Introduction
The Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses has significantly altered the tax landscape for companies operating in the United Arab Emirates (UAE). This legislation not only introduces corporate tax regulations but also enforces transfer pricing in alignment with international standards, particularly those of the Organization for Economic Cooperation and Development (OECD), marking the first instance of such requirements in the UAE.
Article 36: Criteria for Deducting Payments to Connected Persons
Article 36 of the Corporate Tax Law specifies the conditions under which payments to connected persons can be deducted. The key requirements for these deductions are:
1. Arm’s Length Test: Remuneration must be determined as if the transaction occurred between independent entities.
2. Wholly and Exclusively Test: Payments must be incurred solely and entirely for business purposes.
A “Connected Person” is defined by the UAE Corporate Tax Law as an individual who is an owner, director, or officer of a taxable entity, or a related party to any of these individuals.
Interaction with General Deduction Rules
Article 36 operates alongside the general deduction rules outlined in Article 28. This means that even if a payment meets the criteria under Article 36, it may still be disallowed under Article 28 if it is not incurred for business purposes or is capital in nature. Thus, the arm’s length pricing principle alone is not enough; there must be a legitimate business need for the expense, and it must comply with the broader deductibility rules.
Proper documentation and proactive measures are essential to support the deductibility of these payments. Establishing and recording the business rationale, necessity, and compliance with both specific and general deduction rules will strengthen the case for deductibility under UAE Corporate Tax Law.
Arm’s Length Analysis
The arm’s length principle ensures that payments to connected persons are made as if the transactions were conducted between unrelated parties. To substantiate that managerial remuneration aligns with the arm’s length principle, it is crucial to perform comparability analyses. This involves detailed documentation considering factors such as functions performed, risks assumed, and the economic conditions of the entities involved. By adhering to these practices, businesses can demonstrate compliance with transfer pricing regulations and justify the deductibility of such payments as per Article 36.
Managerial remuneration refers to the compensation and benefits provided to individuals in managerial positions within an organization, such as owners (with ownership interest or control), directors, or officers. This remuneration typically includes salaries, bonuses, stock options, and other perks related to their role in overseeing and directing business operations. Due to their close association, their compensation is categorized as payments to connected persons, necessitating analysis to ensure these transactions adhere to arm’s length principles and comply with regulatory standards like those outlined in Article 36 of the UAE Corporate Tax Law.
Functional Analysis
When benchmarking managerial remuneration, it is essential to start with a functional analysis, one of the key comparability factors in transfer pricing. This step assesses the roles and responsibilities involved in the transaction. Functional analysis is vital for understanding the value contributions of the management roles, especially in the UAE’s dynamic and diverse business environment.
To enhance the functional analysis, businesses should adopt a holistic approach such as the “triangle analysis.” This approach delves deeper into three pivotal aspects that support the comparability analysis:
1. The Individual: Focuses on the management’s professional attributes, including their skills, experience, and qualifications. Important factors to consider include the individual’s educational background, years of relevant experience, specialized knowledge, and the market demand for professionals with similar profiles.
2. The Role: Assesses the scope of the managerial role within the organization. This includes examining the job title, breadth of responsibilities, level of decision-making authority, and key performance indicators. Understanding these aspects is crucial for evaluating the significance and impact of the role on business operations.
By integrating these elements, businesses can ensure that their managerial remuneration is in line with arm’s length principles, thereby supporting compliance with the UAE Corporate Tax Law.
Arm’s Length Analysis
The arm’s length principle ensures that payments to connected persons are conducted as if the transaction occurred between unrelated parties. To substantiate that managerial remuneration aligns with this principle, it is essential to perform comparability analyses. This involves detailed documentation of factors such as functions performed, risks assumed, and economic conditions. Adhering to these practices allows businesses to demonstrate compliance with transfer pricing regulations and justify the deductibility of such payments under Article 36.
Managerial remuneration refers to the compensation and benefits provided to individuals in managerial positions within an organization, such as owners, directors, or officers. This typically includes salaries, bonuses, stock options, and other perks related to their roles in overseeing and directing business operations. Due to their close association with the company, their compensation is categorized as payments to connected persons, necessitating analysis to ensure these transactions adhere to arm’s length principles and comply with regulatory standards outlined in Article 36 of the UAE Corporate Tax Law.
