As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

Pillar One – Amount B

Final report issued by OECD / Inclusive Framework

21 February 2024

Summary

The Organisation for Economic Co-operation and Development (OECD) / G20 Inclusive Framework (IF) issued the report on simplified and streamlined approach, earlier referred to as Amount B, on 19 February 2024. This report, which was an outcome of the two Pillar solution, will now form part of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TP Guidelines) – Chapter IV.

The report is largely on the lines of the public consultation document issued in July 2023 and includes additional guidance for operation of the simplified and streamlined approach (‘the approach’). It is optional for Jurisdictions to consider this approach. When adopted in their respective tax regime, it can either be elective – in the nature of a Safe Harbour or prescriptive – mandatory for taxpayers and tax authority to follow the approach for in scope transactions. The approach cannot be considered as the basis to interpret the application of the remainder of the TP Guidelines.

Election of the approach by a jurisdiction cannot be binding on counterparty jurisdiction where the approach has not been adopted. The IF members commit to respect the outcome where the approach has been adopted by a Low-capacity jurisdiction (LCJ) and relieve potential double taxation arising due to adoption of the approach. IF explicitly caveats that the arm’s length consideration under this approach does not represent a ‘floor’ or ‘ceiling’ for the distribution activities in other cases. IF is working on an additional optional qualitative scope to apply as an additional step to identify baseline distribution activities, which it expects to conclude by March 2024. The IF will agree on the list of LCJ by March 2024. Jurisdictions can apply / implement the approach for fiscal years commencing on or after Jan 2025.

India has made reservations in areas pending finalization such as inclusion of definition of LCJ, political commitment on the approach. India has also made critical reservations to support the approach in the absence of additional qualitative criterion being incorporated in the scoping criteria.

This alert discusses in detail the report on the approach in the ensuing sections.

Qualitying and In Scope Transactions

The Approach is applicable to wholesale distributors, sales agents, and commissionaires involved in the sale of goods, excluding distribution of digital goods, commodities and digital services. Where distributors undertake both wholesale and retail distribution, retail sales should not exceed 20% of the total annual net sales.

Distributors (tested parties) that meet qualifying transactions definition and scoping criteria are eligible under the approach.

Qualifying Transactions

The qualifying transactions under the approach are as follows:

Scoping Criteria

In-Scope

Qualifying transactions will be ‘In-scope’ if:

1. They can be reliably priced using one-sided transfer pricing method, with the distributors, sales agents or commissionaire being the tested party and the most reliable method for pricing distribution activity should be Transactional Net Margin (TNMM). Exception being where there is availability of reliable internal comparables for the in-scope transactions and comparable uncontrolled price (CUP) method can be adopted as the most appropriate method.
2. Annual operating expenses/Net sales of the tested party is not lower than 3% or greater than the band between 20% to 30%. Jurisdictions can select any point between 20% to 30% while applying the approach in their tax laws. The three-year weighted average ratio is considered while computing the said ratio. The ratio for Year ‘y’ would be computed based on three-year data prior to the year under consideration:

Out of Scope

Qualifying transactions will be ‘Out-scope’ if:

1. They are involved in distribution of non-tangible goods, services or commodities.

Commodities may be – renewable / non-renewable physical products primarily derived from earth’s crust, land or water (Examples include hydrocarbon, mineral, mineraloid and agricultural product), renewable or non-renewable physical product that has undergone qualifying processing.

2. Tested party undertakes non-distribution activities in addition to qualifying transactions and where either the non-distribution activities and qualifying transactions cannot be evaluated on a separate basis or cannot be reliably priced separately.

Non-distribution activities include manufacturing, R&D, procurement, financing or retail distribution. The guidance in TP Guidelines are to be referred for allocation of income, expenses and assets and liabilities between distribution and non-distribution segment – Chapter II (TP methods) and VII (intragroup services).

Arm’s length consideration

Arm’s length price under the approach is captured through ‘Pricing Matrix’. The arm’s length price ranges in the pricing matrix will be updated once in 5 years, unless in case of significant change in market conditions, where interim updates will be provided. In addition, operating expenses cross-check guardrail and net risk adjustment will have to be factored in for the qualifying jurisdictions.

Pricing Matrix

Pricing Matrix is a translation of arm’s length results which is determined from global datasets in a matrix form. Segments of this matrix are Operating asset to sales intensity (OAS), operating expense to sales intensity (OES) and industry. Factory intensity i.e., OAS and OES should be computed using three-year weighted average viz., three years prior to the year under consideration. Industry grouping is as follows:

• Group 1: Perishable foods, Grocery, household consumables, construction materials and supplies, plumbing supplies and metal.
• Group 2 –IT hardware and components, electrical components and consumables, animal feeds, agricultural supplies, alcohol and tobacco, pet foods, clothing and apparel, textiles, hides, furs, jewellery, plastics and chemicals, consumer electronics and products and components not listed in group 1 and 3.
• Group 3 – medical machinery, industrial machinery including industrial and agricultural vehicles, industrial tools, industrial components miscellaneous supplies.

In determining the arm’s length return for the tested party involved in qualifying in-scope transactions a three-step process will have to be followed.

• Firstly, determine the industry grouping. Where more than one industry group exists the weighted average return for the 2 or 3 groupings should be considered. If one of the grouping has greater than 80% sales into a single group, then this industry group should be considered for the entire distribution activities.
• Secondly, determine relevant factor intensity classification of the tested party. There are 5 classifications provided viz., A,B,C,D and E. Accounts payable guardrail will have to be considered i.e., the accounts payable will have to restated to 90 days credit period, for the purpose of this approach, where the payable days is greater than 90 days.
• Thirdly, identify the arm’s length price viz., return on sales %, that corresponds to the intersection of relevant parameters

The pricing matrix derived from the global dataset, as per the document, is as follows:

Net operating assets for this purpose is tangible assets (property, plant, and equipment net of accumulated depreciation, land and net capital leases) and intangible fixed assets (include all intangible fixed assets, net of accumulated amortisation, but excluding goodwill) plus working capital (stock plus debtors less creditors).

Net expenses are total costs excluding cost of goods sold, pass-through costs and costs related to financing, investment activities or income taxes. It should not include any exceptional items that are unrelated to recurring business. Expenses should be quantified as per the applicable accounting standards (i.e., accounting standards permitted in the tested party’s jurisdiction).

For net operating assets and operating expenses, the three-year average i.e., three years prior to relevant year, has to be considered for this computation.

In determining whether the qualifying in-scope transactions are at arm’s length, the tested party margins should be within the range. If the tested party margins are outside the range, adjustment would be made to bring it to the range.

Operating expense cross-check

A guardrail in the form of operating expenses cross-check, through a cap-and-collar, has been included. For qualifying jurisdictions, the guardrail has been extended. Subsequent to arriving at arm’s length consideration as per pricing matrix, the return on operating expense is computed for the tested party. This return is mapped with the prescribed operating expense cap-and-collar range:

Where the tested party’s return on operating expense is outside the range, the return on sales will have to be adjusted until the above return on operating expense reaches cap or collar, as the case maybe.

Country Risk adjustment

Certain jurisdictions have been observed to not have sufficient or to have no data points in the global dataset. For these qualifying jurisdictions, a net risk adjustment is to be applied after the application of the aforementioned steps. Adjusted return on sales is arrived by:

ROS™ + (NRA¹ * OAST) where ROS™ is the return on sales of tested party computed after pricing matrix and operating expenses cap-and-collar, NRA¹ is the net risk adjustment percentage with reference to the sovereign credit rating of the jurisdiction of the tested party and OAST² is the operating asset to sales intensity of the tested party for the relevant period and should not exceed 85% for computing the adjusted return on sales.

The list of qualifying jurisdictions for operating expenses cap-an-collar and country risk adjustment will be published on the OECD website and periodically updated.

