Facts
A company registered in a Qualified Free Zone in the UAE sells software to its subsidiary, a wholly owned LLC registered in the US, for onward resale to independent customers. This LLC is treated as a disregarded (pass-through) entity for US tax purposes. The LLC does not have any employees in the US or elsewhere, serving merely as a conduit between the ultimate customer and its parent company. However, there is a business rationale for this structure, as a direct sale from the Emirati parent to the customers is either not feasible or overly complex.
Question
How should these arrangements be treated for Corporate Tax purposes in the UAE?
Summary
Based on the facts and analysis below, we opine that:
- For UAE Corporate Tax purposes, the disregarded US LLC is likely to be treated as a Foreign Permanent Establishment (PE) of the UAE parent.
- The internal dealings between the US LLC (as a foreign PE) and the UAE parent should be recognized in the tax return at market value. To comply with this obligation, the UAE parent must adopt an appropriate Transfer Pricing (TP) model. Concepts such as “risk-free and no-function” return and “disregarded transaction” could be particularly relevant in this case.
Version 1: Unincorporated Partnership
Under US tax regulations, a disregarded entity owned by a foreign person or entity is not subject to federal income tax at the entity level, as it is treated as a “pass-through” entity. Instead, any income generated by the disregarded entity is attributed to its owner and taxed at the owner's level. However, if the disregarded entity generates effectively connected income (ECI) related to a US trade or business, the owner is subject to US taxation on that income
The tax treatment of disregarded entities resembles that of an unincorporated partnership under UAE Corporate Tax Law, where such partnerships are considered “fiscally transparent.” Profits are taxed at the partner level rather than the partnership level. An Unincorporated Partnership does not have a separate legal personality distinct from its partners. The
Business of the Unincorporated Partnership and its owners is or can be considered the same.[1] A Free Zone Person can participate in an Unincorporated Partnership, but if the partnership is fiscally transparent, the Free Zone partner must evaluate its Corporate Tax obligations based on its distributive share, particularly in determining whether it earns Qualifying Income as a Qualifying Free Zone Person.[2]
An “Unincorporated Partnership” is defined as ‘A relationship established by contract between two Persons or more, such as a partnership or trust or any other similar association of Persons, in accordance with the applicable legislation of the State’.[3] Foreign partnership also requires association of an association of two or more persons. It is defined as ‘a relationship established by contract between two Persons or more, such as a partnership or trust or any other similar association of Persons, in accordance with laws of a foreign jurisdiction’.[4]
A similar definition applies to foreign partnerships under foreign jurisdiction. A single-member LLC is treated as a disregarded entity for tax purposes. To be classified as a partnership under US tax law, an LLC must have at least two members as well. Only multi-member LLCs are treated as partnerships by default and are required to file Form 1065 (U.S. Return of Partnership Income), unless they elect to be taxed as a corporation.[5]
However, a structure where the US LLC has only one member (owner or partner) does not meet this definition. To qualify as a partnership, an LLC must have at least two members.
[1] Section 3.3 of the FTA Taxation of Partnerships Guide
[2] Ibid. Section 9.2, 9.3
[3] Art. 1 of the Corporate Tax Law
[4] Ibid.
[5] IRS Publication 3402 (Rev. March 2020) Cat. No. 27940D Taxation of Limited Liability Companies.
Version 2: Foreign Permanent Establishment
A US LLC is a distinct legal entity under US law and may operate independently. If the LLC acts on its own behalf with decision-making authority, it is unlikely to be considered a PE of the UAE company. However, if the UAE parent exerts significant control over the US LLC and uses it merely as an extension to conduct business, the US LLC is likely to be deemed a foreign PE of the UAE company for UAE Corporate Tax purposes. In the scenario described, the US LLC appears to act as a dependent agent, conducting substantial business on behalf of the UAE parent.
Article 14 of the UAE Corporate Tax Law defines a Foreign PE as ‘a place of Business or other form of presence outside the State of a Resident Person that is determined in accordance with the criteria prescribed in Article 14 of this Decree-Law’.[1] Clause 1(b) of Article 14 sets forth that an activity constitute a PE where ‘a Person has and habitually exercises an authority to conduct a Business or Business Activity in the State on
behalf of the Non-Resident Person’. Clause 5 of this Article clarifies that ‘a Person shall be considered as having and habitually exercising an authority to conduct a Business or Business Activity in the State on behalf of a Non-Resident Person if any of the following conditions are met:
The Person habitually concludes contracts on behalf of the NonResident Person.
The Person habitually negotiates contracts that are concluded by the Non-Resident Person without the need for material modification by the Non-Resident Person’.
Given the described arrangements, it is highly likely that US LLC would meet these criteria for a Foreign PE.
[1] Article 1 of the Corporate Tax Law.
Transfer Pricing Considerations
Section 1 of the Guide No. CTGFZP1 explains that a Foreign Permanent Establishment ‘should be treated as if it were a separate and independent Person from a Free Zone parent. For example:
- ‘The income or profits attributable to the Free Zone parent, Foreign
Permanent Establishment … should be consistent with the arm’s length principle (i.e. based on the respective functions, assets and risks of the Free Zone parent and the Foreign Permanent Establishment …, as if the Free Zone parent were a separate Person transacting at arm’s length). The Free Zone parent must earn and record an appropriate level of operating profits or losses determined in accordance with internationally accepted profit attribution methods such as the separate entity approach.
- ‘If the outputs from the Free Zone parent are used in the Business
of its Foreign Permanent Establishment …, the Free Zone parent would be treated as if it has derived Revenue from a NonFree Zone Person.’
Therefore, although treated as a PE, the disregarded entity must still be regarded as a separate and independent entity from its Emirati parent.
