You may have heard about the ‘arm’s length principle’ before. But what does it actually mean? This short article explains it in more detail.
This article goes into further depth on our main article on transfer pricing. If any terms here don’t ring a bell, please go back and read that article first.
When you look at countries around the world, you can see huge differences in tax rates. If left unchecked, Multinational Enterprises (MNEs) could shift profits from high-tax countries to low-tax countries. How?
Well, MNEs always have internal transactions. A regional head-quarter invoicing management and service fees. A holding company providing financing to an operational company. A manufacturing branch supplying finisheds product to a distributing branch. MNEs are able to control the terms and conditions of these transactions. They can set the price, so to speak. This way, they can influence taxable profit and the amount of tax due.
To prevent this from happening, tax administrations (organized in the OECD) have invented the arm’s length principle. This principles requires that controlled transactions are done at market rates.
The arm’s length principle means that:
‘entities that are related via management, control or capital in their controlled transactions should agree the same terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions’.
If this principle is met, we can say that the terms and conditions of the particular transaction are ‘at arm’s length’.
Are you confused? No worries, let’s look at an example to make this clearer.
Transaction #1: Company A produces apples and sells these to distributor Company B. Company A and Company B are not related. This is an uncontrolled transaction. The terms and conditions are considered to be ‘at arm’s length’.
Transaction #2: Company X produces the same apples and sells these to distributor Company Y. Company X and Company Y are related. They are both owned by Company Z. This is a controlled transaction and the terms and conditions should satisfy the arm’s length principle to comply with transfer pricing regulation.
If transaction #2 is concluded under the same terms and conditions as transaction #1, we can say that the terms and conditions of Transaction #2 are also ‘at arm’s length’.
The main source of the arm’s length principle is Article 9 of the OECD Model Convention, which is adapted in most bilateral tax treaties. The OECD has incorporated the arm’s length principle as part of transfer pricing rules which set forth the guidelines that MNEs should apply to the determination of the terms and conditions of controlled transactions.
Most countries have adapted the arm’s length principle by including an according provision in domestic legislation.
Criticism of the Arm’s Length Principle
There is some criticism.
The main complaint is that it leaves (too) much room for interpretation, which results in a lot of discussions between taxpayers and tax administrations. This point is even acknowledged by the OECD. Not every product is the same and not every brand has the same value. How do you compare these different products? Therefore, discussions often focus on whether transactions are ‘comparable’ enough or whether all terms and conditions should be same.
Another complaint is voiced by lobby groups like Tax Justine Network and Oxfam Novib. They argue that an ‘arm’s length’ price could still facilitate tax avoidance by MNEs by shifting profits to low-tax jurisdictions. The standard example used is the allocation of passive income to companies in tax havens with no real activities.
Whether these and other complaints are well-founded or not, the international tax community so far hasn’t been able to come up with a workable alternative in the past few decades.
So it seems that the arm’s length principle is here to stay!
Go back to transfer pricing in Asia…