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The arm’s length principle (ALP) is central to transfer pricing (TP), requiring that related-party transactions reflect market conditions. However, achieving compliance often involves TP adjustments
TP adjustments are modifications made to in-scope transaction prices to align them with the ALP. These adjustments ensure that the profit allocation among associated enterprises (AEs) is consistent with what independent entities would have earned under similar conditions. Adjustments may be initiated by taxpayers proactively or imposed by tax authorities during audits.
There are three types of adjustments as follows:
- A primary adjustment is an adjustment to the taxable income of a taxpayer to align related-party transactions with ALP.
- A corresponding adjustment is a consequential adjustment in the counterparty’s jurisdiction to mitigate double taxation.
- A secondary adjustment refers to additional tax implications arising from the primary adjustment, often treated as deemed dividends or loans.
The FTA’s guide on Transfer Pricing in the UAE provides that in cases where the application of ALP results in an adjustment to the transfer price made by a foreign competent authority, the UAE taxable person can request the FTA to make a corresponding adjustment to their taxable income in the UAE.
Let’s understand TP adjustments with the help of examples.
Example 1: Royalty Payments between AEs
A multinational group’s subsidiary in the UAE pays royalties to its parent company in Ireland for using proprietary technology. During an audit, the FTA determines that the royalty rate exceeds rates paid by unrelated parties for similar technology. Consequently, the FTA adjusts the royalty rate downward to align with ALP, reducing the deductible expense in the UAE and increasing its taxable income. To avoid double taxation, Ireland’s tax authority may implement a corresponding adjustment.
Example 2: Intercompany Sale of Goods
A manufacturing entity in the UAE sells products to its distribution subsidiary in Nairobi at a transfer price below market rates. Nairobi’s tax authority identifies that the transfer price does not reflect ALP, leading to reduced profit margins for the distributor. To address this, the tax authority increases the purchase price to match the market price, resulting in a higher taxable income for the distributor. The manufacturing entity’s tax authority (i.e., the FTA) may agree to a corresponding adjustment to reduce double taxation risks.
Example 3: Management Fees and Service Charges
A parent company provides management services to its subsidiary and charges a fee for the same. If the subsidiary fails to substantiate the arm’s length nature of the fees, the tax authority may deem a portion of the fees excessive and disallow the excess as a deductible expense. The adjustment ensures that the service charges align with the value of services provided.
TP Adjustments and Litigation
TP adjustments are a major source of tax litigation worldwide. Hence, it becomes imperative for companies to maintain adequate documentation evidencing the nature of the transaction, the TP methodology adopted, the comparables selected etc.
Besides, considering that cross-border litigation can involve huge costs, corporates can also opt for alternate dispute resolution methods like the procuring advance rulings (private clarifications in the UAE) or executing the advance pricing agreements (APAs) with the tax authorities. Such mechanisms are internationally recognized methods that ensure tax certainty.
Conclusion
As tax authorities adopt intensify the use of artificial intelligence in tax scrutiny, businesses must adopt robust TP policies, backed by diligent documentation and proactive compliance measures. Besides, alternate dispute resolution methods like advance rulings and APAs can help to reduce tax litigation and usher in tax certainty.
Disclaimer: Content posted is for informational and knowledge sharing purposes only, and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/interpretation of the publisher is based on the available Law, guidelines and information. Each reader should take due professional care before you act after reading the contents of that article/post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide, and should not be relied on for tax or accounting advice
