Alvarez & Marsal Middle East Limited (A&M) is delighted to publish the first edition of its FSI Tax Insights series. In this new series, our tax experts will share key insights and thought leadership on tax matters impacting businesses active in the financial services industry.  The series aims to help Tax professionals, C-suite and heads of finance to look at tax more than just through a compliance lens, and stay current on industry trends.  We hope that you will find our series useful and informative.

1.Background - Evolving Transfer Pricing Regulations in the Middle East

The tax landscape in the Middle East has seen significant transformation in recent years, marked by the introduction of taxes and the implementation of Transfer Pricing (TP) regulations across various countries. This evolution signifies a major shift in the region's tax and TP framework. The United Arab Emirates (UAE) has recently introduced TP regulations, providing guidance on the governance of transactions between related parties. These regulations largely align with the Organization for Economic Cooperation and Development (OECD) TP Guidelines for Multinational Enterprises and Tax Administrations.

Among the key areas covered in the UAE TP guidelines is the treatment of financial transactions. Section 7.1 of the UAE TP guidelines delves into this aspect, offering detailed guidance that financial institutions should consider when structuring intercompany financial arrangements. This section closely mirrors the OECD Guidance on Financial Transactions (GOFT).

Given that banks primarily generate income from interest, fees, and investments, their financial products must be appropriately structured to align with both regulatory and TP considerations. These products are typically funded through customer deposits, borrowings from the wholesale market, or, in many instances, through related parties.

In this context, the role of a bank’s treasury department becomes even more critical. Treasury teams are responsible for sourcing funds on the best terms, managing Foreign Exchange (FX) risks, addressing liquidity mismatches, and ensuring compliance with capital adequacy requirements under Basel III and local regulations. As such, effective treasury management is crucial for maintaining financial stability while adhering to TP regulations that govern related party transactions.

Banks function on a model known as "borrow short, lend long". This essentially means that banks obtain funding on a short-term basis at relatively lower interest rates and then lend these funds to customers on a long-term basis at higher interest rates. The profit for the banks comes from the difference in these interest rates, also known as the interest rate spread. A key consideration in this regard is how banks source funding, particularly from related parties. Considering that related party borrowings may offer more favourable terms, it's crucial for banks to adhere to TP regulations. Banks should undertake a comprehensive TP analysis, inclusive of thin capitalisation analysis and interest rate benchmarking studies, to ensure that the interest on funding from related parties are in line with market rates and satisfy the arm's length principle.

Beyond funding arrangements, banks can engage in various financial transactions with their affiliated entities such as FX transactions, derivative transactions such as interest rate swaps, and trade financing instruments like Letters of Guarantee (LGs) and Letters of Credits (LCs). Additionally, banks may issue explicit or implicit bank guarantees, participate in syndicated loans, and manage cost recharges within their affiliated entities. Given the implicit complexity and volume of these transactions, ensuring that they meet TP compliance requirements is important.

2. Transfer Pricing Considerations for Banks

It's important for banks to ensure their TP arrangements align with the arm's length principle. If TP adjustments were to occur, these could impact a bank’s financial position through increased tax liabilities and decreased overall cash-flow due to additional taxes and penalties to be paid. Moreover, TP adjustments often impact both parties involved in a transaction, adding further complexity. For example, if a UAE-based bank provides funding to its branch in Saudi Arabia (KSA), and a TP adjustment is made in KSA to reduce the interest expense in line with the arm’s length principle, this would increase the taxable profits of the KSA branch. At the same time, a corresponding adjustment in the UAE could lead to lower interest income reported by the bank. However, in practice it is difficult to get certainty through a compensating adjustment. It is yet to be seen how the Mutual Agreement Process (MAP) will operate in the UAE, and in any respect, it may not be possible to relive the double taxation in full.

To mitigate potential scrutiny from tax authorities and prevent costly TP adjustments, banks should conduct detailed TP analyses on all intercompany transactions. Proactively aligning their TP models with regulatory requirements not only ensures compliance but can also present opportunities for tax optimization. Thoughtful TP planning can help banks reduce tax liabilities, and improve cash flow.

