The Arm’s Length Principle

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This Note looks at the arm’s length principle in Transfer Pricing and introduces the concept of “comparables”.

“Comparables” basically means using comparable transactions to the connected-party transaction being reviewed, but between independent unconnected businesses. Such comparables are used to fix an arm’s length indicator, e.g. price or margin etc. (or the arm’s length range for a particular indicator). Comparables will be discussed further in my next Note.

The choice of comparables must also be considered alongside the choice of the most appropriate Transfer Pricing method for the case under review. By this I mean the most appropriate benchmark for the facts and circumstances of the case, e.g. gross margin or net margin etc. This will also be the subject of a future Note.

Let’s start with a recap……

In today’s globalised economy, a multinational enterprise’s manufacturing may occur in one country and assembly in another, whilst sales and marketing are likely to be based in local markets or, perhaps more likely in today’s market, over the internet. The management, R&D and finance functions are likely to be similarly dispersed across the globe.

Where such transactions in goods and services take place between associated enterprises and across international borders it is necessary to establish Transfer Prices for those transactions.

So, the Transfer Price is the price charged in a transaction between two connected parties, which usually means between members of the same corporate group.

The Transfer Prices set can determine to a large extent the group’s effective tax rate.

Perhaps stating the obvious, but the focus is on connected parties because their Transfer Price may not be consistent with the price charged for the same transaction between separate entities dealing at arm’s length.

Therefore, multinational enterprises operating in the UK can use Transfer Pricing to shift their profits abroad. As a result they may pay little or no UK Corporation Tax, even if they comply with the law.

The UK’s Transfer Pricing legislation aims to prevent multi-nationals from manipulating their Transfer Prices to gain a UK tax advantage. The arm’s length principle is its cornerstone, in fact it forms the basis for Transfer Pricing legislation and enforcement in virtually all countries.

This requires that transactions between two connected persons must be treated for tax purposes as if they were made on an arm’s length basis between two independent enterprises, with both trying to maximise their advantage and neither favouring the other in any way, often referred to as the “separate entity approach”.

For example, one enterprise is unlikely to accept a price offered for its product by an independent enterprise if it knows that other customers will pay more under similar conditions.

The statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention.

Article 9 provides:

  1. 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,

and in either case conditions are made or imposed between the two 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.

Basically this mean that if transactions between connected parties are not at arm’s length then the profits can be increased to what they would have been at arm’s length for the same transaction.

Where such arm’s length pricing is not used, Article 9 allows adjustments to be made to get to an arm’s length result. The UK Transfer Pricing rules ensure that such adjustments only increase UK profits (or reduce UK losses), i.e. a one-way street.

Attention is therefore focused on transactions between members of multi-national groups and on whether their Transfer Prices are at arm’s length.

An analysis of controlled (i.e. connected party) transactions and their equivalent uncontrolled (i.e. arm’s length) transactions is referred to as a “comparability analysis”. This is at the heart of the application of the arm’s length principle.

The objective of the comparability analysis is to identify one or a range of independent enterprises that engage in similar transactions in similar circumstances that can be used to benchmark the arm’s length price for the controlled transaction under review.

A comparable can be a transaction between a party to the controlled transaction and a non-connected party (an “internal comparable”), for example where a business sells goods to connected parties and the same goods at arm’s length to unconnected parties.

More common is the “external comparable” between two totally independent enterprises. A potential external comparable would exist if unrelated third parties perform similar functions and sell the same or similar products or provide the same or similar services as the case under review, but their transactions are with other unrelated parties.

Comparables in the same time period as the transaction under review are preferred, although in practice access to the information you need may be limited. Historic information can be used so long as it can be adjusted to account for the changes in the marketplace.

So, what does “comparable” mean?

It does not mean “identical”, but it does mean that:

  • none of the differences (if any) between the situations being compared could materially affect the price or financial benchmark being examined, or
  • reasonably accurate adjustments can be made to eliminate the effect of any such differences.

So, to summarise:

  • Most tax authorities require the Transfer Price for transactions between connected parties to be consistent with the price that would have been set by two independent parties for the same transaction under similar circumstances, i.e. the Transfer Price is consistent with the arm’s length price for the same transaction.
  • The arm’s-length principle is applied to connected parties in conjunction with the separate entity approach, under which members of multinational enterprises are recognised as separate entities for Transfer Pricing and tax purposes.
  • A comparability analysis is carried out to identify independent parties that carry out similar transactions to the case under review, but at arm’s length.
  • The OECD Guidelines set out five comparability factors to consider in this analysis and that’ll be the subject of my next Note in this category.

Bye for now.

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I try to make the contents of this website as useful, reliable and factual as possible but any opinions expressed are solely my own. They do not represent the views of my employer or any other person I’m connected with.

The purpose of the site is to inform and educate readers with general guidance and useful tips. It provides only an overview of the regulations and guidance in force at the date of publication and is not a substitute for professional advice. It is not designed to provide professional advice or financial advice and should not be relied on as such.

You should not base any action on the contents of this website without first obtaining specific professional advice from appropriately qualified Transfer Pricing experts. They can establish the full facts and circumstances of your business – I can’t.

Therefore, no responsibility for loss occasioned by any person acting or refraining from action as a result of this Website can be accepted by the author.

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