Other Aspects

• Documentation: Local file of the distributor opting under the approach should include accurate delineation and detailed functional analysis of the qualified in-scope transactions, calculations and workings to align with pricing approach, etc. Taxpayers and tax administration can also leverage information in Master File to support their position. Once the taxpayer decides to opt under the approach for the first time, it needs to notify the local tax authorities and may need to continue to apply the approach for minimum three years.
• Transitional Issues: MNEs may restructure the entities either to opt-in or opt-out from the approach, evaluating its pros and cons. When doing so, the tax authorities have the right to analyse such reorganization in light of OECD guidelines (Chapter IX – Restructuring).
• Tax certainty: Taxpayer invoking MAP (mutual agreement procedure) cases should rely on rest of the OECD Guidelines where the relevant jurisdiction has not adopted the approach. Where primary adjustment is on the premise of application of pricing approach by one of the jurisdiction and the counterparty jurisdiction has not adopted the approach, the issue should be resolved by the competent authorities in light of the guidance in the rest of the OECD Guidelines and request for corresponding adjustment also should be evaluated. Instances where APA or MAP cases have already been settled prior to the adoption of the pricing approach, the agreed terms and conditions to prevail for the covered years. This will ensure uncertainty is not created owing to pricing approach, which is against the premise of the approach.

India

Several reservations were made by India in the report on the simplified and streamlined approach.

• Qualitative criterion: India opined that a critical aspect to determine baseline activities is having qualitative criteria. Since the existing report did not include these criteria, India conveyed its inability to support the approach if the same was not included.
• LCJ: As LCJ was not defined / listed, India expressed its reservation in any political commitment unless the definition of LCJ is agreed by the IF.
• Pricing Methodology: In connection with pricing of baseline activities, reservations by India included exclusion of goodwill from the definition of intangible fixed assets, no requirement of variation band of +/-0/5% to the operating margin in the pricing matrix, use of single commercial database and hence the dataset not being geographically representative, appropriateness of filtering criteria and factor used in the matrix and their categorisation.
• Operating expenses cross-check: India is of the view that value created by a distributor is more of a function of sales generated than the operating expenses incurred, and therefore made its reservation. This can be viewed parallel to stand of India to factor in demand side rather than just the supply side. Further, considering that low-income countries would having lower operating costs, as compared to high income countries and hence India argued operating expenses cross-check would not principally meet its objective.
• Qualifying Jurisdiction: India made its objection to non-inclusion of definition of qualifying jurisdiction w.r.t. operating expenses cross-check and country risk adjustment.
• Framework development: IF is to gather information on practical application of the approach after a period of time. India made a reservation as no details w.r.t. framework has been provided, and the exercise being resource intensive and in light of capacity constrained jurisdictions.

In light of the reservations / objections made, the adoption of the simplified and streamlined approach in the Indian tax laws will have to be awaited. Further points for consideration with regard to adoption of the approach in India Tax laws include current stance of Indian tax authorities to treatment of incurring of ‘excessive’ AMP/marketing intangible and its preference on use of local database / selection of local comparable companies.

Conclusion and Key Takeaways

The publication of the final report on the simplified and streamlined approach is itself a milestone considering complexity and multi-dimensionality of the topic. Incorporating the approach in the OECD guidelines, post the demerger from the two-pillar approach (referred as ‘erstwhile Amount B’) is in alignment with its spirit of effecting administrative procedures aimed to minimize transfer pricing dispute. The approach will become an elective safe harbor w.r.t. the OECD Guidelines, similar to low value adding activities, and thereby providing jurisdictions to decide implementation in their respective tax / transfer pricing regime.

The approach provides a right tool to MNE facing protracted litigation on baseline distribution activities and in applicable cases businesses can be expected to reorganize their structure (including demerger / hive-off) to insulate on transfer pricing disputes. Reorganization should be undertaken optimally as the provisions on restructuring (OECD TP Guidelines – Chapter IX) will be carefully analyzed by the tax authorities.

Considering the quantitative thresholds for applicability adopts data of the previous three years – instead of the relevant / current year, MNEs can be well prepared whether they would be in scope for the relevant year, upfront contemporaneously

One needs to be aware of that no economic adjustments will be available for the tested party distributor while opting for the approach. Further to the returns in the pricing matrix, the other adjustments such as operating expenses cap-and-collar, accounts payable guardrail and country risk adjustment will have an impact on the expected returns

The continuum of the success of the simplified and streamlined approach will depend on the wide adoption of this ‘safe harbour’ by the jurisdictions. Though the quantitative benefits accruing to tax administrations have largely not been arrived at, unlike the two-pillar solution, jurisdictions can be expected to implement the approach as the report issued is post the consensus of the Inclusive framework(exception of India). This may find favour with jurisdictions having marked ‘limited capacity’ with high litigation on baseline distribution activities for implementation in their local tax / transfer pricing laws. Jurisdictions with emerging tax reforms / introduction of tax regime may also consider adoption of the approach.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

Kingdom of Saudi Arabia (KSA)

Transfer Pricing Updates

February 2024

Introduction

As we step into 2024, this alert provides an overview of the recent transfer pricing updates which may be relevant for taxpayers in Kingdom of Saudi Arabia (KSA) starting 2024.

The First one is the applicability of transfer pricing provisions to Zakat payers from 1 January 2024 and the second one focuses on the specific incentives provided for companies having their regional headquarters in KSA with a focus on what relevant parameters should one have in mind for such RHQ companies from a transfer pricing side.

A. TP for Zakat Payers

The Zakat, Tax and Customs Authority, “ZATCA” has issued a guideline on treatment of Zakat Transactions with related parties for Taxpayers maintaining statutory accounts. This guideline comes in pursuance to ZATCA’s amendment of the Transfer Pricing Provisions, in April 2023, widening its ambit to cover Zakat payers effective from Financial Year commencing on or after January 1, 2024.

The objective of this guideline is to reduce the disputes and disagreements between the Zakat Taxpayers and ZATCA regarding Zakat treatment of the transactions. With this intent, ZATCA has analysed and categorized the key related party transactions and has detailed the treatment of such transaction for computing the Zakat base.

1. Related Parties for Zakat Transactions

• Related parties (RP) for the purposes of Zakat Transactions is defined to include natural or legal person who are related as per
  • Accounting standards; or
  • Transaction Pricing Instructions and their subsequent amendments

2. RP Transactions and Treatment

• The guideline classifies the zakat transactions between related parties into three types namely:
  • Commercial Transaction
  • Indirect Financing
  • Direct Financing
  • Zakat Treatment of Related Party Transactions

• Commercial Transactions
  • Refers to sale of goods and provision of services
  • Transaction value should meet arm’s length criteria for computation of zakat base else necessary adjustments need to be made

• Indirect Financing
  • Refers to transactions where costs or expenses are borne by related parties on behalf of taxpayer.
  • These do not affect the income statement of the Taxpayers and hence no adjustment required.
  • However where this is treated as a liability in the financial statements, then it shall be considered as debt for Zakat treatment.

• Direct Financing
  • Usually takes the form of
    • Working Capital
    • Long term shareholder’s financing
    • Shareholders cash asset financing
    • Shareholder’s in kind financing

• Related Party loans which are long term are normally treated as debt and added to the Zakat Base within the limits of the deducted assets.
• Loans which are short term and are used to finance deducted assets are added to Zakat base unlike those that do not finance deducted assets are not added to zakat base.
• If the essence of the financing transaction is free of debt, then it shall be treated as equity and added to the internal source of funds.
• Owners/ Shareholders loans to individual establishments and one person companies treated as equity irrespective of their treatment in the financial statements and added to Zakat base without capping limits.
• Thus any financing arrangement with related parties, where the nature and terms of arrangement does not comply with the arm’ length principle, can be re-characterised and treated accordingly.

• Compensation paid to Members of the Board of Directors and Partner’s salary
  • Compensation to members of the Board of Directors are allowed as deduction while determining the tax base.
  • The Salaries and allowances to Partner/ Owner is fully deductible only if there is a legal employment contract, registration with general organisation for social insurance(GOSI) is complete and the provision of wage protection system applies.

• Further the transaction pricing guidelines now require these rewards and compensation to be at arm’s length to be fully deductible.
• The ZATCA can at any time request for additional information to verify that the salaries and allowances provided to Owners/ Partners are rational and meet arm’s length.

• Assets recorded in Zakat Payers Financial Statements but Registered in the name of the Partner/ Owner
  • Allowed as deduction not exceeding their source of funding added to zakat base provided such asset is:
    • Used in company’s activity
    • It constitutes in-kind share in the capital
    • There is an obstacle preventing transfer of ownership of asset to the company

• Other Points for consideration
  • Related Parties debit and credit arising from different financial and commercial transactions not allowed to be offset, unless done as per accounting standards.

