ARMS LENGTH PRINCIPLE

Arms length Principle


International transfer pricing standard


Independententerprises transact with each other, under
conditions determined by market forces


Transaction between related parties may not be directly affected
by external market forces in the same way as independent parties
 OECD

OECD member countries agreed this is the standard to be
used for tax purposes by MNCs and tax administrations.
 Forum of 34 countries, HQ- paris
 Formed to
 address economic, social & environmental challenges of
globalisation
 To help governments foster prosperity and fight poverty through
economic growth and financial stability

Includes Australia, UK, United States, Japan, South Korea etc.
 MODEL TAX CONVENTION


OECD Model Tax Convention on Income and on Capital
published in 1992 to clarify, standardise and confirm common
solutions to juridical double taxation.


Built upon earlier Model Conventions back to 1928 which
informed bilateral conventions concerning double taxation.


Principles also incorporated in the Model UN Double
Taxation Convention between Developed and Developing
Nations.
 ARTICLE 9

OECD Model Treaty -Art. 9(1) “Associated enterprises”

Where
–an enterprise of a Contracting State participates directly or
indirectly in the management, control or capital of an enterprise
of the other Contracting State,
Or
–the same persons participate directly or indirectly in the
management, control or capital of an enterprise of a Contracting
State and an enterprise of the other Contracting State……..
 ARTICLE 9

 and in either case conditions are

made or imposed between the two
[associated] enterprises…..which
differ from those which would be
made between independent
enterprises, then any profits which
would, but for those conditions, have
accrued to one of the enterprises………
may be included in the profits of that
enterprise and taxed accordingly.”
 OECD TP GUIDELINES


OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations
 Internationally recognised guide focusing on the practical
application of the arm’s length principle.

Published 1995 (building on earlier OECD reports addressing
TP).
 Intended to help tax administrations (OECD member
countries and non-members) and MNEs.

Consensus regularly reviewed.
 Updated Guidelines published July 2010
 Further revisions expected - BEPS project
 Arms length principle

 When independent enterprises transact with

each other, the conditions of their commercial
and financial relations e.g. price are determined
by market forces.

 When associated enterprises transact with each

other, their commercial and financial relations
may not be directly affected by external market
forces in the same way
 Arms length principle

 Tax administrations should not automatically

assume that associated enterprises have
sought to manipulate their profits


When transfer pricing does not reflect market
forces and the arm's length principle, the tax
liabilities of the associated enterprises and the
tax revenues of the host countries could be
distorted.
 Arms length principle


For tax purposes the profits of associated enterprises may be
adjusted as necessary to correct any such distortions and
thereby ensure that the arm's length principle is satisfied.

 An appropriate adjustment is achieved by establishing the

conditions of the commercial and financial relations that they
would expect to find between independent enterprises in
comparable transactions under comparable circumstances.

 Treat the members of an MNE group as operating as separate

entities rather than as inseparable parts of a single unified
business- treat them as independent parties
 Definition of terms

 Controlled transactions- Transactions

between two enterprises that are associated
enterprises with respect to each other.


Uncontrolled transactions- Transactions
between enterprises that are independent
enterprises with respect to each other.
 Definition of terms

 Comparable uncontrolled transaction - Transaction

between two independent parties that is comparable to the
controlled transaction under examination

 Comparability analysis - A comparison of a controlled

transaction with an uncontrolled transaction/s. Controlled and
uncontrolled transactions are comparable if none of the
differences between the transactions could materially affect the
factor being examined in the methodology (e.g. price or
margin), or if reasonably accurate adjustments can be made to
eliminate the material effects of any such differences.
 Reason for adoption

 Provides broad parity of tax treatment for members of

MNE groups and independent enterprises.

Puts associated and independent enterprises on a more equal
footing for tax purposes,
 avoids the creation of tax advantages or disadvantages that
would otherwise distort the relative competitive positions of
either type of entity.
 In removing these tax considerations from economic
decisions, the arm's length principle promotes the growth of
international trade and investment.
 Reason for adoption


Has also been found to work effectively in the vast
majority of cases.
 many cases involving the purchase and sale of
commodities and the lending of money where an arm’s
length price may readily be found in a comparable
transaction undertaken by comparable independent
enterprises under comparable circumstances.

many cases where a relevant comparison of transactions
can be made at the level of financial indicators such as
mark-up on costs, gross margin, or net profit indicators
 Difficulties in application


Associated enterprises may engage in transactions that
independent enterprises would not undertake
 not necessarily motivated by tax avoidance
 members of an MNE group face different

commercial circumstances than would

independent enterprises.
 ALP difficult to apply because there is little or no

direct evidence of what conditions would have

been established by independent enterprises
 Difficulties in application


MNE groups dealing in the integrated production of highly
specialised goods, in unique intangibles, and/or in the provision
of specialised services.
 Viewed by some as inherently flawed because the separate entity
approach may not always account for the economies of scale and
interrelation of diverse activities created integrated businesses.

 Administrative burden for both the taxpayer and the tax

administrations of evaluating significant numbers and types of
cross-border transactions.
 Difficulties in application


Tax administrations and taxpayers often have difficulty in
obtaining adequate information to apply the arm’s length
principle
 incomplete and difficult to interpret
 geographical location
 May not be possible to obtain information from independent
enterprises because of confidentiality concerns.
Q
&
A
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