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Is your business corporate tax ready?

Navigating related party transactions

As we continue our series on corporate tax readiness, it is crucial to examine a vital aspect of the new landscape: related party/connected person transactions. While our previous series well covered a general overview, wherein we explored the fundamental implications of the new corporate tax landscape. Now, we delve deeper into a critical aspect: How businesses must adjust their approach to related party/connected person transactions. The implementation of corporate tax has significantly altered the flexibility with which the transactions with related parties were undertaken.

The technical jargon in this context is ‘undertaking transactions at arm’s length price’. In simpler terms, it should reflect the price at which the same transactions would occur with an unrelated party, reflecting the true market value.

Historically, many businesses operated with a degree of elasticity in their financial arrangements, often booking costs in a centralized cost center without appropriate allocations among group entities. This practice might have been convenient, but it’s no longer viable in the wake of corporate tax.

Businesses must grasp the understanding of functional analysis, often referred to as FAR analysis (functions performed, assets used, and risks taken), and economic analysis before embarking on transfer pricing exercises.

While these terms may sound complex, they are exercises that businesses routinely perform in their daily operations. Functional analysis involves assessing the functions performed by the organization vis a vis its related party. For instance, it would include operational activities such as procurement, marketing, sales as well as functions around decision making i.e. strategizing and risk.

Discussing about the assets used, it considers the age, market value, location etc. of the assets. Further, with respect to risks, all the material risks assumed by each entity within the group must be considered. In transaction with unrelated party, increased risk would be ideally compensated by an increase in the expected return.

Practically, a functional organization chart would be required to be prepared, listing the functions performed by each related party identifying relevant departments and personnel within the organization who perform those functions – interviewing personnel on questions like what the process is, who is responsible for taking decisions, approving budgets, would further provide clarity.

While functional analysis focuses on above stated, an economic analysis focuses on justifying the appropriate pricing of intra-group transactions based on the arm’s length principle typically, known as benchmarking. Both analyses are essential components of establishing and defending transfer pricing policies and practices within multinational corporations.

Another significant area affected by the introduction of corporate tax and also involves transfer pricing, is the way companies compensate their key managerial personnel. Previously, shareholders and executives could withdraw salaries with little consideration, as these payments were tax-free for both the company and the individual. Now, there is an arbitrage opportunity: businesses can claim the expense of salaries paid (and save 9 percent) while these payments remain tax-free in the hands of the individual.

While this might seem advantageous, it also requires careful scrutiny. Companies must ensure that salaries paid to key managerial persons are indeed at arm’s length. This means that the compensation must reflect the true market value for the roles and responsibilities undertaken, avoiding excessive or unjustified payments.

As businesses embrace these new tax regulations, strategic planning becomes paramount. Companies need to reassess their internal processes, from cost allocations to managerial compensation structures. By integrating FAR analysis and establishing clear documentation practices, organizations can ensure compliance while optimizing their tax positions.

This evolution will require collaboration across departments, nurturing a unified approach to financial management. Finance teams, legal advisors, and operational managers must work together to align on policies that support arm’s length transactions and sound business practices. It is critical that the approach here is proactive approach rather than reactive as there will be a very limited time available to react at the stage of audits or reviews by tax authorities.

Embrace the change, adapt to the new requirements, and ensure your organization is ready to thrive in the corporate tax landscape!

The writer is Partner, MICS