The below chart summarizes the related party transactions and its treatment

Way forward

The Transaction Pricing guidelines brings indirectly all Zakat related party transactions within the ambit of Transfer Pricing. Hence it becomes imperative for Zakat Taxpayers to assess existing and proposed related party transactions to ensure that they adhere to the arm’s length principle along with satisfying the required compliance of local file and Masterfile subject to the thresholds.

B. Regional Headquarters

The Ministry of Investment of Saudi Arabia (MISA), in coordination with Ministry of Finance and ZATCA announced on December 05, 2023, a 30 year tax incentive package for “The Regional Headquarters Program”, as a further stimuli for multinational companies to establish their RHQ in Saudi Arabia.

The Qualified RHQ’s will be subject to:

• Zero percent (0%) Corporate tax and withholding taxes for a period of 30 years
• 10 year exemption from Saudization requirements which demand a specific percentage of Saudi nationals in a company’s workforce
• Issue of unlimited number of visas for RHQ employees.
• Ajeer program (to work and apply for jobs) for dependents of RHQ employees
• Exemption from professional accreditation requirements in KSA, if the RHQ employees are duly accredited in their country.

The Saudi Ministry of Finance has issued conditions that limit Saudi Government Agencies to undertake business with MNC’s that do not have RHQ in Saudi Arabia and has placed further regulations curtailing allotment of government projects except in exceptional circumstance to such MNC’s.

The guidance has issued the list of mandatory activities that are to be carried out by a RHQ and also optional activities that can be carried out by RHQ, which are highlighted in the below table¹.

Impact on TP

MISA has clarified that RHQs will be subject to transfer pricing regulations however no specific Transfer Pricing guidelines has been issued to address the applicability of TP provisions to RHQs. Accordingly the prevailing Transfer Pricing Regulations would need to be applied for RHQ transactions as well.

Considering that the program comes into effect from 01 January 2024, and RHQs are subject to TP Regulations, it becomes imperative to ensure that the RHQ earns an arm’s length markup for the services that it renders. Further given that RHQ are required to perform strategic direction and management functions, clear delineation of transactions between shareholders activity and management functions becomes essential and warrants robust documentation including appropriate legal agreements, cost pool workings, demonstrating the “Need Benefit Test”, rationale for adoption of allocation keys for apportionment of common cost in case of management services. Where the RHQ engages in other optional activities, then they need to earn an appropriate arm’s length return for their services commensurate to their functional and risk profile, including consideration of control over risk.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

UAE Corporate Tax

Tax Groups- A Snapshot!

January 2024

Introduction

Recently the Federal Tax Authority (FTA), published yet another comprehensive corporate tax guide encompassing the tax provisions governing “Tax Groups”.

Like the previous guides, this guide also seeks to provide clarity and better understanding of the aforesaid tax provisions, apart from exhibiting numerous examples with an intent to remove ambiguities in applying the said provisions, covering the following topics:

• What is Tax Group?
• Who can form a Tax Group
• Attribution of Income, taxability and compliance obligations of Tax Groups
• Special topics pertaining to treatment of Tax losses, Interest deductions, foreign tax credit and foreign PE’s
• Changes in members of Tax Groups and Cessation of Tax Group

Forming a Tax Group offers several advantages in terms of:

1. Filing of a single tax return by the Parent company of Tax Group on behalf of all members
2. Elimination of income and losses, transfer of assets and liabilities and other transactions between members of the Tax Group
3. Tax Groups are also eligible to opt for Qualifying Group Relief
4. Relief from complying with Transfer Pricing regulations (Arm’s length principle), except in certain cases

However Tax Group do have their share of limitations which also have to be factored while deciding to form a Tax Group.

This alert intends to highlight certain key aspects relating to Tax Groups as brought out in the Guide.

1. What is Tax Group?

• Tax Group can be formed by a Parent Company and one or more subsidiaries.
• The Parent Company and each subsidiary seeking to form a tax group shall make a joint application to the FTA.
• Once approved by the FTA the Parent Company and subsidiaries shall be treated as a single taxable unit.
• Once Tax Group is formed, the Parent Company shall be responsible for :-
• Preparing consolidated financial statements for tax group
• File Tax Return on behalf of the Tax Group (i.e. members of tax group need not file a separate return)
• Settle the corporate tax payable and apply for tax refund on behalf of Tax Group
• Maintain sufficient documents related to financial records, Transfer Pricing documentation and submitting clarifications to FTA.

Tax Group

Who can form a Tax Group?

• Resident Juridical Persons and Free Zone entities are eligible to form a Tax Group.
• Qualified Free Zones, Non Resident Persons and Exempt entities not eligible to form a Tax Group.

Who can form Tax Groups?

Conditions to form a Tax Group

• A parent company and each of the subsidiary companies should meet the eligibility criteria specified above.
• In addition the parent company shall be required to meet all the following conditions to be able to form a tax group, namely:
• Share Capital Ownership Condition
• Holds ≥ 95% of shareholding in each of the subsidiaries either directly or indirectly through one or more of its subsidiaries; and
• Voting Rights Condition
• Owns ≥ 95% of the voting rights in each of the subsidiaries either directly or indirectly through one or more of its subsidiaries; and

• Profits and Net assets condition
• Entitled to ≥ 95% of the each of the subsidiary’s profits and net assets either directly or indirectly through one or more of its subsidiaries: and
• Financial Year Condition
• Parent company and each of the subsidiaries should follow the same financial year
• Accounting Standards condition
• Parent company & each of the subsidiaries should prepare the financial statements using the same accounting standards (i.e. Whether IFRS or IFRS (SMEs)).

Thus if the above conditions are fulfilled the Parent Company and each of its subsidiaries can make a joint application to FTA for forming a Tax Group.

No limit as to number of members in a Tax Group. However an eligible person (Parent company/ Subsidiaries) can only be member in one Tax Group.

For a tax Group to exist, all the above conditions to be met by the Parent company and the subsidiaries.

The Tax Group will cease to exist from the tax period in which such conditions are not met by the Parent company. A Subsidiary not meeting the conditions to be a member of the Tax Group shall cease to be a member from beginning of the tax period in which the conditions are not met.

Conditions to form a Tax Group

Parent Company should be entitled to at least 95% of subsidiaries both profits and net assets.

Newly incorporated entities can join the Tax group from date of incorporation provided it meets the other criteria

Taxable Income of Tax Group

• Tax Group is treated as a single taxable person
• Taxable Income shall be computed by Parent Company after consolidating the financial results, assets and liabilities of all members of the Tax Group.
• All Intra Group Transactions (except for certain exceptions as provided in Article 40), between the members of the Tax Group are eliminated while determining the consolidated financial results of the Tax Group.

Tax Losses

• Tax Losses of a Tax Period can be carried forward to subsequent Tax Periods upon satisfaction of certain conditions specified in Article 39 of the Corporate Tax Law
• A Tax Loss carried forward can be set off against Taxable Income of that period up to 75% of taxable income with any remaining loss available carried forward to subsequent Tax Periods.
• Pre-Grouping Tax losses can only be offset against the Taxable Income of the Tax Group insofar as this income is attributable to the relevant Subsidiary.

Cessation of Tax Group

A Tax Group will cease to exist in the following situations

Key aspects for consideration

1. Liability for Corporate Tax Payable

Members of Tax Group are jointly and severally liable for any corporate tax and administrative penalties due for the Tax Group. Thus even a member of the Tax Group not having taxable income, shall still be liable for any corporate tax dues and administrative penalties.

2. Threshold for determining Corporate Tax rate

• 0% corporate tax rate is limited to AED 375,000 for the Tax Group as a whole and not applied to individual members of the Group which may result in higher tax liability. Consider the following example: – Parent Company, Subsidiary A and Subsidiary B form a Tax Group. Their Taxable income AED 1,500,000, AED 500,000 and AED 300,000 respectively.

However if no tax group is formed, the tax liability will be as follows:

Thus formation of Tax Groups results in an additional tax liability of 60,750 to the members of the Tax Group.

However in scenarios where certain subsidiaries are into losses, Tax Groups may prove to be beneficial as the losses can offset against the Taxable Income of other members of the Tax Group thereby resulting in lower taxable income.

3. Small Business Relief

• Tax Group is considered as a single tax unit and hence all corporate tax thresholds will apply to the consolidated Taxable income of the group and not to individual members.
• Accordingly the limit of AED 3 million for claiming SBR will be applied on the consolidated income of Tax Group.

