When we imagine big corporates, handshakes are one of the prominent flashes in our mind. We are often reminded that a good handshake is key to a good meeting. So, what’s a good handshake? As experts list the rules – “Approach the person from his line of sight, look straight in the eye, keep a smile on the face, offer a hand when you have the attention, hold hand with a firm grip, with clean hands and withdraw your hands in time”. Thus, a good handshake, places two professionals, in a position where they are both standing facing each other, and at an arm’s length distance signifying the equal status of participants and dealing in good spirit. The term ‘Arm’s Length Price’ is derived from and signifies the same phenomenon – transactions at a price between two equal companies, dealing in a good spirit.

Why enforce Arm’s Length Pricing?

There is a huge difference in the tax rates in various countries around the world. If the Governments leave them unchecked, the Multinational Corporations can easily shift their profits from countries with high tax rates to countries with low tax rates. This is possible because of the intercompany transactions between the enterprises forming part of their group.

  • A regional head company is registered in low tax countries, which invoices management and service fees to all companies in other locations. Thus, effectively reducing its tax liability.
  • A holding company is registered in a country with low tax rates and then provides capital financing to other companies located higher tax countries. Thus, transferring profits to a country with low tax rates.
  • A manufacturing entity may have to be located in a high tax rate country due to operational reasons and may end up paying higher taxes, however, it sells all its product to a distributing company located in a low tax rate country. Thus, escaping higher taxes.

Multinational entities are able to control the terms and conditions of these transactions and set the price, in way that they can influence taxable profit and the amount of tax due. Well, in the past three decades, almost every corporate has adopted the said approach and today it is a common practice to save taxes. It is for this reason, to prevent income from escaping taxation, Governments have Transfer Pricing Regulations in place, to make sure that the intercompany transactions occur at arm’s length price i.e. in good spirit.

What is Arm’s Length Principle?

The main source of the Arm’s Length Principle in Article 9 of OECD Model Convention, which is adopted in almost all bilateral tax treaties. The Arm’s Length Principle of Transfer Pricing simply states that the price charged by one related entity to another must be the same as it would have been if the parties were not related. So, in simple terms, the arm’s length price is the price of that transaction if it would have taken place in an open market. The influence that associated enterprises may have on each other should not reflect in the price, or in other terms, should be eliminated from the price.

Let’s consider two transactions:

Case 1 – Alpha produces laptops and sells them to its distributor ABC Ltd. Here, Alpha and ABC are unrelated entities. Thus, this transaction would be called an Uncontrolled Transaction and the terms and conditions are considered would be considered to be ‘at an arm’s length’.

Case 2 – Alpha produces the same laptops and sells them to its distributor Beta. However, Alpha and Beta are both owned by Gamma. Thus, this transaction would be called a Controlled Transaction, as any of the entities may have influenced the pricing. Therefore, the terms and conditions of such a transaction should comply with the arm’s length principle as per the transfer pricing regulations.

Now, if we consider Case 1, the price is absolutely commercial and uninfluenced. If the Case 2 has taken place under the same terms and conditions as in Case 1, then the price used for Case 1 can be considered as an Arm’s Length Price for Case 2, and the same must be adopted.

Thus, to identify an arm’s length price we need a price from another comparable transaction, which satisfies the following two characteristics –

  1. It must be comparable – The transaction must be comparable to the transaction being considered. The product or service in both cases must be the same or similar. The geographical markets in which the transaction took place and other such factors that may influence price, must all be similar for the price to be adopted. If there are no similar transactions, the arm’s length price is determined by adjusting the price in an almost similar transaction, where adjustments are made for differentiating factors between the two transactions.
  2. It must be uncontrolled– The transaction must be the one which has taken place between two entirely Non-Associated Enterprises or between the enterprise itself and a third Non-Associated Enterprise. The terms and conditions of such transactions must be similar to the transaction being considered.

Criticism of the Arm’s Length Principle

Though the Arm’s Length Pricing Principle helps in keeping tax avoidance in check, however, it is wide open for interpretation which results in more discussions, more tax planning, and of course, a lot of tax litigations. Every product and services is different, there are various versions of qualities among them too and then there several brands in the market with their own differentiation in the product and service. Thus, finding a comparable transaction, a transaction closely resembling the features of the product, the terms of the arrangement, and all other aspects, is a giant task. Therefore, while Arm’s Length Principle is theoretically sound, it is quite difficult to implement practically,

Besides, Arm’s Length Principle doesn’t entirely put the tax avoidance to an end, as corporates can still establish their businesses in tax havens, and shift passive incomes through allocation to such tax havens, without conducting any real operations.

Arm’s Length Pricing in India – Key Highlights

  1. DefinitionSection 92C of the Income Tax Act, 1961 elaborates on the computation of arm’s length price. It defines Arm’s Length Price, as the price computed by a most appropriate method, on the basis of nature and class of transaction and the enterprises involved.
  2. Methods of ComputationThe section lists the methods which may be used for computing the arm’s length price. These methods are –
  • comparable uncontrolled price method
  • resale price method
  • cost-plus method
  • profit split method
  • transactional net margin method
  1. Selection of Most Appropriate MethodThe above methods are only recommendatory, as the Rule 10AB further permits the usage of any other method which considers the price charged or paid, for a similar uncontrolled transaction, between non-associated enterprises, entered under comparable circumstances, taking into account all the other relevant facts. Further, an enterprise may also use a combination of any two or more methods.
  2. Arithmetic Mean – In case, the methods result in multiple prices, an arithmetical mean of such prices must be considered as the Arm’s Length Price.