A Branch Can Owe Tax on Profits the Group Never Made

A permanent establishment has no separate legal existence. It cannot contract with its own head office, and nothing moves between them that a court would call a transaction. For tax purposes the Corporate Tax Law requires you to pretend otherwise, and the pretence has consequences that catch people out.

Where the fiction comes from

Permanent Establishment takes its meaning from Article 14 of the Corporate Tax Law. Article 24(4) then supplies the rule that governs attribution: when determining the income and associated expenditure of a Permanent Establishment, a Resident Person and each of its Permanent Establishments should be treated as separate and independent entities.

The guide describes what that means in practice. The arm's length principle requires treating a PE as if it were a separate entity operating independently from other parts of the group and from the head office to which it belongs. It calls the separate entity approach a hypothetical construct that distinguishes the functions, assets and risks of the PE from those of its parent entity.

It applies in both directions. A Non-Resident Person may perform activities creating a PE in the UAE, and a Resident Person may operate through a PE in another jurisdiction. The FTA expects profits to be attributed appropriately either way.

Step one: the functional analysis, and the people in it

The first step is a functional analysis identifying the activities performed by the PE on one side and the head office on the other, each treated as separate from the other, taking account of the assets used and the risks assumed by the PE. The guide sets out what that analysis should produce.

• Attribution to the PE of the rights and obligations arising from dealings between the head office and separate persons.
• Identification of the significant people functions relevant to the assets, and the attribution of economic ownership of those assets.
• Allocation of risks, assets and rewards to the function, taking into account the significant people function as key decision makers with the ability to assume risks.
• Identification of the other functions of the PE.
• Recognition and determination of the nature of the dealings between the PE and other parts of the same enterprise.
• Attribution of capital based on the assets and risks attributed to the PE.

Attribution of capital is the item most often missing altogether. Once assets and risks sit with the PE, capital has to be attributed to support them — and a PE funded entirely by head office, with no attributed capital, has an interest position that will not survive examination.

Step two: price the dealings

The second step determines the compensation for transactions between the head office and the PE. The guide asks for comparability between the dealings and uncontrolled transactions, established either by applying the comparability factors directly — the characteristics of property or services, economic circumstances, and business strategies — or by analogy, in the case of the functional analysis and the contractual terms.

The most appropriate method is then selected and applied by analogy to the guidance in the guide, to arrive at an arm's length compensation for the dealings, taking into account the functions performed and the assets and risks attributed to the PE.

The word doing the work in both halves is by analogy. There is no contract between a head office and its own branch, so the contractual-terms limb of comparability has nothing literal to read. The analysis substitutes conduct for paperwork.

The guide's worked example

Example 23 takes Company A, the parent of a group headquartered in country X with a core business of procuring and selling goods there. Company A has a PE in the UAE that performs procurement activity on its behalf from unrelated UAE suppliers, and the PE habitually exercises an authority to conduct a business in the UAE. The PE never owns title to the goods and has no entitlement to the amounts Company A charges its customers. Company A pays the PE a commission as a percentage of the cost of purchases made on its behalf.

The functional analysis finds that Company A performs the sale of goods to independent third-party customers in country X, and the PE performs procurement support. Step two then prices the dealings between them by reference to what would have been paid had the same functions been performed by an unrelated supplier in the UAE on Company A's behalf.

Documentation, and where to look when the guide runs out

The FTA expects taxable persons to follow this approach, and expects contemporaneous documentation supporting its application to be maintained and provided on request. The guide says this is expected to form part of the transfer pricing documentation prepared for each period — so PE attribution is not a separate exercise filed elsewhere, it belongs in the same file.

Where an issue is not addressed in the guide, it encourages taxable persons to refer to the OECD's 2010 and 2018 reports on the attribution of profits to permanent establishments.

Where the enterprise is a free zone company, a PE is not only an attribution question. A domestic or foreign permanent establishment of a Qualifying Free Zone Person carries its own consequences under the free zone rules.

What to check

1. Establish that a PE exists under Article 14 before attributing anything to it.
2. Run the functional analysis on both sides — the head office is not a residual.
3. Identify the significant people functions and who actually has authority to assume risk.
4. Attribute capital to support the assets and risks the PE has been given.
5. Identify the dealings between PE and head office explicitly, since no contract records them.
6. Price those dealings by analogy, using the comparability factors that can be applied directly and those that cannot.
7. Do not assume the PE shares the group's profit or its losses; the branch result is built from the branch's functions.
8. Keep the attribution inside the period's transfer pricing documentation, contemporaneously.

The FTA Transfer Pricing Guide (CTGTP1) is guidance rather than legislation; the operative provisions are Articles 14, 24 and 34 of the Corporate Tax Law. Confirm the position for your own facts before relying on it.