• Thus even members of the Tax Group having Taxable income less than AED 3 million will not be eligible for SBR if the consolidated revenues of the Tax Group exceeds the said limit.

4. Deduction of Business Expenditure

• Per Article 28 of the Corporate Tax Law, all expenses related to the Taxable person’s business not being a capital expenditure is allowed as deduction in computing the taxable income.
• In case of Tax Groups, all expenditure incurred wholly and exclusively for business of another member of the tax group is deductible.
• No deduction is available if such expenditure is incurred for the purposes of a non group member e.g. foreign parent

5. Application of Arm’s Length Standard

• Transactions between members of the Tax Groups are not required to comply with Transfer Pricing compliances including arm’s length condition except in certain cases where the Tax Group is required to calculate taxable income attributable to one or more members in the following situations:
1. A member of the Tax Group has unutilised pre-Grouping Tax Losses
2. A member of the Tax Group has earned income for which the Tax Group can claim a Foreign Tax Credit.
3. A member of the Tax Group benefits from any Corporate Tax incentives as specified under Article 20(2)(g) of the Corporate Tax Law.
4. A member of the Tax Group has unutilised carried forward pre-Grouping Net Interest Expenditure

Thus only in the above instances the Tax Group will need to comply with the arm’s length principle and related Transfer Pricing compliance regulations.

Way Forward

Whilst the concept of Tax Groups is lucrative and offers several advantages in terms of easing tax compliance and administrative burden for the Group as a whole, the same is not without shortfalls. Hence it is imperative for Businesses to evaluate the relative pros and cons of forming a Tax Group in light of given circumstances and the value addition that it is likely to generate for the business group as a whole before concluding on forming Tax Groups.

3Pre-Grouping Tax Losses are the unutilised Tax Losses of a Subsidiary that joins a Tax Group. Pre Grouping tax
losses can be offset against the taxable income of the Tax Group only to the extent of the income attributable to the
relevant subsidiary.

4Where a member’s foreign source income is subject to corporate tax in UAE, foreign tax credit can be claimed by
deducting taxes paid in foreign jurisdiction to the extent of the taxable income of the said individual member of the
tax group and to that extent it will reduce the corporate tax due of the Tax Group. Any unutilised foreign taxes (if
any) cannot be carried forward or carried back and shall be forfeited.

5Article 20(2)(g) relates to any incentives or special reliefs for a Qualifying Business Activity as specified in a decision
issued by the Cabinet at the suggestion of the Minister.

6Similar to the restriction of pre-Grouping Tax Losses, pre-Grouping Net Interest Expenditure can only be utilised
against the Taxable Income that is attributable to that Subsidiary.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

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Safe Harbour Rules

Amendment in Financial transactions and definition of operating expense / income
December 2023

Summary

The Central Board of Direct Taxes issued Notification No. 104/2023 dated 19 December 2023 to update the Safe Harbour Rules w.r.t. financial transactions and definition of operating income and operating expenses, effective from Financial Year 2023-24 (i.e., Assessment Year 2024-25).

In the notification, the benchmark rate in the Safe Harbour Rules have been transitioned from existing LIBOR to Alternate Reference rates viz., SOFR (USD), EURIBOR (EUR), SONIA (GBP), TORF (Yen), BBSW (AUD) and SORA (SGD). Further, the definition of intra-group loan was substituted to cover advance of loan to any associated enterprise and the loan can be sourced in any currency. Currently the definition covered only loans to wholly owned subsidiaries and loans sourced in INR. The definition of operating income and expense has been parallelly updated to include income / loss on transfer of assets for which depreciation forms part of operating expense. This alert summarizes the updates to the Safe Harbour Rules and the key takeaways / way forward in the following sections.

Financial Transactions

Benchmark rates, Quantum and Credit rating

Benchmark Rates – Transition to Alternate Reference Rates

The key amendment in this notification is the transition from LIBOR as the benchmark rate to Alternate reference rates for the respective currencies as on 30th September of the relevant year. With the phasing out of LIBOR, various legislations have transitioned to alternate reference rates and the same was expected with respect to Safe Harbour Rules as well, which was effected through this notification. While updating the references to alternate rates, the CBDT also increased these reference rate by certain basis points (bps), on a case-to-case basis.

The alternate reference rates currently in this notification has been provided for six currencies viz.:

1. US Dollar: 6-month Term SOFR by Chicago Mercantile Exchange (CME), increased by 45 bps.
2. Euro: 6-month EURIBOR by European Money Markets Institute.
3. GBP: 6-month SONIA by ICE Benchmark Administration/Refinitiv, increased by 30 bps.
4. JPY: 6-month TORF by QUICK Benchmarks Inc, increased by 10 bps.
5. Australian Dollar: 6-month Bank Bill Swap Rates (BBSW) by Australian Securities Exchange.
6. Singapore Dollar: 6-month Compounded SORA by Monetary Authority of Singapore, as increased by 45 bps.

Increase in the quantum of covered transaction

With respect to loans denominated in foreign currency, the consideration for loan advanced to associated enterprise has been split into two categories viz.,

1. Total sum of loans to all associated enterprises as on 31 March of the year not exceeding INR 250 crores.
2. Total sum of loans to all associated enterprises as on 31 March of the year exceeding INR 250 crores.

Currently the Safe Harbour rules cover only loans where the aggregate value of which does not exceed INR 100 crores. The spread to the reference rate has also been revised for the respective categories as follows:

The key aspect to note is that in the current Safe Harbour Rules, the spread in case where credit rating of the associated enterprises if not available was 400 bps, while in the revised Safe Harbour Rules the spread has been mapped with the lowest credit rating.

In connection with the loans denominated in INR, the spread and the associated credit ratings has remained unchanged.

Credit Ratings

An explanation for Credit Rating has been inserted in the Safe Habour Rules to mean credit rating assigned by an agency registered with SEBI and accredited by RBI. Consequently, the specific reference to “CRISIL credit rating” has been modified to “credit ratings” in all the applicable sections.

Further the explanation also states that where there are multiple credit ratings for an associated enterprise, the lowest of all the ratings shall be considered while arriving at the spread for the purpose of Safe Harbour Rules.

Other Aspects / Definition

1. The definition of intra-group loan has been modified to in order to widen the coverage of applicability of the Safe Harbour Rules to any associated enterprise. Currently, the Safe Harbour Rules defines intra-group loan as that which is extended to non-resident wholly owned subsidiary. Wholly owned subsidiary has been replaced with associated enterprises, thereby extending the coverage of Safe Harbour Rules.
2. The condition on sourcing the loan in INR has been omitted in the updated definition. Currently, the Safe Harbour Rules are applicable where loans are sourced in INR, which can be either through internally generated reserves or external lenders which provide INR denominated loans. However, businesses often source funds from overseas owing to myriad economic factors, in order to funds their foreign subsidiaries / associated enterprises. With this amendment, businesses sourcing such loans in foreign currency can also opt under the Safe Harbour Rules.

Operating Income / Expenses – Definition

The Safe Harbour Rules defines operating income and operating expenses for the purpose of computing the arm’s length mark-up for provision of services to associated enterprises. These definitions provide illustration of both operating and non-operating items. Among others ‘income on transfer of assets or investments’ has been excluded as non-operating in nature. Similarly, ‘loss on transfer of assets or investments’ has been excluded as non-operating in nature.

Under operating income and operating expense, the revised Safe Harbour Rules have restricted the ‘income / loss on transfer of assets’ to other than assets on which depreciation is included in operating expense. In other words, in case of assets for which depreciation is included in the operating expenses, the profit or loss due to transfer of such assets will be treated as operating in nature.

The key point to note is that while computing the arm’s length mark-up under the Safe Harbour Rules, since the depreciation on such assets are usually included in operating expense, the loss on transfer of assets will also have to be included in the cost base. Similarly, any income arising out due to transfer of assets can also be considered as operating income arriving at the mark-up for the purpose of Safe Harbour Rules.

Through this amendment, the CBDT seeks to harmonise the classification of income / loss as the expensing of the asset during the year of transfer would otherwise be two-fanged i.e., as per the existing definition for assets transferred, the depreciation portion would be considered as operating in nature and considered in operating expense while the loss or profit on account of such sale would be treated as non-operating in nature. With the amendment, this variance will be removed.