Section 4. outlines the application of the “separate entity approach”. To attribute profits between a Free Zone parent and its Foreign Permanent Establishment, a two-step approach is required:
- Step one: ‘Conduct a functional analysis to identify the functions
performed by the Foreign Permanent Establishment … on one side, and the Free Zone parent on the other side, treating each as separate to the other. This analysis should also take into account the assets used and the risks assumed by the Foreign Permanent Establishment … and the Free Zone parent’.
At this stage, the relationship between the UAE parent company and the US subsidiary should be classified based on the functions performed by each entity. Based on the facts of this case, the US LLC’s role is limited to holding contracts with US customers, serving
solely as a conduit for these transactions. This arrangement does not align with the distributor model. Instead, it closely resembles a commissionaire model, where the US LLC acts on behalf of the principal (the UAE parent), operating at the principal’s expense, with all risks fully assumed and managed by the principal while acting in the agent's (US LLC’s) name.
- Step two: ‘Determine the compensation relating to arrangements
or dealings between the Foreign Permanent Establishment …. and the Free Zone parent, commensurate with their respective functions performed, assets deployed, and risks assumed’.
At this stage, the commission that an unrelated party would charge for providing similar commissionaire services must be determined. Given that the US LLC performs minimal functions and assumes no risks, it is likely that only a limited return would be attributed to the US LLC.
For instance, para 1.106 of the OECD’s TP Guidelines ‘a party which, under these steps, does not assume the risk, nor contributes to the control of that risk, will not be entitled to unanticipated profits (or required to bear unanticipated losses) arising from that risk’. Para 2.127 provides for the similar approach describing transactional profit split method: ‘… where the accurate delineation of the transaction determines that one party to the transaction performs only simple functions, does not assume economically significant risks in relation to the transaction and does not otherwise make any contribution which is unique and valuable, a transactional profit split method typically would not be appropriate since a share of profits (which may be impacted by the playing out of the economically significant risks) would be unlikely to represent an arm’s length outcome for such contributions or risk assumption’.
Examples in Annex I to Chapter VI of the OECD TP Guidelines further emphasize that only the functions performed by the US LLC should be remunerated at an arm’s length price. Example 2 highlights that administrative or similar functions may warrant remuneration. However, this does not seem applicable to the current scenario, as the functions attributed to the US LLC are expected to be carried out by the UAE parent company’s employees. If any functions are performed by the US LLC’s officers, only those specific functions should be evaluated and priced at arm’s length.
Risk-Free or Disregarded Transaction?
A deeper understanding of the facts is essential to determine the appropriate TP treatment. Two possible approaches include:
- Risk-free and minimal function pricing, or
- Disregarded Transaction treatment.
Under para 25 of the OECD TP Guidelines, ‘when, under accurate delineation, the lender is not exercising control over the risks associated to an advance of funds, or does not have the financial capacity to assume the risks, such risks should be allocated to the enterprise exercising control and having the financial capacity to assume the risk...’
The OECD exemplify with ‘a situation where Company A advances funds to Company B. Consider further that the accurate delineation of the actual transaction indicates that Company A does not exercise control functions related to the advance of funds but that Company P, the parent company of the MNE group, is exercising control over those risks, and has the financial capacity to assume such risks. Under Chapter I analysis, Company P will bear the consequences of the playing out of such risks and Company A will be entitled to no more than a risk-free return ...’.
Para 1.109 defines ‘a risk-free rate of return is the hypothetical return which would be expected on an investment with no risk of loss’.
A similar treatment applies in cases where a company does not perform any relevant functions. This is likely applicable to the US LLC in this scenario, as it has no employees to carry out such functions. Consequently, the company may be entitled only to a “risk-free and no-function” return as its arm’s length reward for this transaction.
This logic leads to the next level of pertinent treatment: the concept of a disregarded transaction. The OECD references this in the footnote to paragraph 103, stating that ‘Company A could potentially be entitled to less than a risk-free return if, for example, the transaction is disregarded under Section D.2’.
Paragraph 1.141 of Section D.2, however, cautions tax administrations against disregarding ‘the actual transaction or substitute other transactions for it unless the exceptional circumstances described in the following paragraphs 1.142-1.145 apply’. Para 1.142 sets forth that ‘the transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction’.[1]
Here, the key question is whether an independent party would conclude a transaction in which one party (its employees) performs all functions and manages all risks, while the other party operates solely in a contractual capacity with all paperwork handled by the parent company’s employees.
This question is not as straightforward as it may seem. Paragraph 1.143 of the OECD Guidelines emphasizes that The key question in the analysis is whether the actual transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties. The non-recognition of a transaction that possesses the commercial rationality of an arm’s length arrangement is not an appropriate application of the arm’s length principle’.
In the scenario at hand, the commercial rationality is given. The transaction involving the US LLC serves as a practical tool for market entry. It is conceivable that an independent party might register a company to perform such a role for another independent party, without assuming significant risks or functions beyond setting up the company and handling contractual paperwork. However, if a closer delineation of the actual transaction reveals that these functions were effectively carried out by the parent company’s employees, this setup might not align with realistic arrangements between independent parties in comparable real-world scenarios. Even so, the “disregarded transaction” treatment warrants additional assessment. The OECD notes that ‘the mere fact that the transaction may not be seen between independent parties does not mean that it does not have characteristics of an arm’s length arrangement’.
[1] This para also explains that ‘It is also a relevant pointer to consider whether the MNE group as a whole is left worse off on a pre-tax basis since this may be an indicator that the transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties’. However, this explanation appears inapplicable, as the customers in the current scenario were not directly contracting with the Emirati parent.
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.
