Challenges in applying the transfer pricing methods

On October 23, 2023, the Federal Tax Authority (FTA) issued the Transfer Pricing Guide (TP Guide), (FTA TP Guide). FTA TP Guide specifies the TP rules that were introduced in UAE a little earlier by the Federal Decree-Law No. 47/2022 on the Taxation of Corporations and Businesses.

According to the transfer pricing (TP) rules, indicated in FTA TP Guide, as well as in OECD TP Guidelines, the commercial and financial transaction between the related parties must comply with the arm's length principle. It means that the conditions and remuneration set in related parties’ transaction should be valued as if it had been carried out between unrelated parties, each acting in his own best interest.

General information on TP methods

Clause 5.2.1 of the FTA TP Guide describes the TP methods that should be applied to establish whether controlled transactions are conducted at arm's length. The FTA TP Guide refers to five internationally accepted TP methods detailed in the OECD TP Guidelines and incorporated in TP UAE rules under Article 34(3) of the Corporate Tax Law.

These TP methods are the following:

1. Comparable uncontrolled price method (CUP);
2. Resale price method (RPM);
3. Cost plus method (СРM);
4. Transactional net margin method (TNMМ);
5. Transactional profit split method (PS).

The first three methods belong to the traditional methods, while the final two refer to the cost-benefit based analysis methods. More details on each method and details of their application are provided below.

Main distinctive features of TP methods. Principles of TP method selection

First of all, the chosen method should be appropriate to the details of the controlled transaction and business activities of the counterparties.

Under FTA TP Guide, there is no absolute hierarchy in relation to applying traditional transaction methods (CUP method, RPM or CPM). However, traditional transaction methods are regarded as the most direct way of establishing whether transactions and arrangement between related parties / connected persons are in line with the arm’s length standard.

Traditional transaction methods

If during the preliminary analysis of the controlled transactions it is discovered that the CUP method and another TP method can be applied in an equally reliable way, the CUP method should be applied as a priority TP method.

So, the CUP method is applied to determine whether the price used in a controlled transaction corresponds to market prices, if there is at least one comparable transaction involving identical (when unavailable, homogeneous) goods (work and services) on the relevant market and if sufficient information on such a transaction is available.

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, this method is reliant on the comparability of available data relating to comparable transactions to ensure its effectiveness. Therefore, the CUP method is mostly applied in following transactions:

1. with commodities;
2. with intangible assets (royalties for the use of intellectual property);
3. intercompany loans;
4. when goods (works, services) are sold both to a related / connected and an independent party on identical / comparable terms (internal CUP).

While applying the CUP method, it is necessary to answer the following questions:

• Are the contractual terms identical / comparable (e.g., volumes and delivery terms)?
• Are the economic conditions in which the transactions take place identical / comparable?
• Are the business strategies identical / comparable (e.g. sometimes market penetration strategy means setting lower prices)?

Resale Price method (RPM) is based on a comparison of the gross profit margin received by the person, who made the analyzed transaction in the subsequent sale (resale) of goods purchased by him in that analyzed transaction (group of homogenous transactions), with the market gross profit margin range.

Typically, RPM is applied where the reseller adds relatively little value to the goods being transacted. The more value the reseller adds to the goods, the less appropriate it would be to apply the RPM to determine the arm’s length price of the transaction. This is especially valid when the reseller contributes significantly to creating or maintaining intangible assets, 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 assets.

As a result, the RPM is often the most appropriate method where it is applied to distribution and marketing operations.

Further, the reliability of the RPM may be affected if there are material differences in the ways the related parties / connected persons and independent parties carry out their business. Such differences could include, for example, the effect of management efficiency on levels and ranges of inventory maintenance, as well as differences in accounting practices.

Thus, in practice RPM is applied when internal comparables (own comparable transactions of related parties) are available.

Nevertheless, when applying the RPM, using either internal of external comparable transactions, it is necessary to answer the following questions:

• Are the contractual terms identical / comparable (e.g. volumes and terms of delivery)?
• Have the goods been significantly changed / finalized?
• Has the affiliated distributor increased the value of the goods?
• Do the companies perform comparable functions, take comparable risks and use comparable (intangible) assets?

