The Necessity of Working Capital Adjustments: A Closer Look

Working capital adjustments (“WCA”) have long been considered a standard refinement in benchmarking under the Transactional Net Margin Method (“TNMM”). In many jurisdictions, particularly those following OECD guidance, it is often assumed that applying a WCA automatically improves comparability.

However, as UAE and GCC businesses prepare their first sets of TP documentation under the Corporate Tax Law, a question is emerging: Are working capital adjustments always necessary, or even appropriate, in every TNMM analysis?

The answer requires a more nuanced look at when WCA add value, when they distort the outcome, and how the FTA may approach them in practice.

1. Why Working Capital Matters in TNMM

   The logic behind WCA is simple. Businesses with:

   • high receivables bear higher financing costs and risk
   • high payables gain financing benefits
   • high inventory incurs carrying costs

   These working capital positions influence operating margins. To ensure comparability between a tested party and independent comparables, analysts adjust for differences arising purely from financing effects rather than functional differences.

   In theory, WCA increases accuracy by isolating the operational performance of the tested party.

2. GCC Reality: Are WCAs Being Overused?

   In many TP reports globally, WCA is applied almost automatically, a “tick-box adjustment”. In the GCC context however, this approach may not always be appropriate due to:

   • limited availability of detailed comparable data
   • industries with low working capital intensity
   • short operating cycles where financing impact is negligible
   • absence of reliable cost-of-capital benchmarks

   The UAE FTA, while aligning with OECD principles, is likely to challenge WCAs that appear mechanical rather than supported by robust economic reasoning.

3. When Working Capital Adjustments Make Sense

   WCA is most useful when:

   a) There is a significant working capital differential

   For example:

   • Tested party has receivables at 120 days
   • Comparables average at 40–60 days

   Here, the financing differential materially affects margins.

   b) The industry has long cash conversion cycles

   For example:

   • Trading businesses
   • Electronics distribution
   • Manufacturing groups with inventory-heavy operations

   c) The tested party operates on a “routine, low-risk basis”

   • In such cases, differences in working capital structure may distort comparability unless normalised.

   d) The TP method applied is highly sensitive to margin variations

   Especially where:

   • Net cost-plus margins are small
   • Even minor WC variations affect overall outcomes
   • In these cases, WCA improves accuracy and defensibility.
4. When Working Capital Adjustments May Be Unnecessary
   • If differences fall within normal industry ranges, an adjustment adds complexity without adding value and may even create unnecessary audit questions.

   b) Where reliable working capital data is missing from public comparables

   Many comparable companies (especially in the GCC, Asia, or privately held entities) do not disclose:

   • Trade payables separately
   • Inventory by type
   • Receivable ageing

   Using incomplete data to compute WCA undermines the credibility of the adjustment.

   c) For service providers with minimal receivables and no inventory

   Back-office, IT, consulting, and support service providers often have:

   • negligible inventory
   • short receivable cycles
   • low working capital intensity

   For these companies, WCA does not materially change margin comparability.

   d) When the computation introduces volatility

   Errors arise when:

   • different fiscal year ends are not aligned
   • payables/receivables include related-party balances
   • revenue is not matched to the periods used for working capital cycles

   e) When the adjustment masks real functional differences

   If the tested party consistently carries higher inventory because of:

   • different procurement strategy
   • market risk profile
   • vendor pressures
   • contract terms

   Then the working capital difference is a functional difference, not an “adjustable financing difference.” In such cases, no WCA should be made instead, the FAR analysis must reflect the real risk and asset differences.

5. Practical Recommendations for UAE Taxpayers
   • Perform a WCA materiality assessment: Before calculating anything, ask: Does working capital materially affect profitability in this industry?
   • Ensure data quality: Remove comparables with incomplete WC data.
   • Document the reasoning clearly: Whether to apply WCA or not, explain why.
   • Keep the computation conservative: Avoid overstated adjustments or untested cost-of-capital assumptions.
   • Validate with sensitivity analysis: Show how margins move with and without WCA to support your conclusion.
     
     
6. UAE Taxpayers Conclusion: WCAs Are a Tool — Not a Rule

When the tested party and comparables have similar working capital positions

Working capital adjustments can significantly improve comparability but only when applied thoughtfully, backed by reliable data and clear economic reasoning.

In the UAE and GCC context, where comparables are often global and industry structures are diverse, analysts must avoid the temptation to treat WCA as an automatic requirement. Instead:

• Apply WCA where it improves accuracy
• Avoid it where it distorts economic reality
• Justify the decision in the Local File

Ultimately, WCAs should serve the purpose of TP and not the other way around.