The arms length principle
The arms length principle
The arm’s length principle arises out of paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD Member countries and an increasing number of non-member countries.
The arm’s length principle arises out of paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD Member countries and an increasing number of non-member countries.
Article 9 provides:
[When] conditions are made or imposed between … two [associated] enterprises in their commercial or financial relations 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, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
Focus on the nature of the dealings between members
By seeking to adjust profits by reference to the conditions which would have obtained between independent enterprises in comparable transactions and comparable circumstances, the arm’s length principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. Because the separate entity approach treats the members of an MNE group as if they were independent entities, attention is focused on the nature of the dealings between those members.
Reasons for adopting the arm's lenght principle
There are several reasons why OECD Member countries and other countries have adopted the arm’s length principle. A major reason is that the arm’s length principle provides broad parity of tax treatment for MNEs and independent enterprises. Because the arm’s length principle puts associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity. In so removing these tax considerations from economic decisions, the arm’s length principle promotes the growth of international trade and investment.
A fundamental aspect in the application of the arm’s length principle is the comparability analysis process, whereby an assessment is carried out to accurately delineate the transaction in respect of which the related parties are establishing the arm’s length price. The accurate delineation of the transaction requires an assessment of the following aspects:
- The contractual terms,
- The specific factors of the product or service,
- The functions performed, the assets used and the risks assumed,
- The economic environment of the two parties, and
- The business strategy
The application of the arm’s length principle results in a comparison of the internal transaction delineated through the comparability assessment, with an independent transaction which is comparable, and thereby establish the pricing that would apply between independent parties carrying out a comparable transaction.
How can BDO help?
BDO Malta offers valuable assistance in the area of transfer pricing by providing expertise in the application of the arm's length principle. By leveraging BDO's knowledge and guidance, you can ensure compliance with tax regulations, promote equitable treatment between multinational enterprises and independent entities, and navigate the complexities of international trade and investment.