Key Takeaways / Way Forward

The transition of benchmark rates from LIBOR to Alternate Reference Rates was expected in the Safe Harbour Rules. Revision of the Safe Harbour Rules before the close of the corresponding financial year is a welcome move, considering that applicability of Safe Harbour Rules are usually extended after the year-end. Further, the removal of the ceiling for financial transactions w.r.t. loans advanced in foreign currency from the existing threshold of INR 100 crores would incentivize taxpayers to opt under Safe Harbour Rules and thereby increasing tax certainty.

Nevertheless, there exists other facets of Safe Harbour route on which businesses await amendments including rationalization of mark-up for manufacturing of core and non-core auto components, increase of the threshold for low value adding services and inclusion of other commonly litigated transactions such as royalty under the Safe Harbour Rules. With these changes, Safe Harbour route should witness wider adoption by businesses, as it would be effective and efficient approach in transfer pricing dispute resolution and contribute to the ease of doing business in India.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

An Intuitive Adjustment To Indian Arm’s Length Range

Date of Submission: 12-11-2023 Date of acceptance: 22-11-2023

I. Introduction

In the Indian transfer pricing landscape, the arm’s length range is 35th percentile to 65th percentile. Often representations have been made before the Ministry of Finance to update the arm’s length to interquartile range, which is generally prevalent across other tax jurisdictions. This article aims to understand if interquartile range does not hold water with the tax authorities due to the existing legislations, is there an adjustment required for the existing range in the first place. If yes, how can it be adjusted through an intuitive approach.

Let’s start with two observations we would have made while concluding our benchmarking exercises under Indian Transfer Pricing regulations:

• Material difference between mean and median of the dataset; or
• Where the median is closer to 35th percentile than 65th percentile or vice-versa.

Reminisce of statistics would answer this as skewness, which leads to the moot question under discussion does the Indian arm’s length range coincide with the ‘modal range’.

II. Analysis

Comparability analysis is at the heart of application of arm’s length principle. While undertaking a benchmarking study under Transactional Net Margin Method (TNMM), we know greater emphasis is placed on functional rather than product comparability¹. Further, not all the companies engaged in similar business activities are part of databases used for benchmarking searches and even if available they might get rejected due to various standard quantitative and qualitative filters. Hence, identification of companies engaged in very similar business activities (functions) in the same segment of the industry is more often hard to obtain. The companies selected as comparable would be broadly similar to that of tested party. This limitation is accepted while adopting TNMM and is also the reason it is widely adopted – its flexibility.

To this point, the OECD Guidelines² states that though effort would have been made to exclude data points which are less comparable, there can exist certain defects which cannot be identified / quantified and hence provides for use of statistical measures to narrow the range in order to enhance the results of this benchmarking analysis viz, measures of central tendency (interquartile range or other percentiles).

Ex-Post – Journey of Mean to Median

Where there are multiple prices for similar commodities, price agreed would be that which is “mostly prevalent”. settle within a range – that can be named as equilibrium price range. From a transfer pricing perspective, the arm’s length price, the value at which two unrelated parties would transact, would be that price range.

In a large discrete data set, having limited number of unique values, more often there would be certain value(s) which recur more frequently than others. Further these certain values would be positioned near each other, and the group or set of these values would have majority of data points in the data set – representative of the data set. However, in case of data set with continuous data points (such as profitability of companies), it would not be possible to identify these values, but a range of values would represent the data set.

From a statistical perspective, data sets can be distributed in different ways, but data sets are said to follow normal distribution on a rebuttable presumption basis. In finance literature, profitability of companies is said to follow normal distribution (this is often debated even from a transfer pricing perspective³). Where data sets follow normal distribution, the mean is more appropriate measure of central tendency⁴.

Let’s take an example of a discrete data set (having 100 data points) following normal distribution. In this example, the mean is 10.5 and data points center around the mean. The interquartile range is 8 to 13 and the 35th to 65th percentile being 9 to 12.

The quartiles are 8, 10.5 and 13 and each quarter i.e., 1-8 (Q1), 8-10.5 (Q2), 10.5-13 (Q3) and 13-20 (Q4) have 25% of the data points each. In the entire data set (range of 19 viz, 20 minus 1), 50% of the data is within the small range of 81.3. Other characteristics include the median being the same as mean and symmetry in data.

Key aspect that follows in the normal distribution is that data points are closest to each other near the mean / median, and moving farther from the mean / median data points appear sparsely distributed. This is similar to 80/20 rule used in management and business, where a small range of values (in our example 8-13) has a significant number of data points (in our example 50%). A simple statistical tool – standard deviation can measure how the data points are spread across. Q1 and Q4 have a standard deviation of 1.79 each, and Q2 and Q3 have standard deviation of 0.78 each.

As long as the data set follow normal distribution mean would be used as de facto measure to represent data set. However, where there are extreme values (outliers which are not representative of data), mean would be significantly influenced by such outliers. To ensure that the measure is not impacted by such outliers, median is generally considered. Median is based on position of data points rather than the value of data points. Hence median is insulated from these extreme values in the data set, following which interquartile ranges are used to represent the data set.

Let’s ponder over the reason for moving from mean to median. Where there are outliers in the data set and have extreme values, the measures of central tendencies of datasets wobble or do not equilibrate. The mean materially changed due to these extreme values, while median was not impacted since it considers position of the data point rather than its value. This means that such data sets are not normally distributed, which is corroborated by difference in mean and median of such data sets.

There are instances where material number of outliers are present in the data set, which then skews the data set. ⁵Let’s use an academic pictorial representation of skewed data sets to understand movement of mean and median when a data set is skewed. Mean is significantly impacted due to outliers and even median is impacted. Median is a center from a positional perspective. And if there are material number of outliers on one side of the data, median too would succumb, though not as much as mean. Mode, by definition, is the point which has the highest frequency and is not impacted. This is from a theoretical view. However, if we see arithmetically for a continuous dataset, mode would not be representative. Hence, median is practically the next best measure.

Though the median also moves due to skewness in the data set, interquartile range would be representative since it is a resistant measure. This is because interquartile range covers 50% of the data set and hence would cover the ‘peak of the curve’ which has the highest frequency. As mentioned earlier, nearing the ‘peak of the curve’ the data points are closer to each other, and inclusion of such area in the range is key to state that range (interquartile) is representative of the data set. The OECD guidelines too refers to interquartile range while discussing on measures of central tendency.

Ex-ante –Median to modal range

Continuing the foregoing discussion on skewed data sets, let’s dwell on skewness using a box-plot⁶. This analysis would throw light on skewness of a dataset – why median would not be equidistant to 35th percentile and 65th percentile.More likely than not, we would be aware of the rationale behind the two observations (in yellow and green), academically or intuitively.

Data is divided into four quarters to accommodate equal number of data points in each quarter, sliced by the three quartiles. In figure 3′ data in blue plot is symmetric and though it qualifies as a uniform distribution than a normal distribution, it has been used to provide a contrast while analyzing skewed distribution. While in yellow and green plots, data is concentrated in left and right sides, and data points in the other sides appear disconnected / non-representative – outliers. Depending on the number of outliers and their absolute value, they stretch interquartile range differently. In the yellow plot, data points are concentrated in the left and spread-out after the half (median). The green plot is inverse of the yellow plot i.e., data points are predominantly in the right half.

The bottom line is that where material number of outliers included in one direction, median does succumb marginally, though it depends on the frequency of these data points. And therefore the 25th (or35th) percentile is closer to median than 75th(or 65th) percentile.

Interposing the left most graph in Figure 2 with middle boxplot in green color of Figure 3, we will be able to guess that 25th/35th percentile would be farther away from the median as compared 65th/75th percentile in the left most graph in Figure 2. Similarly, in the right most graph of Figure 2, the results would be similar to yellow boxplot in Figure 3.

Even if the dataset is skewed, the interquartile range or 35th to 65th percentile capture 50%/30% central to the dataset. Yes, but the question is the range(s) representative? The answer is perhaps a yes when interquartile range is concerned. But for 35th to 65th percentile it requires examination.