Cost Plus method (CPM) is based on a comparison of the gross margin on costs of the party to the analyzed transaction (a group of analyzed homogenous transactions), with the market range of gross margin on costs in comparable transactions.

The CPM is most useful where semi-finished goods are sold between related parties / connected persons, where they have concluded joint facility agreements or long-term buy-sell arrangements, as well as where the controlled transaction is the provision of services.

Similar to the RPM, for the purposes of the CPM, all relevant comparability factors should be considered:

1. 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. However, it is quite difficult to make adjustments to ensure product comparability.

On the contrary, reasonably accurate adjustments can be done to the following aspects (if necessary):

2. Comparability of functions performed, assets used and risks assumed.
3. Comparability of cost base (or a method to compute cost).
4. The impact of accounting practices.

Often it is difficult to ensure comparability when using information from the financial statements of independent companies, so this method is used if the taxpayer has its own comparable transactions (internal comparables).

So, while applying the CPM, the following questions should be answered:

• Are the contractual terms identical / comparable (e.g. volumes and delivery terms)?
• Do companies perform comparable functions, take comparable risks and use comparable assets (intangible assets) in transactions?
• Are the cost principles described in the accounting policies applied by the related party and potentially comparable independent companies the same?

Transactional profit methods

As can be seen from the above, the traditional transaction methods are quite demanding in application, therefore more frequently transactional profit methods (namely, TNMM) are used.

TNMM analyzes profitability at the operating profit level, which is less affected by differences in transaction terms and more resistant to minor functional differences between controlled and market transactions compared to the gross profitability used under the RPM and CPM.

The TNMM allows estimating the market price level through the ratio of operating profit on the transaction to the selected benchmark indicator. While applying the TNMM, a profit level indicator (PLI) should be selected to determine the profitability of the controlled transaction. A PLI expresses profitability in relation to an appropriate base such as:

• sales,
• costs or expenses, or
• assets.

The choice of PLI depends on the nature of controlled transaction and the tested party selected. The tested party is a party to the controlled transaction that performs fewer functions, bears less risk, and does not own significant assets (including intangible assets). Its profitability is compared to the market range of profitability of companies carrying out comparable activities. Depending on the nature of controlled transaction and the role of the tested party in it, one of the following PLIs can be chosen:

Profit Split method (PS method) consists in comparing the actual allocation between the parties to a controlled transaction of the total profit received with the allocation of profit between the parties to comparable market transactions.

PS method is the so called last resort method and has some peculiarities in application.

First, profit distribution is performed based on the assessment of the contribution of the parties to the transaction to the aggregate profit.

Algorithm of application of the PS method is the following:

• Determine the profit to be distributed between the parties to the controlled transaction;
• Distribute this profit as it would be distributed by independent companies in similar conditions (arm’s length principle).

Then, there are two most common approaches in applying the method:

• Contribution analysis approach involves dividing the total operating profit earned by the related parties from a controlled transaction between them based on the relative value of the contributions made by each party to the controlled transaction.

• Residual analysis can be applied when profit received by one party to the controlled transaction can be reliably benchmarked: typically, less complex contributions for which reliable benchmarks can be found (using the TNMM or any other TP method).

  As the next step of the analysis, 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. Such non-routine contributions can include as the unique and valuable contributions or assets, as well as high level of economically significant risks).

  Finally, these contributions should be identified through a functional analysis of each party to the transaction.

The PS method, as all TP methods has its specifics in application:

• It is rarely used because it is difficult to find comparable companies and financial information necessary for analysis.
• It is necessary to bring the financial data of the parties involved to unified accounting standards.
• The analysis is usually based on forecasted rather than actual financial data.
• It is necessary to analyze financial information of both parties to the controlled transaction.
• On the one hand, it may be necessary to defend the chosen approach in disputes with tax authorities, but on the other – sometimes allows for a faster agreement with the tax authorities.

Conclusion

It is important to consider, that each of the abovementioned methods has its own peculiarity. Furthermore, these peculiarities consist in their application, as well as depend on local regulation specifics.

Therefore, before preparing TP documentation or even planning transfer pricing for the company, it is important to reconcile the methodology between two counterparties to the transaction.