Arm’s Length behavior in a land Joint Development Arrangement

Facts

Company A (Landowner) is a UAE tax resident holding title to a plot of land available for development. The market value of the land is AED 1,000,000.

Company B (Developer) is a UAE-registered real estate development company with the personnel, resources, and technical capacity to carry out the development.

The parties entered into a joint development agreement, classified as a Cost Contribution Arrangement (CCA), with the following terms:

• Company A contributes the land.
• Company B contributes the development services.
• Each party is entitled to a 50% share in the completed building.

Company A and Company B are Related Parties in terms of the Corporate Tax legislation.

The market value of the development services contributed by Company B is AED 2,000,000, whereas the market value of the land contributed by Company A is AED 1,000,000.

The CCA does not provide for a balancing payment to reflect the disparity in the value of contributions.

The fair market value of the completed apartment building is AED 5,000,000.

Questions

1. What transfer pricing adjustments should each party reflect in their Corporate Tax returns to ensure compliance with the arm’s length principle?
2. Should the companies allocate ownership interests based on the market value of their respective contributions, or should their contributions be adjusted to reflect the market value of the benefits (i.e., property share) actually received?

Summary

Upon examination of the applicable accounting and tax standards, we concluded that:

1. Since legal ownership is allocated on a 50/50 basis, for tax purposes, the parties' contributions must be adjusted to reflect the market value of the benefits actually received.
2. Company B (Developer) should recognize AED 500,000 as service revenue representing the balancing payment it would have received at arm’s length.
3. Company A (Landowner), whose contribution of land is valued at AED 1,000,000, should reflect a corresponding development expense of AED 500,000 to align its share of benefits (50% of the final asset) with its lower contribution. However, the recognition of this adjustment is subject to the operation of a formal procedure to be adopted by the FTA. Until such procedure is in place and successfully followed, Company A cannot unilaterally deduct or capitalize this amount for Corporate Tax purposes.
4. The absence of an actual balancing payment may trigger a secondary adjustment, depending on the nature of the relationship between the parties and the underlying intent:

• If Company A is a shareholder in Company B, the unremunerated benefit may be reclassified as a constructive dividend
• In other cases, the secondary transaction may assume the form of a capital contribution, interest-bearing receivable, unjust enrichment liability, or a gratuitous transfer. While such recharacterizations do not give rise to withholding tax in a domestic UAE context, they may affect accounting classification and corresponding Corporate Tax treatment, VAT issues.

Analysis

According to Sec. 7.4.3 of the FTA Transfer Pricing Guide No CTGTP1, ‘the key step in applying the Arm’s Length Principle in a CCA [Cost Contribution Arrangement] is to calculate the value of each participant’s contribution to the joint activity, and finally to determine whether the allocation of CCA contributions (as adjusted for any balancing payments made among participants) align with their respective share of expected benefits’. Therefore, accurately valuing each party’s contribution and implementing a mechanism to address discrepancies is fundamental to satisfying the arm’s length principle.

The same section clarifies that ‘for service CCAs, contributions primarily consist of the performance of services. For development CCAs, contributions typically include the performance of development activities and additional contributions relevant to development CCA such as pre-existing tangible assets or intangibles. All contributions of current or preexisting value must be identified and accounted for appropriately in accordance with the Arm’s Length Principle’.

Accordingly, in the scenario under consideration, the parties’ contributions are:

• For Company A – the land as ‘pre-existing tangible assets’;
• For Company B – the services (‘performance of development activities’).

The value of each participant's contribution ‘should be consistent with the value that independent business in comparable circumstances would have assigned to that contribution’, i.e. should me measured at market value.

Pursuant to Sec. 7.4.5, disparities in contribution versus benefit allocation must be resolved through balancing payments. The FTA defines such payments as ‘payments made between participants in a CCA to ensure that each participant receives its proportionate share of the benefits from the activity. A compensating payment may be required if a participant’s contributions are not proportional to their anticipated benefits and is made by participants that have received a greater share of the benefits than their contributions would warrant. However, it can also be paid to participants whose contributions are greater than the benefits received’.

This provision confirms that the arm’s length nature of a CCA depends not only on accurate valuation of contributions, but also on correcting any misalignment between contributions and benefits through balancing payments. The FTA explicitly acknowledges that such payments may flow in either direction: from parties who have received a disproportionate share of the benefits, or to those who have over-contributed relative to what they receive. Accordingly, where no balancing payment is made despite evident disparity, the arrangement fails to meet the arm’s length standard and gives rise to the need for a primary transfer pricing adjustment.

Need for transfer pricing adjustment

In the current arrangement, Company A contributes land worth AED 1,000,000, while Company B contributes development services worth AED 2,000,000. Despite this disparity, both parties receive a 50% share in the developed property.

From a transfer pricing perspective, this equal allocation does not reflect what independent parties would have agreed to under comparable economic conditions. At arm’s length, the developer would not accept a disproportionate allocation of benefits without a corresponding adjustment.

Independent parties in this situation would typically resolve the imbalance by either:

• Making a balancing payment by the under-contributing party; or
• Adjusting ownership interests in the completed asset in proportion to the market value of their respective contributions.