Functional Analysis
When benchmarking managerial remuneration, it is crucial to begin with a functional analysis, a key comparability factor in transfer pricing. This step assesses the roles and responsibilities involved in the transaction, providing a clear understanding of the value contributions of the management roles, particularly in the UAE’s dynamic business environment.
To enhance the functional analysis, businesses should adopt a holistic approach such as the “triangle analysis,” which focuses on three pivotal aspects:
1. The Individual: This focuses on the professional attributes of the management, including skills, experience, and qualifications. Important factors include the individual’s educational background, years of relevant experience, specialized knowledge, and market demand for professionals with similar profiles.
2. The Role: This assesses the scope of the managerial role within the organization, including the job title, breadth of responsibilities, level of decision-making authority, and key performance indicators. Understanding these aspects is crucial for evaluating the role’s significance and impact on business operations.
3. The Company: This looks at the organizational context in which the managerial person operates. Considerations include the company’s size, complexity, industry sector, financial performance, stage of development, and geographic footprint. These factors help contextualize the managerial role within the broader corporate structure and industry norms.
By employing triangle analysis, businesses can ensure thorough documentation and justification of managerial remuneration. This comprehensive approach aligns with transfer pricing principles and supports the selection and application of the most appropriate transfer pricing method, ensuring that comparability analyses meet the stringent requirements of the arm’s length principle.
Selecting the Appropriate Transfer Pricing Method
UAE transfer pricing regulations require businesses to select and apply one of the prescribed methods to substantiate the arm’s length nature of transactions. The recognized methods are:
1. Comparable Uncontrolled Price (CUP) Method
2. Resale Price Method (RPM)
3. Cost Plus Method (CPM)
4. Transactional Net Margin Method (TNMM)
5. Profit Split Method (PSM)
6. Any Other Method
Based on the nature of the roles and responsibilities of the managerial personnel and the availability of data, the following mechanisms can determine the arm’s length price:
CUP Method
For scenarios where direct comparables exist, the CUP method is the most straightforward and reliable approach. This requires detailed documentation of the roles and responsibilities of the managerial position to ensure comparables are truly alike.
Internal CUP: This involves comparing the remuneration of connected persons to that of non-connected persons performing similar functions within the same organization. For example, ABC Company LLC, owned by Mr. A, who also serves as the Managing Director, can use the remuneration of Ms. Fatima, a General Manager not related to the shareholder, as an internal reference to demonstrate that Mr. A’s remuneration is in line with what an unrelated party would receive for similar functions.
Transactional Net Margin Method (TNMM)
This method compares the net profitability of the company to that of comparable companies, ensuring that the company’s profit remains at arm’s length even after managerial remuneration payments. This helps demonstrate that the remuneration is justified based on the economic value and business contributions of the managerial role.
Even when using the CUP method, corroborative analysis with another method such as the TNMM is beneficial. This dual-method analysis reinforces the reliability of the findings and provides a safeguard against regulatory scrutiny by demonstrating thorough due diligence. In the absence of direct comparables, businesses should rely on the TNMM or other methods, documenting the economic circumstances and industry-specific insights gathered through triangle analysis.
Other Method
Article 34(4) of the Corporate Tax Law allows for the use of methods other than the five recognized transfer pricing methods if they cannot be reasonably or reliably applied, provided these methods satisfy the arm’s length principle. In cases where no direct comparable data exist and the TNMM is not appropriate, the following methods can be considered:
1. Industry Salary Bands: HR departments establish salary bands based on industry standards and market data, providing a range of acceptable remuneration for specific roles. Companies should identify the appropriate salary band for the connected person’s role, compare their remuneration to the band, and document any deviations.
2. External Published Data: Companies can leverage published data on remuneration trends and benchmarks from sources such as salary surveys, paid databases, and research reports. The data used should be relevant, reliable, and comparable to the connected person’s role.
3. Commission Agreements: In industries where commission-based remuneration is common, companies can analyze commission rates in similar third-party agreements to benchmark connected persons’ remuneration. This involves identifying comparable agreements, analyzing the rates and structures, and comparing them to the connected person’s arrangement.
4. Service Agreements: When connected persons provide services, their remuneration can be benchmarked against fees charged by third-party consultants or service providers. This requires identifying comparable agreements, analyzing fee structures and rates, and comparing them to the connected person’s remuneration while documenting justifications for any deviations.
By utilizing these methods, businesses can develop a robust and comprehensive benchmarking approach, ensuring that managerial remuneration adheres to the arm’s length principle and complies with regulatory standards.
