Arm’s length principle – The basis of International Transactions

Ashish M. Shaji

17 Mar, 2022

Transfer pricing is a significant issue in many developing nations when it comes to related-party transactions. A transfer price refers to a price at which related parties (businesses with existing relationships as a result of common ownership or control) deal with one another. In such cases, associated parties have a tendency to transact business at a price lower or higher than the market value in order to apportion profit for tax or other objectives. Transfer pricing can deprive governments of their due share of revenue while also exposing corporate entities to possible double taxation. To address these issues, numerous countries have incorporated the arm’s length principle into their laws and regulations.

When is a transaction considered to be at Arm’s length?

A transaction between related parties is considered to be at arm’s length if it is carried out in the same way that it would have been carried out if the parties were independent businesses with no prior relationship. As a result, the transaction is carried out in the same way that a third party would have carried it out under similar circumstances.

In other words, an arm’s length transaction, also known as the arm’s length principle (ALP), is a transaction between two independent entities in which both parties are operating in their own self-interest. Both the buyer and the seller are autonomous, have equal negotiating power, are not under pressure or coercion from the opposite party, and are working in their own self-interest to obtain the best possible deal.

When related-party transactions are considered to be non-compliant with the arm’s length principle, the Regulation enables the Income Tax Department to make the required changes to the taxable profits arising from such transactions to draw them into compliance with the Arm’s length principle.

Fair market value

An arm’s length transaction is said to be one in which both parties act freely and in their own self-interest, resulting in a transaction that nearly equals the fair market value of the consideration. Assume a buyer and seller who are functioning independently and are unfamiliar with one another. In this case, each side seeks a price that optimizes their welfare. The buyer would make the lowest bid conceivable, while the seller would make the highest offer as may be possible.

Each side would then utilize the information at their disposal to bargain and, finally, achieve an agreement. As a result, the price at which the buyer and seller are prepared to transact would be very near to the fair market value of the consideration.

Why is Arm’s length principle important?

The issue of whether or not a transaction is at arm’s length price is important since it might have legal and tax repercussions. For example, when a global firm conducts transactions with its connected entities throughout the world, it must guarantee that the transactions are conducted at fair market value in order to pay the right taxes in each country.

On a similar note, conglomerates and holding corporations may face legal and regulatory issues if the entities within their group do not deal with one another at arm’s length. Finally, Arm’s Length Transactions are meant to foster fair and acceptable corporate practices while also protecting the public at large.

The Arm’s Length Principle was agreed upon and endorsed by all OECD member nations as an objective guideline for multinational corporations and tax agencies to follow in international taxation. Its goal is to prevent the tax base from eroding or earnings from being transferred to low-tax nations.

When unrelated organizations do transactions with each other, market forces usually decide the commercial and financial parameters of the agreements (e.g., the price of goods transferred or services rendered). However, when transactions occur between related organizations, external market factors may not have a direct impact on prices, due to corporate synergies, economies of scale, or tax planning.

As a result of the foregoing, the following factors should be considered when examining transactions among associated companies:

• The agreed-upon prices of goods and/or services
• The profits made through the acquisition and selling of products and/or services
• Assets used and risks taken
• The transaction’s agreed-upon terms and conditions.

The evaluation is carried out using a comparative analysis from an economic and legal standpoint to determine whether or not the associated firms follow the arm’s length principle. In other words, to guarantee that the associated firms commit to their transactions in the same way that independent companies would in analogous circumstances.

Criticism

The arm’s length concept raises various issues for tax authorities. The first is that it is just too complicated to apply, especially in the case of valuable intangibles and sophisticated financial operations. This issue is further worsened by a lack of available data. The most basic concern, however, is that Multinational enterprises have been able to employ the arm’s length principle in such ways that have allowed them to report a considerable portion of their income in low-tax jurisdictions, hence avoiding to pay an acceptable level of taxes in the nations in which they operate.

These issues have grown for digital enterprises, which do not require the same number of local activities and assets as traditional offline stores having a physical presence of their organizations, as well as underdeveloped nations, which lack the considerable knowledge required to conduct transfer pricing audits.

These concerns prompted the OECD to initiate an inquiry into “Base Erosion and Profit Shifting” (BEPS). As part of the BEPS initiative, the OECD has issued significant & extensive guidelines on how the arm’s length requirement should be applied, the paperwork required to establish transfer prices across controlled affiliates, and the techniques used to address transfer pricing disputes.

However, the OECD^[1] has always been consistent to consider even more fundamental changes in how earnings will be distributed across MNEs’ various managed affiliates, at least in the case of MNEs with extensive digital operations and/or considerable consumer sales. While it is uncertain how far these initiatives will go in the future, they are meant to offer tax authorities a wider capacity to tax activities that are dependent on users or consumers situated in their nation. This may result in major changes in taxation rights, which will have a considerable influence on where MNEs are taxed and the total level of taxes paid by MNEs.

Despite the fact that the arm’s length concept is always under review, it is a well-established framework for calculating transfer pricing and remains a key guiding principle. The fact is that transfer pricing is a difficult concept that frequently needs the assistance of a specialist.

How to calculate arm’s length price?

The whole Transfer Pricing Mechanism in India is based on the calculation of income originating from cross-border transactions in relation to the arm’s length price, according to Indian Transfer Pricing rules. According to the Organisation for Economic Co-operation and Development’s (‘OECD’) Transfer Pricing Guidelines, an ALP is a price at which transactions between people other than connected firms are carried out under unregulated conditions.

The below-mentioned methods have been prescribed by Section 92C of the Income Tax Act for the ascertainment of the arm’s-length price:

• Comparable uncontrolled price (or CUP) method
• Resale price method (or RPM)
• Cost-plus method (or CPM)
• Profit split method (or PSM)
• Transactional net margin method (or TNMM)
• Any other method(s) as may be prescribed

The Central Board of Direct Taxes (i.e., CBDT), in regard to the above, has prescribed that the ‘other method’ for computation of the arm’s-length price in respect of an international transaction will comprise of any method that takes into consideration the price which is being charged or paid, or might have been charged or paid, for the same kind of uncontrolled transaction, with or between unrelated entities, under similar circumstances, after taking into account all the relevant facts.

There is no approach that has been given a higher or lower priority. The most acceptable technique for a specific transaction would need to be decided in light of the nature of the transaction, the class of transaction or connected parties, and the functions performed by such parties, as well as other relevant criteria.

Conclusion

The idea of arm’s length takes its meaning from the independent relationship shared by two separate parties. Unlike commercial transactions between related parties, transactions between unrelated parties are done at an open market price, and so, Arm’s Length Price (‘ALP’) indicates the price that should have been paid between connected parties if those parties were not related to each other.