We have set the key considerations for the most typical related party transactions for banks below.

a. Value Chain for Loan Issuance and Booking Model

In corporate banking, performing a Value Chain Analysis (VCA) for loans is crucial for determining how income, particularly fee income, should be distributed among related parties based on their respective contributions. The VCA refers to the series of activities undertaken to deliver products and services to customers. As such, a VCA helps identify how each step of the process adds value, and where efficiencies and competitive advantages can be gained.

Typically, the loan value chain consists of the following stages: 

Origination and structuring: This includes key functions regarding relationship management, and sourcing/identifying customers. Once the customer has been sourced, the next step is to structure the loan which includes negotiating the contractual terms.

Approval process: Depending on the quantum of the loan, there may be several committees that are required to approve a loan prior to its issuance.

Booking: It is essential to determine whether assets are booked on the originating bank’s balance sheet or booked offshore due to exposure limits or regulations. Risks are typically transferred via risk participation agreements for balance sheet items and unfunded agreements for off-balance-sheet assets like LGs.

Monitoring: This function includes monitoring the probability of customer defaults, monitoring if covenants have been breached, the creditworthiness of financial assets, reducing exposure of defaulting customers, tracking repayments, and monitoring the value of any provided collateral (if any).

Support services: This involves reviewing preliminary contracts and finalizing contractual formalities, addressing any remaining legal matters, verifying any collateral provided, signing the agreement, documenting the financial asset in the records, and disbursing the loan funds.

In relation to the loan value chain, it's crucial to conduct a comprehensive analysis to evaluate the importance of each function and how each related party contributes to the key functions within the value chain. This assessment will inform the allocation of fees derived from a particular deal among the group entities.

For instance, the functions related to origination and structuring of the loan and the approval process in most instances are viewed as high-value functions. As such, a larger portion of the fee income could be distributed towards these functions. On the other hand, the monitoring and support function, which is considered as a lower value function within the loan value chain, could potentially receive a smaller allocation of the fee income. The distribution of fee income should be proportional to each entity's individual contributions towards the loan value chain.

While the starting position for any TP analysis is through a transactional lens, a holistic VCA approach will ensure that the final outcomes are in line with where value is created.

b. Value Chain of Trade Financing

Trade financing is another critical aspect of corporate banking, covering key products such as the issuance of LCs and LGs, which are typically classified as off-balance sheet items.

The primary income streams from trade financing transactions usually include issuance fees and commissions. Similar to the loan booking model, the value chain for trade financing consists of origination, structuring, approval, administration, and monitoring. However, a significant aspect to consider is identifying the entity that carries the credit risk of the LC or LG. Typically the entity that manages and bears the credit risk should receive a higher portion of the fees.

In the context of trade financing, it's crucial to conduct a thorough analysis of the value chain to understand how different group entities contribute to it. This analysis should then guide the distribution of the fees among the group entities.

c. Interest Rate Swaps

Banks often engage in derivative transactions, such as interest rate swaps, as a strategy to hedge against potential interest rate fluctuations. When a decrease in interest rates is expected, banks typically adopt a strategy of shorting the interest rate swap in which they will receive fixed and pay floating. Conversely, if interest rates are projected to increase, banks may take a long position, receiving floating and paying fixed. The profitability of these transactions stems from the differential between fixed and floating payments. When conducting such transactions with related parties, it is essential to ensure that the fixed rate or the spread on the floating rate aligns with the arm's length principle. A comprehensive TP study should substantiate these transactions and be properly documented.

d. Syndicated Loans

Syndicated loans are a key tool for banks to mitigate risk by allowing multiple lenders to contribute capital based on their respective risk tolerance. There may be instances where multiple entities from the same group, along with third parties, participate in a syndicated loan. In such scenarios, it's crucial to ascertain whether the interest received aligns with the arm's length principle. This can be achieved by benchmarking against interest rates received by independent third parties in comparable transactions.

e. Intragroup Services

It is common for banks to either provide or receive services from other entities within the same group. These services encompass a wide range, including but not limited to, management, information technology, human resources, accounting, and finance. As per chapter VII of the OECD TP Guidelines, intra-group services must meet certain criteria to be deemed as performed on an arm's length basis. The primary focus is on two aspects: whether intra-group services have indeed been provided and whether the charge for the intra-group service aligns with the arm's length principle. This process involves the following steps:

1. Benefit Test: Conducting a benefit test is crucial as it helps to confirm if the benefits possess economic or commercial value to a degree that an independent entity, under similar conditions, would be willing to pay for the service or would have opted to perform the service internally.
    
