At Pro Tax Accountant, we understand the importance of maintaining compliance and fairness in business transactions, especially when dealing with related parties.
One of the key principles guiding such transactions is the arm’s length principle.
In this blog, we’ll break down the concept, its relevance, and how it impacts your business operations.
What Is the Arm’s Length Principle?
The arm’s length principle ensures that transactions between related or connected parties are conducted as if they were between independent parties in a free market.
This means the price, terms, and conditions must reflect what unrelated parties would agree upon in similar circumstances.
For example, if Company A sells goods to its subsidiary Company B, the price charged should be similar to what Company A would charge an independent third party for the same goods.
Why Is the Arm’s Length Principle Important?
1. Prevents Tax Avoidance
Without this principle, businesses might shift profits to lower-tax jurisdictions by manipulating transaction prices.
For instance, a company could overcharge its subsidiary in a low-tax country, thereby reducing its taxable income in a high-tax country.
By adhering to the arm’s length principle, businesses avoid penalties and ensure compliance with tax regulations. For more insights, check out our guide on UAE corporate tax compliance.
2. Ensures Fair Valuation
The principle mandates that all transactions reflect the actual economic value of goods, services, or assets exchanged.
This prevents companies from inflating costs or revenues to minimize tax liabilities.
3. Applicable to Various Transactions
From the sale or purchase of goods and services to loans and intangible assets, the arm’s length standard applies to a wide range of transactions.
It’s especially crucial for businesses operating in the UAE, where corporate tax rules now require stricter compliance.
Key Applications of the Arm’s Length Principle
Related Party Transactions
When dealing with related parties, payments or benefits must align with market value.
For instance, if you’re paying a director who is also a shareholder, only the portion corresponding to their market-value services is deductible for corporate tax purposes.
Market Value and Transfer Pricing
Market value refers to the price agreed upon in a similar transaction between unrelated parties.
Transfer pricing, a related concept, involves setting prices for transactions between connected entities.
| Key Element | Definition |
|---|---|
| Market Value | Price agreed upon in an arm’s length transaction between unrelated parties. |
| Transfer Pricing | Rules for pricing goods, services, or assets exchanged between related parties. |
Learn more about compliance with our corporate tax services.
Permanent Establishments
Transactions between a company and its permanent establishment (PE) must also meet the arm’s length standard.
For example, if a Dubai-based PE provides services to its parent company, the pricing should reflect market rates.
Employment-Related Expenditure
If employees are related parties, their compensation must be reasonable and align with market standards.
Any excessive payments might not qualify as deductible expenses.
Non-Arm’s Length Expenditure: What Happens?
Payments or transactions that do not meet the arm’s length standard could result in penalties, non-deductible expenses, and reputational damage. For instance:
- If a company overpays for goods purchased from a related party, the excess payment may not be tax-deductible.
- Similarly, if an inflated loan interest rate is charged between related entities, the excess interest may be disallowed for tax purposes.
For practical advice, visit our guide on non-deductible expenses under UAE corporate tax.
Comparing Arm’s Length with Non-Arm’s Length Transactions
| Aspect | Arm’s Length Transaction | Non-Arm’s Length Transaction |
|---|---|---|
| Fair Pricing | Based on market value. | May involve inflated or reduced prices. |
| Tax Deductibility | Fully deductible if incurred wholly for business purposes. | May be disallowed if excessive or unreasonable. |
| Regulatory Compliance | Meets compliance standards. | May attract penalties or audits. |
Arm’s Length Principle and UAE Corporate Tax
With the introduction of corporate tax in the UAE, adhering to the arm’s length principle is more critical than ever. According to UAE tax regulations:
- Related party transactions must be at arm’s length.
- Payments to related parties are deductible only if they correspond to market value and are exclusively for business purposes.
For detailed guidance, explore our UAE corporate tax blog.
How We Can Help
At Pro Tax Accountant, we specialize in helping businesses navigate the complexities of UAE tax regulations. Our services include:
- Corporate Tax Compliance: Ensuring your related party transactions meet the arm’s length standard.
- Transfer Pricing Documentation: Preparing comprehensive documentation to support your pricing strategies.
- Audit Support: Assisting with audits to verify compliance with tax laws.
Discover more about our affordable corporate tax accountant services or reach out to us through our contact page.
Final Thoughts
The arm’s length principle is essential for maintaining transparency, fairness, and compliance in business transactions.
By ensuring that transactions with related parties reflect market value, businesses can avoid tax complications and build trust with stakeholders.
At Pro Tax Accountant, we’re here to guide you every step of the way. Whether you need help with transfer pricing, corporate tax, or bookkeeping, we’ve got you covered.
For more tips and expert advice, visit our blog or explore our online accounting and bookkeeping services.
Let’s keep your business compliant and thriving!
