Arm’s Length Principle in a Nutshell
International production, trade and investment are increasingly organized within global value chains. Enterprises that produce goods or deliver services in more than one country are called multinational enterprises (“MNEs”). They play the central role in global value chains, and, consequently, in global economy.
As explained in more detail in our article What is Transfer Pricing?, the pricing of cross-border transactions between associated enterprises forming an MNE group may affect the amount of taxes each state involved can collect. To protect their tax bases, tax administrations around the world turn their attention to the policies of the MNEs concerning transfer pricing, i.e., the pricing of transactions between associated enterprises.
Key Issues
- Transfer prices policies are subject to heavy scrutiny by tax authorities worldwide.
- Transfer prices must reflect the arm’s length principle.
- The comparability of the transactions is at the heart of the application of the arm’s length principle.
- Malta introduced Transfer Pricing Regulations in November 2022.
The Background to the Arm’s Length Principle
Generally, tax authorities approach each enterprise within an MNE group as a separate entity and aim to tax each individual group member on the income arising to it. However, because members of the same MNE are associated and have a common economic aim, they can establish special conditions in their intra-group relations that differ from those that would have been established if they operated as independent enterprises in open markets. That, in turn, could distort the number of profits or losses attributed to each MNE member.
To ensure the correct application of the separate entity approach, OECD member countries have adopted the arm’s length principle, under which the effect of special conditions on the levels of profits should be eliminated1.
What Is the Arm’s Length Principle?
The arm’s length principle is set forth in Article 9 of the OECD Model Tax Convention as follows: where “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”.
A similar wording has been included in Article 9 of the UN Model Tax Treaty and was used as a basis of numerous domestic TP legislations worldwide.
Comparability Analysis
The arm’s length principle is all about comparability. It imposes an obligation to make a comparison between the conditions adopted in a transaction between members of the MNE (“controlled transaction”) with the conditions that “would have” been adopted under “comparable circumstances” between independent parties (“uncontrolled transactions”). The OECD TP Guidelines confirm expressly that “the analysis of the controlled and uncontrolled transactions, which is referred to as a “comparability analysis”, is at the heart of the application of the arm’s length principle.”2
Two transactions will be considered comparable if one of the two conditions is met:
- none of the differences (if any) between the transactions being compared could materially the price or the profit, or,
- where such differences exist, reasonably accurate adjustments can be made to eliminate this effect3.
Comparability Factors in the Arm's Length Principle
In order to test the comparability, one should look at economically relevant characteristics of the transactions, so-called “comparability factors”. The comparability factors are as follows:
- contractual terms of the transaction.
- functions performed by each of the parties to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the MNE group to which the parties belong, the circumstances surrounding the transaction, and industry practices.
- characteristics of property transferred, or services provided.
- economic circumstances of the parties and of the market in which the parties operate.
- business strategies pursued by the parties4.
Transfer Pricing Methods
To establish whether conditions in commercial and financial relations between associated enterprises are at arm’s length, the OECD TP Guidelines propose applying special transfer pricing methods. Each TP method has its strengths and weaknesses, and we describe them in more detail in our series of articles on Transfer Pricing Methods. Nonetheless, all of TP methods are based on the concept that independent enterprises, when comparing different options available to them, consider their comparability and any differences that would significantly affect their value5.
For instance, before making a purchase, independent enterprises would try to find equivalent product on comparable conditions but for a lower price. This is reflected in a one of main TP methods – the comparable uncontrolled price method. This method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price that would be quoted in an open market. To deliver reliable estimates, it requires a high comparability of conditions, in particular concerning the product characteristics.
What This Means for You
Under the arm’s length principle, a transfer price will be considered adequate if it reflects the price that would have been set between independent enterprises in comparable transactions and comparable circumstances. If tax authorities decide that transfer prices do not reflect the arm’s length principle, they can impose additional tax on the companies involved, often with interest.
In November 2022, Malta has introduced its first Transfer Pricing Regulations. Starting from year 2024, the Regulations impose transfer pricing documentation obligations on Malta resident companies engaging in intra-group transactions. It is expected that Malta tax authorities will ramp up their efforts in the fields of transfer pricing. Taxpayers involved in transactions with related entities should make sure that their transfer prices conform with the arm’s length principle. Transfer prices should be calculated using an appropriate TP method and ideally supported by comprehensive TP documentation.
How We Can Help
Our team of experienced advisors can help to identify, assess and mitigate potential transfer pricing risks in your business and to develop a sustainable, tax-efficient transfer pricing policy for the future. As a collaborating firm of Andersen, leading global Tax & Legal advisors, we offer the comfort of years of experience in this highly contentious area.
Get in touch with us to learn how we can help you to manage your transfer pricing risks so that your business remains in compliance with Malta Transfer Pricing Regulations whilst retaining its operational effectiveness.
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[1] OECD TP Guidelines, para 1.6.
[2] OECD TP Guidelines, para 1.6.
[3] The OECD TP Guidelines, para 2.15.
[4] OECD TP Guidelines, para 1.36.
[5] OECD TP Guidelines, para 1.40.
