Origin and Fate of Arm’s Length Principle

Meaning

Arm’s Length Price of a transaction can be referred to as such price at which the business profits can be maximized commensurating with the functions performed, assets utilized and risk assumed in such transaction including the fundamental criterion of allocating business income/profits in different tax jurisdictions. In simple, the arm’s length price means the price at which unrelated entities transact with each other in comparable (similar) circumstances.

The Origin

The arm’s length principle was first introduced by the United States in its domestic law (in the Revenue Act, 1928). In 1933, the League of Nations published the “Carrol Report” on transfer pricing as a global standard to address the problem of allocation of taxable income prescribing the methods of such allocation. However, this was not the first time when the arm’s length principle was introduced to the world.

Way back in 1987, the allocation was traced in UK’s “trial & error” method. Further, in all time landmark case of “Salmon vs Salmon Co.”, the allocation theory was amplified viz. “the Corporate Veil” theory.

In 1908, German Economy was on the boom as the German Government was charging the least income tax (in present-day Europe). The UK companies started shifting profits to their German subsidiaries. It came to the notice of the UK authorities in the case of “Gramophone & Typewriter Ltd. vs Stanley” wherein they claimed that profits all the profits of the UK company were shifted to the German Subsidiary actually attributing to the UK company.

After this, “Carrol Report” was introduced, OECD and UN were formed, TP guidelines were published by OECD and UNO, the economies started accepting them, etc. as we discussed in our previous post. (Link: https://taxguru.in/income-tax/history-transfer-pricing.html)

The Fate

The question is whether the arm’s length principle introduced back then is still relevant in today’s Industrial Revolution 4.0.?

Before diving into this question, let’s discuss a few points wherein the principle can be questioned:

• Whether the testing of comparable is feasible and effective which actually can bring the transaction at Arm’s Length? – I don’t know about the rest of the world, but in India, “No”. There is mainly a dispute between Taxpayers and Authorities regarding the selection of comparable except a few.
• Whether the present laws can be manipulated to take advantage of guidelines so that they can repatriate the untaxed profits? – OCED’s BEPS has already prescribed guidelines, on the same, and in India, it has already fixed to some extent by way of Regulations of “Secondary Adjustment”.
• Whether it is feasible for developing or underdeveloped economies or startups to comply with the complex comparable comparison requiring heavy resources and compliance? – It is open to answer still by OECD and Tax Jurisdictions

The former question regarding the relevancy of Arm’s Length cannot be judged without answering the questions quoted above. But no one can deny the fact that the way of application of the current Arm’s Length Principle shall be rationalized in such a way that the tax authorities and MNEs both can apply and accept it. (Current BEPS Action Plans contrast with this argument and, in fact, shall increase the quantum of transfer pricing litigations.)