In this post I will discuss the arm’s length principle and different viewpoints thereof. Please note the arm’s length principle is not easily implemented, even if it may sound easy from a theoretical perspective. Further, I will touch on why the arm’s length principle may not be the best approach or as some say it is inherently flawed. Please note there are many discussions around the arm’s length principle and I am merely trying to summaries it here. I would love to discuss your viewpoints around the arm’s length principle and its application in the comment section below.
From the transfer pricing definition discussed previously, it is clear that it is of the utmost importance to understand the arm’s length principle, as the whole transfer pricing methodology is based upon the arm’s length principle.
The arm’s length principle is the basis of transfer pricing, which is not an exact science but rather a methodology which can be interpreted differently by different people. The arm’s length principle, simply stated, requires that each inter-company transaction is remitted to the same level that would have applied had the transaction taken place between independent parties, all other factors remaining constant. Although this may sound simple, Raby (2009) believes the actual application of the arm’s length principle in practice is notoriously difficult.
Why do we have an arm’s length principle?
The reason for establishing an arm’s length principle was to ensure that each tax jurisdiction will get its fair share from an affected transaction between related parties. The OECD further states that independent parties normally deal with each other within financial and commercial relations which are determined by market conditions. These market forces that determine the price between independent parties are comparable to the arm’s length principle. This means that two independent parties do not have much choice in determining a price between them. If the price is too high the one party will find someone else to contract with and if the price is too low the other party may make losses and will not be interested in doing business under those terms.
When related parties transact with each other, the financial and/or commercial relations may not affect a transaction in the same way as between independent parties. For example an MNE may try to increase profits on a global basis rather than on a company to company basis, regardless of where the companies are incorporated. This means that the MNE tries to be as profitable as possible on a global level even if a single entity of the group has to make losses. This is one of the reasons why it may be so difficult to ascertain an arm’s length principle for some transactions. It is very difficult if not impossible to compare such an MNE transaction to an independent party transaction because an independent party would not enter into a contract which will only guarantee losses or fail to provide a proper return on investment. An MNE as a whole can achieve savings overall due to the loss on one transaction and therefore the transaction makes commercial sense from an MNE perspective. Usually tax jurisdictions would seek to adjust such loss making cross-border related party transactions to profit making as the tax jurisdiction is only concerned with the transaction and not the MNE as a whole (For example a loss making product within a product range – if this still is not clear please ask me for further clarification in the comment section).
There may be justifiable reasons for losses from a tax jurisdiction’s perspective. For example, during the start-up stage of an MNE there may have been high capital costs for the new manufacturing plant and/or manufacturing equipment or if the MNE plans to penetrate a new market, and therefore offers its products at a lower price to gain a niche in the market. The OECD (2001) further acknowledges that this is one of the reasons why tax administrations should not automatically assume that related parties of a global MNE have sought to manipulate their profits, but should recognise that the MNE does have certain loss-leaders for valid economic and commercial reasons.
There are other reasons for MNEs to deviate from an arm’s length consideration but this are left for later blogs/discussions.
Is the arm’s length principle flawed?
Some argue that the arm’s length principle is inherently flawed. This is mainly due to the fact that the arm’s length principle does not account for the economies of scale related to integrated systems when compared to independent parties. MNEs are known to have great cost savings through centralised management structures and cost centres (as discussed previously in ‘The reason for the existence of MNEs’). These savings are, however, not considered in the determination of the arm’s length range.
The OECD Guidelines (2001) acknowledge that the arm’s length principle may not always be simple to use in practice but it is sound in theory and gives the closest approximation to a fair price between related parties. The arm’s length principle usually allocates appropriate levels of income between off-shore related parties and is therefore accepted by tax administrations. There may be instances when the arm’s length principle is flawed but it is the closest method of establishing a fair principle for each tax administration. There are no other acceptable principles or methods to determine values for cross-border related party transactions that are fair and sound in theory. The arm’s length principle has been accepted internationally by the major corporations and tax administrations and the experience with the arm’s length principle has become “sufficiently broad and sophisticated to establish a substantial body of common understanding among [them]” (OECD, 2001:I-6). This understanding ensures that each tax administration receives its fair share of taxes and in addition the corporation does not suffer double taxation.
Global formulary apportionment
The global formulary apportionment has been suggested as an alternative to the arm’s length principle to compare a cross-border related transaction and its related profits for each participating tax administration. The OECD (2001) expresses the opinion that some tax administrations have tried to use the method without success. The global formulary apportionment method is not seen as a suitable method to determine the arm’s length price and the OECD Guidelines do not recommend the use of the global formulary apportionment (Please note some still believe that the global formulary apportionment is the way forward and will take over the arm’s length principle in the future).
The global formulary apportionment method is not accepted by OECD member or observer countries and therefore is not a realistic alternative for the arm’s length principle. The reason given by the OECD Guidelines (2001) is that the global formulary apportionment does not achieve the protection against double taxation or ensure taxation of the profit by a single fiscal authority. In order to achieve this, it would require extensive international coordination and consensus on the global formulary apportionment method. The difficulty in this is that every single tax administration must agree to the method and its predetermined formula. A common accounting system would have to be chosen and adopted within all the tax jurisdictions, even the non-member countries. To achieve this may be very time consuming, extremely difficult and there is no guarantee of no double taxation, because if one tax administration does not apply the method in its jurisdiction there would be a problem.
I hope the above made sense. My opinion is that the arm’s length principle isn’t 100% correct but it is the best we have and as such it is the closest we will get to a fair tax share between all the tax jurisdictions involved in a cross-border related party transaction. If the issues of the global formulary apportionment can be resolved it may be a better option but only time will tell.
Please feel free to share your experiences in the comments below.
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