The Indian Transfer Pricing rules (Rule 10CA of the Income Tax Rules) introduced the range concept of 35th to 65th percentile, which is slightly different from the interquartile range widely accepted by other tax jurisdictions. While interquartile range covers 50% of the data, Indian range covers 30% of the data. Hence the Indian Range (35th to 65th percentile) it sensitive to material skewness, as compared to interquartile range. While undertaking benchmarking, comparable companies are selected based on the functional analysis of the tested party. As indicated earlier some of the companies performing very similar functions might not appear in the database or might get rejected due to various filters even if they appear. To compound this, three-year weighted average of the comparable companies is considered. Therefore, the likelihood of data points following normal distribution is limited. And what is about normal distribution? Symmetry in data. This means data set mirrors around the mean/median.

The question of any adjustment to the range would not arise even in case of a skewed data set provided that interquartile range was adopted. Reason being interquartile range is a ‘resistant measure’ in statistics⁸, and typically used when datasets are skewed.

Further, in order to ensure computational ease, the exercise of arriving at 35th and 65th percentile as prescribed by Rule 10CA of the Income Tax Rules, 1962 has made it more of an arithmetic exercise rather than being a statistical one. As per the rules (including illustrations) if the 35th/65th percent of the total no data points is not a whole number, the next higher data place would be 35th/65th percentile. While computation of percentiles in a statistical way is through interpolation. Therefore, there is a possibility of the 35th to 65th percentile not capturing 30% of the data. Perhaps considering the benefits from an administrative perspective, weighing more than costs of accuracy (interpretation and litigation), it has been left undeliberated by academia at large.

To understand the requirement for adjustment, let’s revisit the right-most graph in Figure 2 while interposing analysis of Figure 3 yellow boxplot. As the dataset gets materially skewed in the positive direction, while the median moves towards the right, 35th percentile and 65th percentile no longer remain equidistant from the median. In an intuitive way (or a ‘thought experiment’ if it may be called) this non-equidistance can be attributed to the difference in the ‘density’ or the change in closeness of data points within the dataset. In the middle graph of Figure 2 as well, which is a normal distribution, there is a difference in density i.e., density of data points is highest near the median and reduces as we move away from the median in a symmetric way in both the directions.

A key point to note is that in a normal distribution the ‘densest’ area has the median as epicenter. Therefore, both interquartile range and the Indian range capture the densest area in dataset. The reason why the densest area is given importance is that it has the most number of data points within the least number of values, and capturing this area is key to ensure that the range (either interquartile or Indian range) is representative of the dataset. Back to the discussion, in the right graph in Figure 2, the median moves always from the densest area and this results in movement in 35th and 65th percentile. However, the 35th and 65th percentile do not move equidistantly from median due to differences in density. The Indian range aims to capture 30% of data central to dataset viz., 15% each on either side from the median. In the right graph in Figure 2 where the median has moved away from the densest area, the 75th percentile would move farther away from the median to accommodate 15% of the data, as the data points are sparse as we move away from densest area. 35th percentile would be much closer to the median since 35th percentile will have to capture 15% of the data set towards the left of the median – which is denser as compared to region right to the median.

We now need to compare two visualizations in the right chart in Figure 2,which are a) 30% area covered by 35th to 65th around the median and b) 30% area covered with the center as the densest line denoted by the dotted line as ‘mode’ i.e., 15% data right and left to dotted line stated as mode. Even in b), values capturing 15% of data on the left and right would not be equidistance due to the skewness – the 15% value on the right would be farther away from median. Though there would be a common area between a) and b) mentioned above, the probability of b) capturing the densest area is significantly higher than of a). Or rather, there is significant probability of a) not capturing the densest area of the data set. The densest region captured by b) can be said as the ‘modal range’. The caveat is that modal range is difficult to be defined mathematically through a simple formula / equation since data sets adopt different distributions and have varying intensity of skewness. The modal range for the purpose of this article / analysis is more relative and is one that captures a set of data points for a particular range (in terms of % of data) that are more dense as compared to other set of data points. If Figure 2 could be translated into graphs (or histograms), modal range would be those intervals that have highest frequencies.

Therefore, the 35th to 65th percentile range does not capture the modal range when the data is materially (not necessarily significantly) skewed.

This can be illustrated through a live example. A search was undertaken for arriving at the mark-up for manufacturing activity in the Auto ancillary sector – FY 2019-20. The following search process was adopted:

• Database: AceTP was used to conduct benchmarking study to arrive at companies undertaking manufacturing of auto ancillary;
• Period: The search was undertaken for FY 2019-20 (since FY 2020-21 was impacted by COVID pandemic, search was conducted for FY 2019-20). As per Indian Transfer Pricing regulations three-year data is considered i.e., FY 2017-18, 2018-19 and FY 2019-20.

Quantitative Filters

• Data Availability: Companies were selected if they had financial information for all the three years or financial information was available for FY 2019-20 and FY 2018-19.
• Sales Filter: Companies were selected if the sales were at least INR 1 crore (10 million) for the three years.
• Manufacturing Filter: Companies were selected if income from manufacturing sales was greater than 50% of the total sales for the three years.
• RPT Filter: Companies were selected if transactions with related parties were lesser than 25% of total revenue for the three years.
• Loss Filter: Companies were selected if they did not incur losses for two consecutive years.
• Industry Filter: Companies were selected if they were classified under auto-ancillary industry as per the database

Margin Computation: For the companies satisfying all the above filters, ratio of operating profit over operating costs was computed. The weighted average for 3 years was computed i.e., summation of the operating profits for three years over summation of operating costs. Operating revenue and cost was computed based on generally accepted heads and operating profit was computed by operating revenue minus operating costs.

The search yielded 342 data points – weighted average operating profit over operating costs for 342 companies. The data points have been plotted as histogram as per Figure 4 below.

Nearly 50% of data points is within the range of 4.6% to 13.0% (frequency of 167). The graph appears to be normal distributed data set but is skewed positively (clue can also be taken from mean (10.24%) being farther away from median (8.88%)).

To analyze if 35th to 65th percentile covers the modal range, the histogram has been plotted at small intervals.

The median (8.88%) falls in the interval of 8.2% to 10.1% (frequency of 37). The mean (10.24%) falls in the next interval 10.1% to 12.0% (frequency of 35). The modal interval is 6.3% to 8.2% (frequency of 43). For pictorial ease of reference, bars highlighted in green represent 35th to 65th percentile and bars highlighted in green and dark blue represent interquartile range.

Pictorially the intervals with highest intervals are 4.4% to 6.3% (dark blue), 6.3% to 8.2% (green) and 8.2% to 10.1% (green). As discussed in the forgoing para, the median falls in the interval next to modal interval and 35th to 65th percentile does not cover second highest interval of 4.4% to 6.3% due to the skewness in the data set. However, the interquartile covers the second highest frequency interval. The 35th percentile is closer to the median as compared to 65th percentile as captured in the below table:

Adjustment to arm’s length range

Indian transfer pricing regulations specify use of 30% of the central data for computation of the arm’s length range. An easier approach to overcome the above issue would be to extend this range to an interquartile range to ensure that even where the data set is skewed the arm’s length range would include the modal range. In such a case the necessity for an adjustment would not be required.

The 30% range might be considered as appropriate or non-negotiable to ensure stricter compliance to arm’s length principle. In May 2015 the draft scheme of the proposed rules for arm’s length range was issued by the CBDT which considered 40th percentile to 60th percentile – a 20% range. Hence the probability of extending the arm’s length range to interquartile range is not high in the coming years as well.

As discussed above, 30% would be an apt arm’s length range provided the dataset is symmetrical at its center, which would then capture the modal range. But due to skewness the median moves away from the modal range, due to which 30% data around the median would not capture the modal range, which is brought out in the above example. As per Figure 3 the modal range can said to be 4.6% to 13% as it cover about 50%, but as per Figure 4 the modal range can said to be the three intervals viz., 4.4% to 6.3%, 6.3% to 8.2% and 8.2% to 10.1% with frequency of 39, 43 and 37 respectively. Cumulatively they cover 34% of data. These three intervals cannot per se be considered since data covered is slightly more than 30% and we should be cognizant of the median (4.4% is approximately the 21 percentile).

