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– Key difference between “Related Party” and “Connected Person” |
Introduced by the Federal Decree-Law No. 47 of 2022, the corporate income tax regime (CIT for Corporate Income Tax) in the United Arab Emirates imposes a 9% rate on taxable income exceeding AED 375,000 for financial years beginning on or after June 1, 2023. Among the most misunderstood aspects are the concepts of “connected persons” and “related parties”. Although these terms may initially seem interchangeable, confusing them can lead to costly compliance errors, denied deductions, and even audits by the Federal Tax Authority (FTA).
Defining “Related Party”
Related parties (“Related Party”) are described in Article 35 of the Corporate Tax Law. This category includes entities or individuals with close ownership, control, or family ties that may influence transaction prices. More specifically, related parties include: - Two or more individuals related by blood or marriage up to the fourth degree of kinship (for example, siblings, cousins, or parents-in-law through marriage or adoption). - A natural person and a legal entity where the individual owns at least 50% of the entity or exercises control over it. - Two or more legal entities under common ownership or control of at least 50%. - Partners in an unincorporated partnership. - A company and its permanent establishment (PE), whether domestic or foreign. - Trustees, founders, settlors, or beneficiaries of a trust or foundation, as well as their related parties.
Control is broadly defined as the ability to influence decisions, such as holding 50% or more of the voting rights, board seats, or rights to profits, or exercising significant influence over operations. The arm’s-length principle, aligned with OECD guidelines, requires transactions between related parties to reflect market conditions in order to prevent artificial profit shifting.
Defining “Connected Party”
Connected persons (“Connected Party”), detailed in Article 36, represent a subset focused on key decision-makers and their close associates. This includes: - Natural persons who own or control the taxable entity, directly or indirectly. - Directors, officers, or senior executives. - Partners in the same unincorporated partnership. - Family members or related parties of the individuals above.
Unlike related parties, which emphasize ownership ties, connected persons target those with direct managerial influence. Payments or benefits granted to connected persons – such as salaries, bonuses, or reimbursements – must not only comply with the arm’s-length principle, but must also be incurred exclusively for business purposes to be deductible. If a payment exceeds market value, the excess is denied as a deduction for the payer. In addition, non-compliant payments could be considered a business activity for the connected person, potentially subjecting them to corporate tax if their income exceeds the thresholds, although natural persons are generally exempt unless they conduct licensed activities.
Key differences: thresholds, documentation, and scrutiny
For “Related Party”:
- Reporting thresholds: Total transactions exceeding AED 40 million must be reported in the transfer pricing disclosure form, with details by category (for example, goods and services) for those exceeding AED 4 million. - Documentation: A transfer pricing study, including a functional analysis and OECD-compliant comparables, is required for large entities (revenue ≥ AED 200 million or part of a multinational group with consolidated revenue ≥ AED 3.15 billion). Master and local files must be prepared and submitted upon request by the FTA.
For “Connected Party”:
- Reporting thresholds: A lower overall threshold of AED 500,000, with category-by-category reporting for amounts exceeding AED 500,000. - Documentation: Support through remuneration studies is mandatory. Up-to-date evidence is crucial to avoid denials.
The FTA applies stricter scrutiny to payments to connected persons because of the increased risk of abuse, such as excessive remuneration compared with the market. While the rules for related parties focus on comprehensive transfer pricing studies, connected-person compliance emphasizes transaction-level evidence.
Common pitfalls and UAE-specific nuances
Many companies fall into the trap of applying international transfer pricing frameworks without adapting them to the specific features of the United Arab Emirates. For example, a bonus of AED 2 million for a director might be treated as ordinary remuneration, but under the connected-person rules, it requires comparison with market rates – failure to do so could result in the deduction being denied in full.
In the UAE context: - The fourth-degree kinship rule may link entities in unexpected ways. - The interaction between CIT and VAT adds complexity: misclassified transactions may affect input VAT credits.
International guidance does not always cover the UAE’s unique “dual-track” approach: - Related parties → extensive documentation for significant transactions - Connected persons → detailed evidence even for modest amounts
Compliance strategies for businesses
To mitigate risks: - In-depth mapping: Identify all related parties and connected persons early in the fiscal year. - Robust comparables: Use comparable data for valuations, in accordance with OECD methods. - Documentation: Keep contracts, analyses, and market studies. - Advance decisions: Request a ruling or APA to clarify complex cases. - Internal training: Raise awareness among finance, HR, and management teams.