Arm’s Length Analysis Based on Economic Circumstances (Other Method)
While traditional benchmarking sources offer valuable reference points, they may sometimes lack the specificity needed to capture the unique characteristics of particular managerial roles. Sole reliance on generic market data may not suffice to meet the arm’s length test, especially within the dynamic and diverse business landscape of the UAE. To address these limitations, businesses should adopt a more holistic approach to benchmarking managerial remuneration.
The OECD Transfer Pricing Guidelines acknowledge the challenges in finding exact comparables. Paragraph 1.33 states that the absence of closely corresponding uncontrolled transactions does not invalidate a comparability analysis. Paragraph 1.35 further emphasizes flexibility by suggesting that transactions should be evaluated based on the economic circumstances and conditions of the entities involved rather than insisting on identical comparables.
By conducting a “triangle analysis,” which examines the functions performed, risks assumed, and economic circumstances, companies can demonstrate that the terms and pricing of the transaction are consistent with what would be expected in an arm’s length scenario. This comprehensive approach ensures robust documentation and justification of managerial remuneration, aligning with the OECD’s guidance on comparability analysis and the application of the arm’s length principle.
Addressing Specific Scenarios
While the principles of arm’s length remuneration apply broadly, certain specific scenarios and challenges may arise when benchmarking managerial remuneration:
1. Loss-Making Companies
2. Early-Stage Companies
3. Dual Roles and Split Employment Arrangements
Loss-Making Companies
In the context of loss-making companies, justifying managerial remuneration can be particularly challenging. Tax authorities may question the commercial rationale for significant managerial remuneration when the company is not generating profits. To address this, businesses should develop robust documentation and commercial justification for the remuneration, considering factors such as:
- Reasons for the company’s losses (e.g., market conditions, business cyclicality, strategic investments)
- The company’s stage of development and expected future profitability
- Industry dynamics and competitive landscape
- Specific roles and contributions of the managers
- The impact of competitive remuneration on attracting and retaining key talent
The objective is to demonstrate that the managerial remuneration aligns with the company’s commercial needs and market realities, despite its loss-making position. A well-reasoned and documented analysis can mitigate the risk of the Federal Tax Authority (FTA) disallowing the deductibility of the remuneration.
Early-Stage Companies
Early-stage companies, particularly startups, often face challenges in justifying managerial remuneration due to limited financial resources and a lack of proven track record. These companies may offer equity-based compensation or other non-cash benefits to attract and retain key talent. When benchmarking managerial remuneration for early-stage companies, businesses should focus on the potential future value creation by managers and their critical role in driving the company’s growth. Factors to consider include:
- Managers’ unique skills, experience, and industry expertise
- Competitive landscape for talent in the relevant sector
- Potential market opportunity and growth prospects
Emphasizing the strategic importance of managerial roles and their potential future value helps build a stronger case for the arm’s length nature of remuneration, even in the absence of current profitability.
Dual Roles and Split Employment Arrangements
In cases where managers hold dual roles or have split employment arrangements between related entities, it is crucial to ensure that managerial remuneration is properly allocated based on the actual services provided to each entity. The benchmarking analysis should consider:
- Specific responsibilities and time commitment for each role
- Value creation and benefit derived by each entity from the manager’s services
- Arm’s length remuneration levels for similar roles in each jurisdiction
- Allocation methodology and rationale for splitting remuneration between entities
Clear documentation of the allocation approach and underlying economic substance is essential to support the arm’s length nature of the remuneration. Consistency with transfer pricing policies and documentation maintained by related entities in other jurisdictions is necessary to avoid potential double taxation or disputes with foreign tax authorities.
Conclusion
Determining the arm’s length pricing of managerial remuneration under UAE transfer pricing regulations requires a comprehensive approach. Applying the dual tests set out in Article 36 of the Corporate Tax Law necessitates an analysis based on roles and responsibilities, as well as the availability of comparable data. Transfer pricing is not an exact science; therefore, conclusions about the arm’s length nature of managerial remuneration should be based on relevant data and economic circumstances.
A well-documented approach that balances arm’s length pricing with the substance of the transaction can help taxpayers justify the arm’s length nature of transactions before tax authorities. By adopting a proactive and comprehensive approach to benchmarking managerial remuneration, businesses can mitigate transfer pricing risks in the evolving landscape of transfer pricing in the UAE.
This article is for informational purposes only and represents the author’s personal views. It should not be construed as legal or professional advice.
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