Guide on Arm’s Length Principle for Financial Transactions

The Federal Tax Authority has issued a guidance in October 2023 detailing specific areas for Transfer Pricing that are relevant from a UAE perspective as a financial and investment hub.

What is Arms – Length pricing?

It means the price of transaction would be as if it was between two independent parties would have agreed upon in similar circumstances (or) transactions would occur how two independent parties would have behaved in similar scenarios.

In other words, Corporate Tax law of the U.A.E requires related parties & connected persons to earn their profits based on the Arms – Length Principle (ALP).

What financial transactions between Related Parties and Connected Persons are required to be consistent with ALP?

In the perspective of Transfer Pricing and Arm’s length principle there may be some transactions such as Related Party loans, cash pooling or guarantees that need to be considered.

Intra-group loans

These are usually made by the central treasury entity or can arise from a parent company to an operating entity.

To determine arm’s length pricing for intra-groups loans we need to –

Analyze the terms of the loan relating to factors that may impact the pricing including issue date, tenure, currency, interest rate etc.
Analyze the credit rating of the borrower to understand the credit risk borne by the lender.
Use reference of third-party loans with similar credit and terms as reference
Calculate the arm’s length range.

Cash Pooling

It is a financial management technique used by companies to optimize their cashflow and efficiently manage liquidity within a group of related entities or subsidiaries.

This involves consolidation of cash balances from multiple accounts into a central pool, typically held by the parent company or a designated treasury entity.

There are two basic types of cash pooling arrangements –

Physical pooling: Bank account balances of all members are transferred daily to a single bank account.
Notional pooling: Some of the benefits of combining credit and debit balances of several accounts without physically transferring. However, the bank may require cross-guarantees from the cash pooling participants the right to set off between accounts if necessary.

With physical pooling the transactional costs would be more while with notional pooling the functions would be carried out by the bank, and this would be accounted for in the form of charges or interest rate of the bank.

Now since cash pooling involves transactions between Related Parties, it needs to be conducted as per Arm’s Length Pricing.

To determine the arm’s length remuneration in a cash pooling arrangement –

The appropriate reward of a cash pool leader will be determined by circumstances and functions performed. In general cash pool leaders perform forecasting, basic analysis, and risk management.
Remuneration for a cash pool function should be directly linked to its activities and services performed by the cash pool leader.
Appropriate Transfer Pricing method must be used and determine arm’s length interest rates applicable.

Hedging

MNE groups can use hedging instruments by which risk is transferred within different group entities.

Possible mechanisms by which an MNE group may centralize to hedge risk include –

Utilize a group treasury entity for hedging, where hedging contracts are in the name of operating companies or another MNE Group entity.
Alternatively, the MNE Group can identify and use natural hedges across the Group, eliminating the need for formal hedging contracts.

Financial guarantees

A financial guarantee is a legally binding commitment which requires the guarantor to meet certain financial obligations in the case there is a default by the party being guaranteed.

To determine the arm’s length conditions of a financial guarantee arrangement it is necessary to understand the economic benefits received by the borrower. The entity that is the borrower may receive more funding or interest at a lower rate because of the Related Party guarantee.

Captive Insurance

A captive insurer within a Group of companies whose role is to ensure certain risks of the Group.

To determine the arm’s length pricing of captive insurance arrangements –

The Comparable Uncontrolled Price (CUP) method can be used if there are similar internal comparables where the captive insurer has done it for other similar businesses or if there are external comparables available.
Actuarial analysis to determine an arm’s length premium for insuring a particular risk.

Intra-group services

This focuses on services performed by one or more Group members that provide a benefit to other Group members and whether such transactions are priced at Arm’s length principle.

Analysis of Transfer Pricing for intra-group services involves two main areas –

Whether services have been performed
Charge for intra-group service is in accordance with Arm’s Length pricing.

To determine whether an intra-group service has been rendered –

Whether there were any benefits of commercial or economic value received by one or more group members or if they are expecting to receive this in the future. These benefits have to be identifiable and capable of being valued.
Usually, the Parent company of a group may perform activities that group members won’t be willing to pay for if they were independent of the Group and maybe this activity was performed because it has ownership interest in one or more Group members. These activities would not be considered to be intra-group services and thus would not justify a charge to other Group members.
Sometimes Group company may arrange or pay on behalf of its Related Party or Connected Persons but there shouldn’t be a profit element or mark-up to the amount paid when recharging such costs to Related Party or Connected Persons.
Duplication of services is considered to be provided since there is no commercial or practical necessity but can be allowed if services are temporary or to reduce risk of a wrong business decision.
Centralized services will be considered intra-group services because they are the type of activities that independent parties would be willing to pay for or perform in-house.

To determine arm’s length charge for intra-group services –

The Comparable Uncontrolled Price (CUP) method or a cost-based method like CPM or TNMM (Cost Plus Method or Transactional Net Margin Method using a cost-based profit level indicator) are commonly used for pricing intra-group services.

**Drawing reference to Chapter VII of the OECD TP guidelines, the TP guide clarifies that a simplified approach can be adopted in case of low-value-adding intra group services which may be charged out at a cost-plus 5% mark-up without the need for a detailed benchmarking analysis.

Intangibles

Intangibles are defined as something that is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.

The approach to determine the arm’s length conditions and price of intangibles between Related Parties or Connected Persons –

Identification of
- intangibles
- of full contractual arrangements
- of entities performing DEMPE (Development, Enhancement, Maintenance, Protection, and exploitation) functions.
Confirming the consistency between terms of contract and actual conduct of parties
Characterization of actual controlled transaction
Determination of Arm’s length price for use or transfer of intangibles

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