 of the guide.

In the event that a cost allocation does not pass the benefits test, such expenditure shall be adjusted while determining the Taxable Income of the Taxable Person in accordance with Article 20 of the Corporate Tax Law. Further a close evaluation should be undertaken to ensure that multiple layering in management does not result in duplication in allocation of cost to the members of the Group.

Centralised services

Other activities that may relate to the Group are those centralised in the parent entity, or in one or more Group service centres (such as a regional headquartered company) and made available to the Group (or multiple members thereof). The activities that are centralised depend on the kind of business and on the organisational structure of the Group. However, in general, they may comprise administrative services including but not limited to:

• Planning and coordination;

• Information technology and computer services;

• Human resource services, recruitment and training;

• Financial advice, financial services, budgetary control, accounting and audit;

• Legal services;

• Customer services; and

• Other support functions such as distribution, procurement and marketing.

These types of activities ordinarily will be considered intra-group services because they are the type of activities that independent parties would be willing to pay for or perform in-house.

Intra-group services can take many forms and can provide varying levels of benefit, it is, therefore, necessary to explore the actual facts and circumstances of the arrangement in order to determine the most appropriate Transfer Pricing method.

For a particular service arrangement, the terms of the activity can be set out in a detailed contract with the party commissioning the service. The activity may involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the activity. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined parameters. Such an arrangement would constitute the rendering of a valuable/chargeable service.

A chargeable service may be provided even where there is no explicit agreement in place. For example, an MNE Group decides to centralise its global finance function. It will provide services which may include maintaining accounting records, preparing financial statements based on accounting records, reconciling financial data, preparing tax returns and computations and reclaim forms, performing operational and financial internal audits, and performing other services of a similar nature. The fact that a written service agreement does not exist between the service provider and a Group member does not automatically mean a service has not been provided or received. The conduct of the parties should be reviewed together with the need for the service and whether an operational burden which the Group member would have paid for or undertaken to address in-house has been removed through centralisation.

An obligation to pay for an intra-group service arises only where the benefits test is satisfied, which is determined by evaluating whether independent parties in comparable circumstances would have been willing to pay for the activity if performed by an independent service provider or would have performed the activity in-house.

Comparability analysis

The determination of the Arm’s Length Price in relation to intra-group services should be considered both from the perspective of the service provider and the service recipient. In this respect, the comparability analysis should analyse relevant considerations such as the value of the service to the recipient and how much a comparable independent enterprise would be prepared to pay for that service in comparable circumstances, as well as the costs to the service provider.

Selection of the most appropriate Transfer Pricing method

The method to be used to determine arm’s length charge for intra-group services should be determined according to the guidance in Section 5 of this guide.

The Comparable Uncontrolled Price (CUP) method or a cost-based method (Cost Plus Method or Transactional Net Margin Method using a cost-based profit level indicator) are commonly used for pricing intra-group services. A CUP method is likely to be the most appropriate method where there is a comparable service provided between independent enterprises, or by the Related Party providing the services to an independent enterprise in comparable circumstances.

Direct and indirect charge methods

An MNE Group may be able to adopt direct charging arrangements, particularly where services similar to those rendered to Related Parties or Connected Persons are also rendered to independent parties. If specific services are provided not only to Related Parties or Connected Persons but also to independent parties in a comparable manner and as a significant part of its business, it could be presumed that the MNE has the ability to demonstrate a separate basis for the charge (for example, by recording the work done, the fee basis, or costs expended in fulfilling its third-party contracts). Thus, MNEs in such cases are encouraged to use the direct-charge method in relation to their intra-group transactions with their Related Parties.

However, this approach may not always be appropriate if, for example, the services to independent parties are merely occasional or marginal. The direct charge method may pose challenges in cases where there is a centralised management services activity performed for the benefit of multiple entities within a Group at the same time. MNE Groups may find they have to resort to cost allocation and apportionment methods, which often necessitate some degree of estimation or approximation as a basis for calculating an arm’s length adjustment. Where cost allocation and apportionment methods are used, these are considered indirect charge methods.

