How the UAE's Transfer Pricing Rules Affect Free Zone Entities
The Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses (UAE CT Law) introduced specific rules for Transfer Pricing (TP) to ensure that transactions between related parties comply with the arm’s length principle.
This principle requires that such transactions be carried out at prices comparable to those agreed upon by independent entities under similar conditions. The regulations apply to all UAE taxpayers, including free zone entities, with varying requirements for disclosure and documentation based on thresholds and business size.
What Are Free Zone Entities and QFZPs?
Free Zone Entities (FZEs) are businesses set up in the UAE’s Free Zones, regionally distinct areas offering various benefits like 100% foreign ownership, no customs duties, and relaxed regulatory requirements. FZEs play a vital role in driving the UAE’s economic diversification, with industries ranging from trading and manufacturing to technology and services.
To qualify as a Qualifying Free Zone Person (QFZP), an entity must meet specific criteria outlined in the UAE’s corporate tax legislation. These include:
- Maintaining adequate economic substance within the relevant Free Zone.
- Earning only qualifying income, which aligns with the defined activities permitted for a 0% corporate tax rate.
- Complying with regulatory requirements, such as maintaining proper accounts and records.
While qualifying income attracts a 0% corporate tax rate, any non-qualifying income is subject to a 9% rate. The distinction between these income types is vital, as improper classification or lack of compliance can jeopardize the preferential tax treatment offered to FZEs.
Why Transfer Pricing Matters for Free Zone Entities
Transfer pricing involves setting the prices for transactions between related parties, such as subsidiaries of the same parent company. For FZEs, these transactions may occur with related businesses located on the mainland or internationally. Ensuring these transactions are conducted at arm’s length, meaning consistent with what independent parties would agree upon, is mandatory under UAE tax laws.
Compliance with transfer pricing rules is vital for the following reasons:
- Eligibility for Preferential Tax Rates: Mispricing or failure to comply can lead to the loss of QFZP status, resulting in the application of a 9% corporate tax on the entity’s entire income.
- Avoiding Tax Adjustments: The Federal Tax Authority (FTA) may adjust figures if transactions aren’t compliant with arm’s length principles, potentially increasing tax liabilities.
- Aligning with International Standards: The UAE’s commitment to global tax standards, such as the OECD Guidelines, underscores the significance of accurate transfer pricing to prevent profit shifting.
Key Transfer Pricing Considerations
To mitigate risks and maintain compliance, FZEs must carefully examine the following aspects of their operations:
Transactions with Mainland or Foreign Related Parties
FZEs often engage in various intercompany transactions, such as trading goods, rendering services, financing, or licensing intellectual property. These transactions must adhere to arm’s length standards:
- Goods and Services: FZEs transacting with mainland or international entities must ensure competitive market rates are applied.
- Financing: Intercompany loans or guarantees must reflect market-based interest rates.
- Intellectual Property: Licensing fees charged for intellectual property utilization must align with pricing applied by unrelated parties under similar conditions.
Substance Requirements
For FZEs to benefit from the 0% corporate tax rate, maintaining substantial business activity within the Free Zone is essential. Substance is assessed based on factors such as:
- The scale of operations within the Free Zone.
- The presence of adequate personnel, premises, and assets appropriate to the business model.
Merely incorporating a company in a Free Zone does not suffice. The entity must demonstrate tangible economic activity to be viewed as a legitimate Free Zone business for tax purposes.
Documentation Obligations
Transfer pricing compliance also entails rigorous documentation requirements. FZEs meeting certain revenue thresholds must prepare and maintain specific documents in line with OECD-compliant practices:
- Master File and Local File: These documents provide comprehensive details of the group’s business structure, financials, and intercompany transactions.
- Supporting Evidence: FZEs must retain agreements, contracts, and benchmarking analyses to substantiate arm’s length pricing.
Timely and accurate documentation is critical, especially during audits by the FTA. Non-compliance can result in sanctions, tax reassessments, or the revocation of QFZP status.
Risks of Non-Compliance
Failure to comply with transfer pricing and economic substance rules can have severe implications for FZEs. Key risks include:
- Loss of Preferential Tax Treatment: If an FZE is found to lack the necessary economic substance or violate transfer pricing regulations, it may lose its QFZP status, subjecting its entire income to the standard 9% corporate tax rate.
- Potential Penalties: The FTA imposes penalties for non-compliance, including fines for inadequate documentation or reporting errors.
- Tax Adjustments and Audits: The authority may intervene and adjust taxable income if transfer pricing rules are not observed, disrupting an entity’s finances.
Staying compliant with transfer pricing regulations is not just a procedural formality but a critical component of preserving the financial and operational advantages inherent to Free Zones. By adhering to these rules, FZEs can continue to benefit from the UAE’s favorable tax regime while avoiding unnecessary risks.
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