Is there a need to revisit Arm’s Length Principle? (Part 1)

  1. Introduction

Arm’s length principle (‘ALP’) was introduced a century ago to ensure proper allocation of taxing rights and it lies as the basis of transfer pricing legislation[1]. ALP is still considered as the ‘…heart, spirit and foundation of the current international transfer pricing system’, however, the question that arises is how efficient and appropriate are such ALP rules for allocation of taxing rights in today’s world.

Introduced in United States as a standard so that an uncontrolled taxpayer would always deal at arm’s length with another uncontrolled taxpayer, it later found a place in the OECD Model convention (‘OECD MC’). Article 9 of the OECD MC contains the authoritative statement for ALP as per which it is a principle that applies to a controlled transaction to determine whether the price of that transaction would have been agreed on between independent parties in the open market to ascertain international income is fairly allocated. From Article 9 of the OECD MC, we can also conclude that it is the foundation for the comparability analysis because it initiated the requirement of[2]: A comparison between conditions (including but not only prices) made or imposed between associated enterprises and those which would be made between independent enterprises, to determine whether the determination of profits is at arm’s length’

2. Criticism that exists for ALP :

It is often criticized that ALP no longer fulfils the objective for which it was created i.e. allocation of taxing rights in a fair manner and hence the principle needs to be re-visited. The broad arguments that critics take in this regard are :

  • Reflecting the economic reality of the transaction :
  • How adequately arm’s length principle reflects the economic reality, especially in the current economic environment (For ex. – In transactions involving intangibles which are becoming an ever-more dominant value driver for multinationals (‘MNEs’))
  • The principle does not take into account the economic interdependence between related entities.[1] It still sticks on separate legal entity concept, however, in today’s world where transactions/ operations are so integrated, it is no longer feasible to rely on separate legal entity concept, in various situations.
  • Consideration of demand-side factors :

       Pillar One approach of the OECD secretariat also resonates with the OECD’s thoughts of markets contributing value to the MNEs value chain. Due to digitization, the idea of taxing markets have become further challenging as digital platforms can create size without mass and are directed toward one predominant objective i.e. the alignment of the jurisdiction where income is reported for tax purposes with the place where value is created (Discussed in section 3 in detail).

       Pertinent to mention, ALP which is based on Function, Assets and Risk (‘FAR’) analysis takes into account only supply-side factors while demand-side factors (such as sales) are ignored. There is a need to move from FAR to a FARMapproach that would add a market factor also to the FAR analysis. Thus, the market state shall also obtain the right to tax certain part of the profit linked to sales in other state based on the nexus.

  • Harmonization issue[2] : ALP’s inclusion into domestic law or treaty law and the application of the OECD guidelines to the principle creates certain harmonization issues (For ex. :  differences in the domestic tax system of the countries makes it difficult to harmonize the application of the ALP approach worldwide). Such issues can be categorized into the following situations:
  • Situations where there is provision both in domestic law and tax treaty that incorporate the arm’s length principle, but they differ in wording and effect;
  • Situations where the domestic[MS1]  law provisions are themselves inconsistent with the arm’s length principle.

While some of this criticism may be regarded as a weakness of ALP, however other weaknesses have been discussed in section 4.

3. Alignment of ALP with value creation

With Action plan 8-10[3] it seems that a new standard to allocate profits from transactions based value-creation principle vis-à-vis functions performed rather than finding comparable transactions based on ALP seems to have been laid down. However, BEPS Project Actions 8 – 10 also reaffirms that ALP is the conceptual core of global transfer pricing principles, as ALP has proven over time to be the acceptable way of reaching an agreement for allocation of taxable income among group entities operating in different states.

The purpose of value creation is to find the true nature of the actual controlled transaction while ALP refers to what the unrelated parties would have done in comparable circumstances. Thus, it is difficult to reconcile both concepts. Value creation, unlike the ALP leaves no room for any hypothetical transaction. On the contrary, it may be said that value creation is a way to predefine the transfer pricing rules, or possibly more accurately, to predefine the method as a method based on functions performed, the capacity to perform those functions and the market for the product or service. It rather reflects the profit allocation character of the ALP.

In all, the following question arises  –

  • Whether the alignment of Transfer pricing rules with value creation will lead to the allocation of  profits in accordance with the ALP
  • Whether reconciliation between economic activities that gave rise to income/ profits and tax jurisdictions in terms of value creation would prevent the profit shifting

[1] De Wilde (2015) ‘In these early days of international taxation the League of Nations, as the ‘predecessor’ of the United Nations and the OECD, drafted the first Model Tax Conventions on Income and Capital’, p.6

[2] J Pleune, ‘The Desirability of the Arm ’ s Length Principle in the 21 St Century’, pg 12-13 

[3] Charles E McLure ‘Replacing Separate Entity Accounting and the Arm’s Length Principle with Formulary Apportionment’ [2002] BFIT 586 at 586

[4] Reference for this has been drawn from paper Duran Timms, ‘The harmonisation of Transfer pricing : The obstracles , the arm’s length principle and the OECD guidelines’.

[5] OECD, Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 – 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project (2015).


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