In the absence of any contractual mechanism to balance contributions, the transaction must be reconstructed for tax purposes to reflect arm’s length behavior. Accordingly:

• Company B (Developer), having over-contributed by AED 1,000,000, should recognize AED 500,000 as service revenue, representing implied compensation for the excess contribution.
• This amount should be recognized as taxable income under the UAE Corporate Tax regime.

Company A (Landowner), conversely, should be deemed to have incurred an AED 500,000 development expense in acquiring its 50% interest in the completed property. Depending on classification, this cost may be capitalized into the cost base of the asset or treated as a deductible service cost.

While the legal agreement provides for equal (50/50) ownership, the economic substance of the arrangement does not align with the contributions made. Under both OECD Guidelines and the UAE Transfer Pricing framework, transfer pricing rules respect the legal form but require tax outcomes to reflect economic reality.

As such, transfer pricing adjustments do not alter legal ownership, but reconstruct the financial flows that would have occurred had the parties acted at arm’s length. This entails:

• treating Company B as having received AED 500,000 in service revenue; and
• treating Company A as having paid an equivalent development expense.

Corresponding adjustment

If Company A (Landowner) seeks to recognize the AED 500,000 development cost as a deductible expense or capitalized asset base, it must obtain approval through procedures to be established by the FTA.

According to Sec. 8.2 of the Guide No. CTGTP1, ‘after submitting their Tax Returns, Taxable Persons may make Transfer Pricing adjustments where these result in increased taxable profits or reduced allowable losses, or make adjustments that result in decreased taxable profits or greater allowable losses. A decrease in the taxable profits or increase in allowable losses may only be affected through the operation of the FTA procedures’.

Therefore, Company A cannot unilaterally deduct or capitalize the AED 500,000 unless the FTA formally adopts the relevant procedure and the taxpayer successfully passes them.

Secondary adjustment

Following the primary transfer pricing adjustment, a secondary adjustment may be required to account for the deemed transfer of economic benefit.

Under established transfer pricing principles, where a balancing payment is deemed but not actually made, a secondary adjustment may be required to account for the resulting uncompensated transfer of value between related parties.

OECD TP Guidelines[1] defines secondary adjustment as an ‘adjustment that arises from imposing tax on a secondary transaction’, i.e. on a ‘constructive transaction that some jurisdictions will assert under their domestic legislation after having proposed a primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment’.

While the UAE TP Guide (CTGTP1) does not expressly use the term “secondary adjustment,” Section 3.1.6 of the FTA Exempt Income Guide No. CTGEXI1 recognizes the concept of “non-arm’s length: constructive dividend”, stating: ‘Constructive Dividends are payments or benefits received by a shareholder as an assignment of income, despite the absence of a formal distribution. This could arise, for example, as a result of a transaction under which a parent company receives compensation that exceeds the fair value of the goods or services provided by it, to its subsidiary. As defined, any payment or benefit that arises to a Related Party or Connected Person (who is a shareholder) as a result of a transaction or arrangement which does not comply with the arm’s length principle will constitute a distribution of profit in substance and accordingly, qualify as a Dividend, to the extent to which it is not at arm’s length’.

The current scenario does not specify the exact nature of the relationship between the parties (e.g., parent–subsidiary or common control). If Company A is a shareholder in Company B, the benefit it receives through the avoided balancing payment may be reclassified as a deemed dividend. In other cases, the appropriate secondary characterization will depend on the economic substance of the relationship.

As per para 4.68 of the OECD TP Guidelines, ‘ordinarily, the secondary transactions will take the form of constructive dividends, constructive equity contributions, or constructive loans.’. In the case at hand, reclassification of the balancing amounts that haven’t been actually paid may include:

1. A deemed (constructed) dividend, where the excess value received is treated as a non-arm’s-length distribution by the developer to the landowner (OECD TP Guidelines, para 4.68, CTGEXI1, Sec. 3.1.6);
2. A capital contribution, where the value is effectively transferred as equity without expectation of repayment (OECD TP Guidelines, para 4.68, IFRS Conceptual Framework, para 4:70);
3. An interest-bearing intercompany receivable, where the absence of settlement indicates a financing arrangement between the parties. Under the arm’s length principle, such amounts may require accrual of interest and recognition of financing income (OECD TP Guidelines, para 4.69);
4. A liability for unjust enrichment under Article 318 and 319 of the UAE Civil Transactions Law;
5. A gratuitous transfer or deemed (constructed) gift.

Since both parties are UAE tax residents, the secondary adjustment does not result in cross-border withholding tax implications.

[1] OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en

The disclaimer

Pursuant to the MoF’s press-release issued on 19 May 2023 “a number of posts circulating on social media and other platforms that are issued by private parties, contain inaccurate and unreliable interpretations and analyses of Corporate Tax”.

The Ministry issued a reminder that official sources of information on Federal Taxes in the UAE are the MoF and FTA only. Therefore, analyses that are not based on official publications by the MoF and FTA, or have not been commissioned by them, are unreliable and may contain misleading interpretations of the law. See the full press release here.

You should factor this in when dealing with this article as well. It is not commissioned by the MoF or FTA. The interpretation, conclusions, proposals, surmises, guesswork, etc., it comprises have the status of the author’s opinion only. Furthermore, it is not legal or tax advice. Like any human job, it may contain inaccuracies and mistakes that I have tried my best to avoid. If you find any inaccuracies or errors, please let me know so that I can make corrections.