Follow Us :

Preserving Arm’s Length Principle status in the international context

While it may not be perfect, the member countries of the OECD focus have a tendency that the arm’s length principle should govern the judgment of transfer pricing between associated enterprises.

In theory, the arm’s length principle has always been coherent as it conveys the nearest estimate of the workings of the open market in situations involving goods or intangible assets being transferred or services performed between the associated enterprises.[1] Even though it is not necessarily clear-cut to administer in practice, it can usually produce a suitable amount of profit between groups in MNE satisfactory to the tax administrations. This has the effect to display the economic reality of the controlled payer’s specific facts and circumstances and embraces it as a criterion for the market’s normal functioning.[2]

Abandoning the arm’s length principle would discontinue the coherent structure and basis as mentioned earlier and jeopardize the general agreement of the international community, expanding the possibility of an increase in double taxation and having the opposite effect of what it stands for.

The know-how and background of the application of the arm’s length principle have reached a point where it is substantive and advanced enough to create an important base of generally known knowledge among the business communities and the tax administrations.[3] This joint informal agreement can be of immense practical worth in accomplishing the goals of safeguarding the suitable tax base in every administration and dodging double taxation. This knowledge should be elucidated further on to develop the arm’s length principle, to refine its workings, and to enhance its authority by giving concise guidance to taxpayers and routinely analysis over a period.[4]

All things considered; member states of the OECD carry on backing up the arm’s length principle firmly. As a matter of fact, no legal tool or no sensible substitute has emerged at the level of the arm’s length principle. Even Global formulary apportionment would be theoretically imperfect and have similar issues with its enactment and practice.[5]

Applicability of Arm’s Length Principle

 Practice and issues involved in comparability analysis

The applicability of the Arm’s length principle requires a ‘comparability analysis’[6] and is often considered the heart of it.

The first step in engaging a comparability analysis is to locate the financial or commercial relations that were made or appointed among the associated enterprises.

For the following purposes, OECD’s definition of a transaction is ‘the consequence […] the parties’[7]. In simple terms, a transaction is the manifestation of a commercial or financial relation among the parties. The traditional approach was a clear-cut process as it referenced and viewed the transactions that had taken place[8]. In case of a drafted agreement, it would generally be honoured with respect to the agreement being stuck to or varying by the behaviour of the associated enterprises.

Following BEPS Actions 8 to 10[9], the new approach follows a top to down method with the top being the multinational group. It adopts a group overview and observes its response to factors influencing performance in the sector, markets, supply chains etc.[10] and an ‘accurate delineation of the actual transaction by reference to the economic relevant characteristics[11].

Preserving and Applicability of Arm’s Length Principle

Another essential part of functional analysis is the analysis of risks taken by the parties entering in the transaction. Risk regarding a commercial chance influences the potential of the profit and the appropriation of risk alters how a loss or profit arising from the transaction is distributed at arm’s length principle. Due to the BEPS actions, risk has been segregated for a comprehensive treatment. Generally, a contract is enough to allocate the risks between the parties, but the BEPS action plan observed how current rules might have given a leeway for profit shifting into poor tax regime countries by allocation of risk through contract[12]. Hence, OECD lays out steps by accurately delineating the actual transaction with respect to risk[13].

Issues with the current applicability

 Choosing a potential comparable is crucial for the comparability analysis being trust-worthy or not, as on several circumstances, it will not generate accurate matches with respect to comparable transactions performed by associated enterprises or comparable enterprises[14].

OECD sets out an ‘additive’ approach[15] and a ‘deductive’ approach[16] to tackle this key issue. The former approach arranges a primary list of third parties that have the potential to carry out those comparable transactions and then further information is gathered on transactions carried out by the mentioned parties to establish if they are an adequate comparable. The latter approach gathers information of a wide variety of third parties as long as they perform activities in the same sector, operate relatable functions and have an absence of economic traits that are clearly distinct.

[1] Reimer E. and Rust, A., Eds Klaus Vogel on Double Taxation Conventions 4th Ed (Wolters

Kluwer),

[2] ibid

[3]  ibid

[4] ibid

[5] ibid

[6] Para 1.6

[7] OECD Guidelines 2010 Para 1.42

[8] OECD Guidelines 2010 Para 1.64

[9] OECD/G20 BEPS Project 2015

[10] OECD Guidelines 2010 Para 1.34

[11] OECD Guidelines 2010 Para 1.35

[12] OECD Action Plan on BEPS 2013 Pg 19, 20

[13] OECD Guidelines, para 1.56 to 1.106

[14] UN Manual, para-B.2.4.1.1

[15] OECD Guidelines, para 3.41

[16] OECD Guidelines, para 3.42

****

Author ‘Hritik Raina’ is Bachelor’s in law at the University of Birmingham & Master’s in International Tax Law at the King’s College London.

Join Taxguru’s Network for Latest updates on Income Tax, GST, Company Law, Corporate Laws and other related subjects.

Leave a Comment

Your email address will not be published. Required fields are marked *

Search Post by Date
March 2024
M T W T F S S
 123
45678910
11121314151617
18192021222324
25262728293031