2. Cost Base Determination: This involves identifying the costs to be included in the cost base, such as direct costs (salary, bonus, other benefits) and indirect costs (rent, utilities, office supplies). Costs that should be excluded from the cost base include shareholder costs, duplicative costs, and incidental costs.
    
3. Determination of Arm's Length Mark-up: After establishing the cost base, the next step is to determine the arm's length mark-up to apply. The mark-up will differ if the service provided is considered as a high-value service or low-value service. The OECD TP guidelines suggest that for low-value services, a simplified approach can be adopted. This approach allows for a 5% mark-up to be applied without the necessity for a benchmarking analysis. Otherwise, a benchmarking study would need to substantiate the mark-up applied.

3. Banks operating through branches

Banks often establish branches as a strategic move to extend their reach beyond their home base and penetrate new markets. These branches essentially act as offshoots of the bank's main operations. This approach can be more cost-effective as it enables the bank to set up smaller offices yet still offer essential services to customers in diverse markets.

From a TP perspective, for banks operating through branches, they should follow the OECD’s guidelines on Attribution of Profits to a Permanent Establishment (AoA). As per Article 7 (2) of the Model Tax Convention, it is necessary to determine “the profits which the PE might be expected to make if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.” Part II of the AoA provides guidance on how profits should be attributed to a bank's Permanent Establishment (PE).

According to the AoA, a two-step process should be followed to ensure that a bank's PE earns profits that commensurate with their functional profile. The first step involves conducting a functional analysis to identify the Key Entrepreneurial Risk-Taking (KERT) functions of the PE. The analysis of the KERTs will help attribute financial assets and related risks to the PE. The KERTs for example in traditional banking typically involve the creation of financial assets, such as loans, and the subsequent management of the risks associated with those assets. The value chain outlined in our example above illustrates the primary functions involved in the creation of financial assets. The functional analysis should also establish the amount of free capital and interest-bearing debt that ought to be attributed to the PE. The second phase involves allocating profits to the PE in line with the arm's length principle for its transactions with associated enterprises and dealings with other parts of the enterprise.

Another crucial aspect to consider is the attribution of capital to a bank's PE. The capital primarily supports the risks assumed by the PE through its lending activities and off-balance sheet items, such as undrawn commitments to make loans. For instance, by lending funds to third parties, banks assume the risk that some borrowers may default. To absorb potential losses from these risks, banks need capital. Further, banks also need to fund the creation of financial assets, such as loans, that generate gross income in the form of interest. This funding can come from a variety of sources such as equity capital, retained earnings, liabilities such as deposits from customers, and various forms of debt funding such as interest-bearing loans, etc.

Funds for example from retained earnings and from issuance of shares, are usually treated as “free capital” for tax purposes. The amount of free capital can significantly influence a bank's potential profitability and the amount of tax it pays. For instance, a bank's gross profit margins may be improved if the funds lent to customers are sourced from "free capital" rather than borrowed funds. This issue has attracted significant attention from tax authorities because, unlike payments to equity holders, payments to debt capital holders are typically considered as tax-deductible.

Moreover, regulatory bodies require banks to maintain a minimum level of capital. The Basel Committee on Banking Supervision sets internationally accepted standards for capital adequacy. Regulatory capital is divided into different Tiers: Tier 1 capital, and Tier 2 capital. The Basel III framework requires that the total capital maintained by a bank should be at least 10.5% of its total risk-weighted assets (including the capital conservation buffer). Within this, Tier 1 capital must account for at least 4.5% of the total risk-weighted assets.

Summary

As discussed, TP planning is a crucial element for banks to improve cash flow, and to avoid the burden of excessive taxes and unwarranted penalties. The transactions mentioned above are just a few examples of the many potential transactions banks can have with related parties. In addition to proactive TP planning, banks should maintain contemporaneous TP documentation to serve as a robust defense in case of tax authority scrutiny. Ensuring proper documentation and compliance will allow banks to operate efficiently while minimizing tax risks.

For further assistance, please feel free to contact a member of our dedicated Financial Services tax team.