Characterization of Distributors in The UAE on Transfer Pricing

The landscape for businesses operating within UAE underwent a significant shift in June 2023, once the Corporate Tax Law came into effect in UAE. As companies in the UAE positioned themselves to navigate the intricacies of international tax regulations, one aspect that demanded close attention was the characterization of businesses in the UAE and how this characterization would affect the attribution of profits/revenue share to the Companies depending on the functions undertaken, assets employed, and risks borne by the UAE entities. 

In common parlance, the industry is divided into three wide sectors i.e. – Manufacturing, Distribution and Service Sector. Amongst these sectors, the Distribution Sector is the most predominant one in UAE , as trading activities are widespread across the country.  

Hence, we would like to delve deep and throw light on how the characterization of distributors in the UAE would have an impact on their respective businesses from a transfer pricing perspective, under the ambit of UAE Corporate Tax Law. 

Characterization of Distributors 

In the context of transfer pricing, the term distributor refers to an entity that purchases goods from a related entity and sells them in the local or international market. Distributors can be broadly classified into three main categories: 

• Full-fledged distributors: These entities undertake end-to-end operations in the value chain of a Distributor, bearing higher risks (for instance inventory risk, market risk, credit risk, warranty risk, foreign currency risk etc.). Accordingly, following the principle –‘ higher the risk higher the return’, these full-fledged distributors earn a commensurate return for the risks they undertake. 
• Limited-risk distributors (LRD): These distributors assume minimal risks and have limited decision-making power earning pre-determined lower profit margins, since the functions undertaken by them are not extensive in nature and their corresponding contribution in the value chain of Distributors is comparatively lesser. 
• Commissionaire model : A Commissionaire Distributor can be referred to as a hybrid model between a traditional distributor and an agent. Such Commissionaire Distributor sells products in its own name, but on behalf of the Principal Distributor. 

Further, we have detailed below, how the appropriate characterization of distributors would have an impact on Transfer Pricing: 

1. Profit Allocation – The fundamental principle of transfer pricing is ensuring that profits are allocated in accordance with the economic activities and risks undertaken by each entity. A full-fledged distributor that assumes more risk is entitled to a higher return than a limited-risk distributor. In-appropriate characterization of a distributor as an LRD, would in fact lead to an inappropriate delineation of profits and may attract scrutiny from tax authorities.
2. Risk Assessment – One of the key criteria in transfer pricing is determining which entity bears the economic risks. In the case of an LRD, the entity is usually insulated from fluctuations in market demand, price volatility, and operational risks. On the other hand, a full-fledged distributor shoulders these risks and earns a corresponding higher profit commensurate with the said exposure. In appropriate risk allocation could result in tax disputes or adjustments.
3. Compliance with UAE Transfer Pricing Rules – With respect to distributors, compliance with the TP provisions encompasses accurate projection of their role in the value chain, based on the functions performed, assets employed, and risks assumed. Incorrect characterization could lead to the possible risk of cherry picking by the tax authorities .

In the UAE’s dynamic business environment, the characterization of distributors has far-reaching implications for transfer pricing. As the UAE continues to align with international tax standards, businesses must remain vigilant in accurately defining the roles undertaken and risks borne by the distributors to ensure compliance with transfer pricing regulations. 

Summary

The implementation of the Corporate Tax Law in June 2023 has significantly impacted businesses in the UAE, particularly regarding transfer pricing and the characterization of distributors. Distributors can be categorized as full-fledged, limited-risk, or commissionaire models, each bearing different levels of risk and profit margins. Accurate characterization is crucial as it influences profit allocation, risk assessment, and compliance with UAE transfer pricing regulations. Inappropriate categorization can lead to tax disputes and increased scrutiny from authorities. As the UAE aligns with international tax standards, businesses must define the roles and risks associated with their distributors to ensure compliance and foster sustainable growth. 

Disclaimer:   The Content offer general guidance and should not be considered legal, financial, or tax advice. Consult qualified professionals for personalized guidance. While efforts have been made to ensure accuracy, no guarantee is provided for completeness or applicability to individual situations. Users are responsible for their interpretation and actions based on this information, at their own risk.   

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