The Federal Tax Authority (FTA) has issued a comprehensive guide on "Determination of Taxable Income," which provides an overview of the adjustments required to be made to the accounting income for determining taxable income and the Corporate Tax (CT) payable.
Certain key considerations from a transfer pricing perspective while determining the taxable income for UAE CT purposes:
A. Payment to Related Parties/Connected Persons
Chapter X of the UAE CT law governs Transactions with Related Parties and Connected Persons. While Article 34 suggests - "In determining Taxable Income, transactions and arrangements between Related Parties must meet the arm's length standard," Article 36 of the UAE CT law governs "Payments to Connected Persons". According to the FTA guide, all payments and benefits provided by a taxable person to Related Party/Connected Persons should meet a dual test:
- Incurred wholly and exclusively for the purpose of business; and;
- Corresponds with the Market Value, i.e., meets the arm's length standard.
B. Interest Deduction Limitation Rule
Article 30 - General Interest Deduction Limitation Rule suggests that Interest expenditure can be deducted while determining taxable income for the tax period in which it is incurred. Where the Net Interest Expenditure exceeds AED 12 million in a tax period, the amount of deductible Net Interest Expenditure is the greater of:
- 30% of adjusted EBITDA (earnings before the deduction of interest, tax, depreciation and amortization) for a Tax Period, calculated as the taxable income for the tax period.
- or the de minimis threshold of AED 12 million.
"Net Interest Expenditure: The Interest expenditure amount that is in excess of the Interest income amount as determined in accordance with the provisions of this Decree-Law."
With reference to the above, it may be noted that the Interest expenditure is total Interest payment on loan from related parties as well as third parties/independent lenders like a bank.
However, if the Net Interest Expenditure is below the de minimis threshold of AED 12 million for a tax period, the General Interest Deduction Limitation Rule does not apply.
The purpose of this provision is to prevent the CT base from being eroded by transactions and arrangements for the sole or main purpose of creating deductible Interest expenditure where the income derived from the relevant transaction or arrangement can benefit from an exemption from CT.
Whilst generally, these deductions are not allowable for CT purposes, the deduction restriction does not apply if the taxable person can demonstrate that the main purpose of obtaining the loan and carrying out the transaction is not to obtain a CT advantage. This will be based on each transaction's specific facts and circumstances. However, if it can be demonstrated that the Related Party receiving the Interest is subject to CT or a similar tax in a foreign country at a rate of at least 9% on the Interest income, then no CT advantage will be deemed to have arisen.
C. Permanent Establishment - Attribution of profit using transfer pricing principle
In certain situations, a Non-Resident Person may perform activities that result in the creation of a Permanent Establishment (PE) in the UAE. Such a Non-Resident Person is required to attribute the appropriate amount of income and associated costs to its PE in accordance with the arm's length standard. The arm's length standard requires treating a PE as if it is a separate entity that operates independently from the parent entity to which the PE belongs (i.e., its head office), and to the other entities of the group.
To accurately attribute the profit between the PE and its parent, a two-step analysis is required:
- Step one: Conduct a functional analysis to identify the functions performed by the PE on one side, and the head office on the other side, treating each as separate from the other. This analysis should also consider the assets used and the risks assumed by the PE and the head office, respectively.
- Step two: Determine the compensation relating to arrangements or dealings between the PE and the head office, commensurate with their respective functions performed, assets deployed, and risks assumed.
Our Comments
The FTA guide on the determination of taxable income offers clear and practical guidance on the computation of taxable income. Application of transfer pricing principles could potentially lead to an adjustment in accounting income/profit. As such, it would be critical to conduct a transfer pricing study and make timely adjustments to related party transactions, preferably at the stage of the transaction itself.
As discussed in this alert, the application of transfer pricing principle could impact the allowability of expenses for the computation of tax bill.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.