Considering that interquartile range has been accepted both academically as well by international Tax bodies like the OECD, a 30% range within interquartile as a cap-and-collar approach can be adopted. That is, depending on how data sets are skewed (positively or negatively) and their extent (moderately or highly skewed), 30% of data that is can be considered to be modal range within the 50% of the data can be considered as the arm’s length range. To ensure administrative ease, threshold limits can be set to trigger exercise of this adjustment such as a) material variance between mean and median or b) the difference between median and 35th is materially higher or lower as compared to the difference between 65th percentile and median. Also, effecting the adjustment can be done by increasing or decreasing by 5 percentiles. Hence there would be a limited number of iterations (4 viz., 25th to 55th percentile, 30th to 60th percentile, 40th to 70th percentile and 45th to 75th percentile). The iteration range that is closest to being equidistant from their respective mid-point can be selected as the arm’s length range. As per Indian transfer pricing regulations if the transaction price is outside the arm’s length range comparison will have to be made with the median. For the 4 iterations mentioned above, adjustment will have to be computed from the mid-point of the respective range.

Implementation of the adjustment can be illustrated by continuing from the earlier example – arriving at the arm’s length mark-up range for manufacturing of auto ancillary.

As per the above table, the 30% range of 25th to 55th percentile (mid-point as 40th percentile) might be considered as the arm’s length price, as it is almost equidistant as compared to other two ranges (35th to 65th percentile and 30th to 60th percentile).

Benchmarking studies undertaken usually have limited number of comparable companies as against 342 as per the above first example. The intention of taking a huge dataset was to bring out pictorially case where the data set has been skewed and the necessity for adjustment i.e., where the 35th to 65th percentile does not capture the modal range.

Following is another example of a specific benchmarking search undertaken for auto ancillary (particular activities / products). Similar search process was adopted and based on analysis of similar functions and products. The results of the search is presented as a histogram.

Since there are limited number of companies it might be difficult to visualize a normal distribution which is being positively skewed, and is the reason for illustrating through a broad auto ancillary search. The summary of the results is as per the below table.

In the second example, the mean is greater than the median, and the graph peaks in the left side and slowly tapers in the right side – which can be classified as positively skewed dataset. The below table details the workings for the iterations.

As per the above table, 25th to 55th percentile (40th percentile as mid-point) can be considered as the arm’s length range since it is being equidistant among the other ranges.

To statistically prove that one of the 30% range is more appropriate against other iterations, perhaps standard deviation of the range can be computed to numerically measure the closeness of data points / density of the range.

The above discussion addresses whether there is a requirement for adjustment to an arm’s length range and a pragmatic approach for effecting an adjustment. There can be alternative solutions as well, which might be subjective, such as (i) ascertaining the nature of distribution of dataset and compute the modal range covering 30% of data, (ii) where the dataset does not follow any distribution, using calculus ascertain the area with the highest density to qualify as modal range. (This can be done by first arriving at the equation of function for the distribution and then using integration arrive at limits covering 30 percent of the dataset. The limits having the least difference can be said to have the highest area under the curve and these limits would be the arm’s length range covering 30 percent of the data being the modal range). Alternatives such as these will require subject-matter experts and at times taking the discussion to very academic level, the efforts of which would far exceed the benefits.

Key considerations

The above approach, though simple, have some issues to bear in mind. The issues and ways to address them are captured below:

(i) Benchmarking studies undertaken is based on public databases, which may not capture the entire universe of companies, and the comparable companies are arrived based on certain level of functional comparability. Arguments can be placed that the comparable companies are subset of larger number of companies within the segment of sub-industry and hence the companies selected would be sample of larger population. On the other hand, it can be argued that the comparable companies partake the nature of population, since all the closely comparable companies in the database has been selected. Due to the above, among other factors, certain benchmarking exercises might result in datasets having two modal areas within the interquartile range. To address this, similar to applicability thresholds, there can be measures in place for non-applicability of this adjustment.

(ii) Due to economic differences the taxpayers might claim economic adjustment such as working capital adjustment to level the differences between circumstances between the companies selected and the tested party. In such cases, post effecting these economic adjustments on the comparable companies the adjustment through various iterations can be undertaken.

III. Conclusion:

The concept of range of 35th to 65th percentile was aimed at providing elasticity to the concept arm’s length price when median is used as measure of central tendency. This range covers 30% of the data as compared to widely used interquartile range covering 50% of data. It has been considered that median would gravitate towards the mode, which is true in case of a normal distribution. This narrower range brings forth question whether 35th to 65th percentile range captures the modal range even at times when dataset is skewed. An intuitive way to align the 35th to 65th percentile range with modal range is if a cap-and-collar approach within the interquartile range can be considered.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

#TransferPricing #TransferPricingFirm#VSTNConsultancy #TaxCompliance #IndiaUAEUSA

#TPExperts#TransferPricingExperts#GlobalTransferPricingFirm

UAE Transfer Pricing

Key Action points for Businesses

November 2023

Introduction

UAE Corporate Tax (“CT”) regime was introduced w.e.f 01 June 2023. However, most of the businesses – following the calendar year, this regime would kick off from 1st January 2024.

This alert is intended to provide businesses with head start on what they need to consider, evaluate and factor to determine the applicability of the CT Regime & Rates, with primary focus on Transfer Pricing requirements.

Applicability of Corporate Tax Regime

• Scope of Taxation and Tax rate
• Compliance Requirements

Pragmatic Approach for Transfer Pricing

• Step 1: Identify Related Parties (RP) / Connected Persons (CP)
• Step 2: Identify RP Transactions
• Step 3: Substantiating Arm’s Length Price

Other Key Aspects

• TP Documentation Requirements
• Key Transactions
• Tax Audit

1. Applicability of Corporate Tax Regime

Scope of Taxation and Tax rate

Scope of Tax

• Corporate tax shall be imposed on a taxable person whether resident or non-resident.

Tax Rate

• Tax rate needs to be determined with respect to each business activity.

• Entities opting for small business relief are treated as having no taxable income for the tax period.

Compliance Requirements

1. Mandatory for taxable persons¹ to meet CT compliance requirements with respect to registration, computation of taxable income, filing of tax returns and maintenance of records. However, in case of entities opting for small business relief, they have the leverage of:
   • filing simplified tax returns;
   • no obligation to compute taxable income;
   • reduced record keeping;
   • no requirement to maintain Transfer Pricing documentation; and
   • preparing financials using cash basis of accounting

¹ Exempt entities (referred to in Article 4) are not subject to any compliance requirements under CT Law

2. Pragmatic Approach for Transfer Pricing

Step 1- Identify Related Parties (RP) / Connected Persons (CP)

• Identify the RP/CP based on the Ownership and Control, Kinship (in case of natural person) and significant influence
• Group shareholding structure maybe the starting point for such analysis however parties falling under the significant influence category need to be separately identified (e.g. based on debt, authority to make strategic decisions etc.).
• In case of KMP, organisation chart of the Company may be used for identification.
• One challenge in case of connected persons maybe to identify ‘officers’ as this term is not defined. This needs to be determined independently for every company depending on their business circumstance.

Step 2- Identify Related Party Transactions

1. Transactions: Related party transactions include:
   1. the supply or transfer of tangible goods,
   2. provision and receipt of services,
   3. funding and other financial transactions,
   4. commercial exploitation of intangible assets such as patents, brands and know-how,
   5. Intra group transactions,
   6. Cost contribution arrangements,
   7. Business Restructuring,
   8. Reimbursements.
2. Entities – The above mentioned transactions can be between:
   1. PEs including foreign PEs,
   2. Two Free Zone entities,
   3. Two mainland entities,
   4. Mainland entity and Free Zone entity,
   5. Trustee, founder, settlor or beneficiary of a trust or foundation and the trust or foundation, including the trust’s or foundation’s Related Parties,
   6. Partner in an unincorporated partnership and related parties of such partner,
   7. Entity and connected persons.
3. Not visible (hidden) transactions: In certain cases though services maybe availed there may be no cross charge for the same, for eg. shared employees, deputation of employees, interest free loans / guarantees, head office management charges. All business facts need to be completely evaluated to identify such invisible transactions.

