Multinational companies operate across borders and often trade within their own group. Without proper rules, these companies/groups would be tempted to shift their profits to low-tax countries, leaving their other group companies with unfairly low revenues. This could spark tensions between businesses and jurisdictional tax authorities and could also lead to double taxation disputes.
To reduce such conflicts, the Organization for Economic Co-operation and Development (OECD) issued guidelines on transfer pricing (TP). These guidelines help countries like the UAE apply fair pricing rules, vis-à-vis cross-border related party transactions, such that the profits are taxed where the real economic activity takes place.
Tax Gian helps UAE businesses understand local as well as global TP regulations, and our TP agents in the UAE help businesses stay in line with the laws and ensure compliance.
What Are the OECD Guidelines?
Essentially, the OECD guidelines provide guidance on issues related to transfer pricing. As such, the subject of transfer pricing concerns the prices that are charged between related companies belonging to the same multinational group. The guidelines aim to ensure that these internal prices are always fair and also reflect the market realities.
Although not legally binding, they are widely adhered by all. Many countries use them when drafting their own tax laws. They also influence international tax treaties and serve as a guide for resolving disputes with and between tax authorities.
The Arm’s Length Principle
At the heart of the OECD guidelines is the term “arm’s length principle”. According to this concept, while doing business transactions, related companies must treat each other as if they were independent. In simple words, the price charged in a controlled transaction should be the same as the price that would be charged between unrelated businesses under similar conditions.
The goal is to stop artificial pricing that attempts to shift profits to low-tax countries. It also ensures that taxation reflects genuine business activity, not just financial arrangements on paper.
Are you confused about the concept of arm’s length? Ask our expert TP agents in Dubai for a better understanding.
How Comparability Works
To apply the arm’s length principle, tax authorities have to check whether the price of a controlled transaction matches the price in a comparable uncontrolled transaction.
This usually involves two steps:
- Identify relationships and conditions: First, authorities look at the commercial and financial ties between the related companies and the conditions of the transaction.
- Compare with independent transactions: Next, they check if similar transactions exist between unrelated parties and whether the conditions match.
This process is known as “comparability analysis”. If the price charged between the related-party transaction differs with that of the price of the comparable, derived through an exercise using statistical analysis, the same would need to be adjusted, so as to reflect the correct market price.
Transfer Pricing Methods
The OECD guidelines outline five primary methods for setting or checking transfer prices. Each method is chosen depending on the nature of the transaction and available information.
- Comparable Uncontrolled Price Method (CUP): Compares the price of a related-party transaction with the price of a similar transaction entered into between independent parties.
- Resale Price Method (RPM): Starts with the price at which a product is resold to an independent customer, then subtracts an appropriate margin.
- Cost Plus Method (CPM): Adds a suitable profit margin to the costs incurred by the supplier.
- Transactional Net Margin Method (TNMM): Examines the net profit relative to sales, costs, or assets that a taxpayer earns in a related-party transaction.
- Transactional Profit Split Method (TPSM): Divides the combined profits from a transaction between the related parties based on their actual contributions.
If none of these methods fit the above situation, the business may use any other method, but the outcome must be able to successfully demonstrate that the chosen approach reflects an arm’s length result.
You can also take help from TP agents in Dubai if you are unsure about the use of TP methods.
Key Factors in Comparability
When deciding whether a transaction meets the arm’s length principles, the OECD guidelines suggest looking at five distinct factors:
- Contract terms: What the written agreements say.
- Transaction features: The nature of the goods, services, or intangibles involved.
- Economic circumstances: The markets and conditions in which the transaction takes place.
- Functions, assets, and risks: What each party does, what resources they use, and what risks they take.
- Business strategies: The long-term plans and approaches of the parties involved.
These factors help ensure that the transfer prices reflect real economic activities.
Example of the Arm’s Length Principle
Imagine Company A in the UAE pays hotel bills for employees of its sister company, Company B, during a visit. Company A later asks Company B to reimburse the exact amount of the hotel bills, without adding any profit margin. Since Company A has added no value beyond paying the hotel bills, the transaction matches the arm’s length principle. Hence, no extra mark-up would be required in this situation.
Why the OECD Guidelines Matter
The guidelines play an important role in reducing tax disputes and building trust between businesses and governments. By promoting the arm’s length principle, they prevent businesses from unfairly lowering taxes and also give countries more certainty vis-à-vis taxing of their profits.
For multinational groups, the guidelines provide clarity on how to structure internal transactions. For governments, they act as a reference point for fair taxation. Although not legally binding, their broad acceptance makes the OECD guidelines a global standard.
How can Tax Gian help?
Tax Gian is equipped with professional TP agents in the UAE, who are seasoned in local and global business standards and have years of experience in helping businesses with tax matters. Understand TP regulations better with the help of our experts at Tax Gian, who are always at hand to assist you.
