The arm's length principle is a fundamental principle in international taxation that governs how transactions between related parties should be treated for tax purposes. It is designed to ensure that cross-border transactions between related entities, such as subsidiaries and parent companies, are conducted as if the entities were independent and unrelated.
According to the arm's length principle, related parties should establish transfer prices for their transactions that are equivalent to the prices that would have been agreed upon between unrelated entities in similar circumstances. This principle aims to prevent the manipulation of transfer prices by related parties to shift profits from high-tax jurisdictions to low-tax jurisdictions, thereby minimising tax liabilities.
The arm's length principle is endorsed by the Organisation for Economic Co-operation and Development (OECD) and is widely accepted and applied by countries around the world. The OECD provides detailed guidelines and methodologies for determining arm's length prices, which assist tax authorities and taxpayers in ensuring compliance with the principle.
To determine arm's length prices, various methods can be used, including comparable uncontrolled price method, resale price method, cost plus method, transactional net margin method, and profit split method. These methods involve analysing comparable transactions between unrelated entities to establish a range of prices that would be considered arm's length.
The arm's length principle is crucial in preventing tax avoidance and ensuring fairness in the taxation of multinational enterprises operating across borders. Tax authorities have the power to adjust transfer prices if they believe that related parties have not adhered to the arm's length principle. Such adjustments may result in the reallocation of income and expenses between related parties, leading to potential tax assessments and penalties.