Step 3- Substantiating Arm’s Length Price

Every transaction with related party and connected persons need to be tested for Arm’s length Principle and thresholds are not applicable. Following are key points one has to bear in mind while justifying the arm’s length nature of RP transactions:

1. Granular analysis of the transaction through FAR analysis/ Transactional Analysis.
2. Characterisation of the Entities, which could be ranging from limited risk bearing to entrepreneur manufacturer/ distributor/ service provider.
3. Selection of Tested party (which is the least complex entity) considering the FAR profile. Tested Party can be local or a foreign entity. Price based methods (e.g. CUP, Other Method) do not require selection of Tested Party.
4. Selection of MAM (most appropriate transfer pricing method)
   1. No hierarchy of methods,
   2. Combination of methods can be used,
   3. TP Methods – Comparable Uncontrolled Price Method (CUP), Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM), Transactional Net Margin Method (TNMM), Other Transfer Pricing Method,
   4. Internal comparability assumes prominence before proceeding to external comparables,
   5. Transaction testing preferred over entity approach using TNMM.
5. PLI
   1. Can be cost based, sales based, asset based.
6. Search Process
   1. Prescribes either deductive (drilled down from the universe of companies) or additive approach (Go back from the probable list of comparables),
   2. No preference to any specific commercial database. However at the time of audit the FTA may request access to the database in which the search has been carried out,
   3. Comparables: First preference towards local comparables, in the absence of the same, one could look at regional/ global comparables.
7. Arm’s Length Range
   1. Any point within the interquartile range (25th to 75th Percentile) to be considered at arm’s length. Comparability adjustments such working capital adjustments maybe provided.
   2. However, in case where the tested party performs more significant functions then the expectation is for it to be remunerated closer to the upper quartile and vice versa.

Other Key Aspects

TP Documentation Requirements

There 5 specific documentation requirements that are required to be complied with depending on applicability.

1. Disclosure form (Applicability, format to be announced by FTA)
   1. May not apply to all entities,
   2. Materiality thresholds yet to be prescribed.
   3. Needs to be filed with FTA
2. Local File
   1. Contemporaneous requirement,
   2. Can be prepared either at the time of transaction (price setting approach) or at the end of the tax period (outcome testing approach)
   3. Applicability of threshold
   4. Exempt for entities claiming SBR (Small Business Relief),
   5. Contents similar to OECD TP Guidelines,
   6. Needs to be prepared every 3 years if no change in facts, however year on year margin update required for comparables and tested party,
   7. Cross referencing of certain sections with Master File permitted.
3. Master File
   1. Thresholds prescribed,
   2. Contents follows the requirement under the OECD TP Guidelines,
   3. Required to be prepared for each tax year,
4. Country-by- Country Reporting (CbCR)
   1. Already in place from April 2019
   2. Applies to businesses which are part of the MNE Group headquartered in UAE
   3. Consolidated Revenue Thresholds prescribed,
   4. Ultimate Parent Entity required to submit a CbCR,
   5. If a company is a constituent entity of a foreign MNE group which is subject to CbCR requirements then it shall be required to file a notification with the FTA.
5. Additional information
   1. Contracts / agreements to be maintained based on materiality threshold,
   2. Invoices, work papers, email and correspondences justifying the decisions taken to ensure Arm’s length
   3. Any other documentation that maybe required to justify Arm’s length price (ALP) when called for by FTA.

Key transactions

Some of the common key transactions and their TP considerations is captured in this section:

• KMPCompensation to Key Managerial Personnel (KMP) exists for all Companies and hence is of paramount importance. TP Aspects one has to bear in mind w.r.t. KMP compensation include:
  • Contract (Job description) Vs Conduct (Role) to be documented.
  • Internal appraisal documents (such as KRA, KPI) maybe leveraged while carrying out ALP analysis.
  • Adopt a practical approach to separately test the transaction based on alternatives.
  • Testing of the margins of the Company at net level (through use of TNMM by aggregating all transactions including KMP payments) may not be the right way to test the transaction.
  • TP exercise can be considered as a cap for the managerial remuneration and should not be a substitute for business considerations such as intelligence on pay-scale prevalent in the industry, existing compensation.
  • There may be scenarios where promoters are KMP as well as, shareholding activities and strategic activities for business will have to be delineated, as shareholding activities will not require separate compensation.
• Intangible/ Intellectual Property (IP)
  • Identify marketing intangibles and technology intangibles in the group
  • Detailed DEMPE (Development, Enhancement, Maintenance, Protection, exploitation) analysis carried by various entities towards the IP
  • Return for intangibles’ running royalty/ lumpsum
  • Use of appropriate methods- CUP/ Other Method
• Intra Group Loans
  • Identify intra group loan transactions including interest free loans
  • Evaluate Terms of loan for e.g.- Secured Loans, Tenure, Credit Rating, country of the borrower, currency, interest rate type, prepayment option etc. influence the pricing
  • Carry out appropriate adjustments such as tenor adjustments
  • Use of appropriate comparable loan agreements to justify ALP
• Guarantee
  • Identify financial guarantee transactions including free of cost guarantees
  • Evaluate appropriate pricing approaches for guarantee such as interest saving approach. Few other approaches as provided in OECD can also be evaluated such as CUP, cost approach, valuation of expected loss approach, capital support method.
• Cash Pooling
  • Good approach to manage liquidity-. Regulatory environment in various countries of the group to be checked before implementing for the group as a whole
  • Two important considerations- every cash pool member should both borrow and lend and the time period should be short term
  • Can be notional or physical cash pooling arrangement
  • Compensation to the cash pool leader to be based on functions performed
  • The savings through cash pooling can be allocated to the cash pool participants based on their debit/ credit positions
• Intra Group Services (IGS)
  • Documenting “Need” for the services and “Benefit” arising from rendering of such service.
  • Exclusion of shareholder cost.
  • Eliminate duplicative activities and direct cost identifiable to any other specific entity.
  • Justification of mark-up. Leveraging safe harbour for Low value adding services viz., compensation for such services at cost +5%. By definition, Low value adding services rendered do not pertain to any core business activity of the group.
  • Consistency in the allocation of costs among group entities through appropriate allocation keys
  • Routine treasury functions identified may be remunerated similar to IGS
• Business Restructuring
  • Reorganisation of commercial and financial relationships both domestic and cross border
  • Some examples of restructuring would be conversion of full fledged manufacturers/distributors to contract manufacturers/limited risk distributors, transfer of intangibles
  • This can be driven by business reasons but should be carried out at ALP. Compensation (exit charge) for the business restructuring may be warranted.
  • Valuation techniques can be adopted to arrive at the arm’s length compensation for such restructuring
  • Post restructuring also the transactions should be conducted at arm’s length
  • Impact of any restructuring in light of GAAR provisions should be evaluated
• Permanent Establishments (PE)
  • Separate/distinct entity approach to be adopted
  • Identification of functions of the PE along with the allocation of risks and attribution of economic ownership of the assets
  • Attribute Profits to PE by adopting the Authorised OECD Approach

Tax Audit

• Onus is on the tax payer to demonstrate ALP.
• FTA can call for additional documents to justify ALP
• FTA can disregard the transaction and recharacterize the transaction
• In case of any adjustments to ALP, taxpayer can claim corresponding cross border adjustment invoking MAP.
• Corresponding adjustments in case of adjustments between domestic entities is granted.
• After submitting the Tax Return, one can make transfer pricing adjustments if it increases the profit or decreases the loss. The reverse situation is also possible after complying with FTA Procedures.
• Taxpayer can seek clarification on any legal position from the FTA
• Detailed guidance on APA is awaited.

Way Forward

While Businesses in UAE, especially with Financial Years starting 01 January 2024, are preparing for Corporate Tax regulations, being transfer pricing ready will ensure smooth implementation of corporate tax laws in respective business environment. Identifying related parties and related party transactions are the first key transfer pricing considerations, based on which determination / substantiation of arm’s length price follow. Further as connected persons have been included under the purview of transfer pricing, transfer pricing compliance will be applicable for all businesses.

Ensuring a robust pricing setting has been undertaken is the cornerstone for a business to substantiate the arm’s length nature of payments with its related parties before the tax authorities.

Since transitional positions apply, Companies need to recheck whether the transactions are at arm’s length and in case of any deviation, they need to ensure that the suitable year end adjustments are made before book closure for 2023 so that the closing and subsequent opening balances in the books reflect arm’s length pricing.

As businesses expand across borders, navigating complex transfer pricing regulations becomes critical. At VSTN Consultancy, a global transfer pricing firm, we specialize in helping companies stay compliant and competitive across key markets including:

India | UAE | USA | KSA | Dubai | Asia Pacific | Europe | Africa | North America

Whether you’re preparing for benchmarking intercompany transactions, or developing robust TP documentation, our team is here to support your international strategy and Compliance.

Contact us today to explore how we can partner with you to optimize your global transfer pricing approach.

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