When using the indirect method, the Taxable Person needs to take into account the commercial features of the individual case (for example, whether the allocation key is reasonable under the circumstances). Further, the approach should contain safeguards against manipulation, follow sound accounting principles, and be capable of producing charges or allocations of costs that are linked to the actual or reasonably expected benefits to the recipient of the service.

The indirect charge method is generally not appropriate for specific services that form a main Business Activity of the enterprise or services that are provided not only to Related Parties or Connected Persons but also to independent parties.

Determination of the cost base

Where a cost-based method is determined to be the most appropriate method to the circumstances of the case, the relevant cost base should be determined. A summary of the approach for determining the cost base for centralised services is as follows:

1. The initial step is to calculate, on an annual basis, a pool of all costs incurred by all members of the Group in performing each category of the centralised intra-group services. The costs to be pooled are the direct and indirect costs of rendering the service as well as an appropriate level of operating expenses determined using an acceptable allocation key where relevant.

2. Secondly, the cost pool should exclude costs that are attributable to an in-house activity that benefits solely the company performing the activity (including shareholder activities performed by the shareholding company).

3. Thirdly, the MNE Group should identify and remove from the pooled costs any costs that are attributable to services performed by one Group member solely on behalf of one other Group member (as this would be charged directly to the specific beneficiary).

4. Lastly, the MNE Group needs to allocate the remaining pool of costs that is attributable to the services which are provided to multiple members of the MNE Group among benefitting members of the MNE Group. More than one allocation key can be applied for this purpose based on the nature of the service and the fact that the allocation key should reasonably be linked to the expected benefit, for example, the allocation key for services related to people might employ the share of total headcount and information technology services might employ the share of total users. The same allocation key or keys must be used on a consistent basis for all allocations of costs relating to the same category of services.

Profit mark-up

In determining the arm’s length charge, the service provider should apply a mark-up to all costs that are not pass-through in nature. ^[28]The mark-up should be determined using comparable data. However, to reduce the compliance burden on Taxable Persons, this Guide adopt the simplified approach provided under Chapter VII of the OECD Transfer Pricing Guidelines, whereby certain low value-adding intra-group services may be charged out at a cost-plus 5% mark-up without the need for a detailed benchmarking analysis. In general, low value-adding intra-group services should meet the following criteria:

• The services are of a supportive nature;

• They are not part of the core business of the MNE Group (i.e. not creating the profit-earning activities or contributing to economically significant activities of the MNE Group);

• They do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles; and

• The services do not involve the assumption or control of substantial or significant risk by the service provider and do not give rise to the creation of significant risk for the service provider.

• Accordingly, the following activities would not qualify for the safe harbour outlined in this section:

  • Services constituting the core business of the MNE Group;

  • Research and development services;

  • Manufacturing and production services;

  • Purchasing activities relating to raw materials or other materials that are used in the manufacturing or production process;

  • Sales, marketing and distribution activities;

  • Financial transactions;

  • Extraction, exploration, or processing of natural resources;

  • Insurance and reinsurance; and

  • Services of corporate senior management.

Below is an illustrative example of services that may be considered low value adding and thus qualify for the safe harbour.

The initial step in applying a simplified approach to low value adding services is to categorise, calculate and pool all costs associated with the low value adding services. These costs should then be allocated amongst group members based on appropriate allocation keys. The appropriate allocation key will depend on the nature of the service. For example, IT services may be allocated on number of users or employee related costs may be allocated based on headcount. The pragmatic intent of using a safe harbour means a balance needs to be struck between theoretical sophistication and practical administration. The final step is to apply a profit mark-up, in the case of the low value adding services safe harbour the mark up shall be 5%.

Taxpayers should maintain sufficient documentation to support their conclusions that services included in the simplified approach are in fact low value adding in nature.