What is three-tiered approach to transfer pricing documentation

The tax authorities make assessments of the transactions between the related parties and with the connected persons to make sure that the transactions have not been influenced by the relationship between the parties. While conducting the assessment, the tax authorities can ask for the information to assess the risk and to conduct the audit. Moreover, the tax authorities wanted to assess the seriousness of the businesses in setting the transfer price. These are the reasons which require proper documentation of the transactions between the related parties and with the connected persons.

Para 7.12 of the UAE corporate tax public consultation document requires that “a business will also need to maintain a master and local file (with format and content consistent with the requirements prescribed under OECD BEPS Action 13) where the arm’s length value of their Related Party transactions exceeds a certain threshold in the relevant tax period.”

As clearly stated in the transfer pricing guidelines issued by the Organisation for Economic Cooperation and Development (OECD), there are three objectives of the TP documentation. One of them is to ensure that businesses give appropriate consideration to transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns.

Secondly, documentation is required to provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment, and thirdly, documentation is compulsory to provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdictions.

To achieve the above-mentioned objectives, the transfer pricing guidelines require that the countries should adopt a three-tiered standardised approach to transfer pricing documentation, and the three-tier structure is that the businesses should maintain (i) a master file containing standardized information relevant to multinational enterprises (MNEs) group members; (ii) a local file referring specifically to material transactions of the local taxpayer; and (iii) a Country-by-Country Report containing certain information relating to the global allocation of the MNE’s income and taxes paid together with certain indicators of the location of economic activity within the MNE group.

The master file of the TP documentation provides an overview and the blueprint of the MNE group and contains relevant information that can be grouped into five categories: (a) the MNE group’s organisational structure; (b) a description of the MNE’s business or businesses; (c) the MNE’s intangibles; (d) the MNE’s intercompany financial activities; and (e) the MNE’s financial and tax positions.

The organisational structure provides information about the legal and ownership structure and geographical location. The description of the businesses contains information about the business drivers, supply chain, service level agreements, geographical markets, detail of the entities in the group etc. The information about the intangibles includes the overall strategy for the development, ownership and exploitation of intangibles, the groups and ownership of the intangibles, the important agreements that provide detail about the cost allocation among the group entities, description of the transfer pricing policies related to the R&D and intangibles etc.

The MNE’s intercompany financial activities include information about the third-party financing of the group, detail about the members of the MNE group that provide a central financing function and transfer pricing policies related to the financing arrangements. The MNE’s financial and tax positions include the annual consolidated financial statement and a brief description of the MNE group’s existing unilateral advance pricing agreements and other tax rulings relating to the allocation of income among countries.

The local file contains detailed information about the specific intercompany transactions, which can be categorised into (i) local entity information, (ii) controlled transactions information, and (iii) related financial information. The local entity information includes an organization chart along with the responsibilities of the individuals, its business strategy and competitors’ analysis. The information about the controlled transactions includes a description of the controlled transaction, intra-group payment and receipts related to such transactions, identification of the related parties, interparty agreements, transfer pricing method adopted, assumption taken to apply the methodology, comparability analysis, adjustment if any required, reasons that transaction has been priced at arm’s length etc. The financial information includes the financial statements of the local entity and schedules of the relevant financial data.

The BEPS Action 13 report provides a template for MNEs to report annually, and for each tax jurisdiction in which they do business, the information set out therein. This report is called the Country-by-Country Report (CBCR). CBCR requires information about the specific tax jurisdiction, like income of the specific jurisdiction, taxes paid, stated capital, accumulated earnings, number of employees, tangible assets etc. This report requires a listing of the constituent entities, their resident status, and business activities conducted by them. The CBCR report is helpful for the high-level risk assessment. CBCR rules have already been introduced in the UAE, which applies to entities that are tax resident in the UAE and are part of the MNE group with consolidated revenues equal to or exceeding Dh3.15 billion ($858 million) in the financial year preceding the ‘financial reporting year’ concerned.

Businesses which are part of the MNE group should prepare themselves to have proper documentation by following the abovementioned three-tiered approach.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax. For any queries/clarifications, please write to him at compliance@kresscooper.com