The arm’s length principle states that the price charged within a transaction carried out between two related companies should be the same with the price charged between two independent parties in a comparable transaction.
With the OECD’s work on BEPS and the growing involvement of other organizations such as the UN, the tax authorities have rethought this principle and how it should be applied.
The arm’s length principle was introduced in many European countries, through the transfer pricing legislation.
For example, as per the transfer pricing Romania eBook, the prices charged in a transaction between two related parties should be the same as the price charged in a comparable transaction between two independent parties.
The Organization for Economic Cooperation and Development (OECD) has adopted the arm’s length principle as an objective guideline for determining how transfer prices should be set in transactions between related parties.
However, the growing size and complexity of transactions between multinational enterprises (MNEs) has made it more difficult to apply the principle of competition in a consistent manner, which is easily applied by taxpayers and accepted by tax authorities.
This has led to a sharp increase in the amount of transfer pricing documentation requested by the tax authorities. Tax authorities have also become concerned that MNEs may apply the arm’s length principle in a way that allows them to make more of their profits in low-tax jurisdictions.
Tax authorities have several concerns about the arm’s length principle. The first is simply that it is too complex to apply, especially in the case of valuable intangible assets and sophisticated financial transactions. In this certain case, the lack of available details represents a problem.
But the most fundamental concern is that domestic businesses have managed to use the arm’s length principle in ways that have allowed them to report much of their profits in low-tax jurisdictions and thus avoid paying an appropriate level of taxes in countries where they have to operate.
Thus, OECD have launch an investigation into “Basic Erosion and Profit Change” (BEPS). As part of the BEPS project, the OECD has published new extensive guidance on how the independent competition standard should be interpreted, the documentation needed to support transfer pricing among related companies, and the approaches used to resolve disputed transfer pricing.
However, more recently, the OECD is exploring even more fundamental changes in the way profits will be allocated between the various related subsidiaries of MNEs, at least in the case of MNEs with significant digital operations and / or substantial consumer sales.
Although it is not clear at this time how far these insiders will go, to a large extent, they are intended to give tax authorities a greater ability to tax their business depending on the users or consumers in their country.
This can lead to substantial changes in tax rights, which will have a significant impact on where MNEs are taxed and on the overall level of taxes paid by MNEs.