Understanding the Arm's Length Price Principle in Modern Taxation

Understanding Arm's Length Price

The Arm’s Length Price (ALP) refers to the price at which business profits can be optimized, reflecting the functions performed, assets utilized, and risks assumed in a transaction. It fundamentally serves to allocate business income and profits across various tax jurisdictions. Essentially, the arm’s length price represents the price at which unrelated entities engage in transactions under comparable circumstances.

Historical Background of the Arm's Length Principle

The arm’s length principle originated in the United States with the Revenue Act of 1928. In 1933, the League of Nations published the "Carrol Report," establishing global standards for transfer pricing to address taxable income allocation methods. This was not the first instance of the arm’s length principle being recognized; tracing back to 1987, the UK employed a "trial and error" method for allocation. The landmark case "Salmon vs Salmon Co." further defined the allocation theory, incorporating the concept of "the Corporate Veil."

In 1908, during a period of economic growth, the German government imposed the lowest income tax rates in Europe. Consequently, UK companies began shifting profits to their German subsidiaries. This raised concerns within the UK authorities, particularly in the case of "Gramophone & Typewriter Ltd. vs Stanley," where it was revealed that profits of the UK entity were being attributed to the German subsidiary.

Following these developments, the "Carrol Report" led to the formation of OECD and UN guidelines on transfer pricing, which have since been adopted by numerous economies.

Current Relevance of the Arm's Length Principle

The pressing question is whether the arm's length principle, established in the past, remains relevant amid the current technological landscape of Industrial Revolution 4.0. To address this, we must consider the following points:

1. Feasibility and Effectiveness of Comparable Testing:

   • Is it practicable to identify effective comparables to ensure transactions reflect an arm's length standard? In India, there is significant dispute between taxpayers and authorities regarding the selection of comparables, limiting effectiveness.

2. Manipulation of Existing Laws:

   • Can existing laws be exploited to gain from guidelines intended for repatriating untaxed profits? The OECD’s Base Erosion and Profit Shifting (BEPS) initiative has provided some clarity, while India has made progress through “Secondary Adjustment” regulations.

3. Compliance Challenges for Developing Economies:

   • Is it feasible for developing or underdeveloped economies, as well as startups, to adhere to complex comparable analyses requiring substantial resources for compliance? This remains an open question for the OECD and tax jurisdictions.

Determining the relevancy of the arm's length principle cannot occur without addressing these pertinent inquiries. Nevertheless, it is clear that the application of the current arm's length principle needs to be rationalized. This would enable tax authorities and multinational enterprises (MNEs) to both apply and accept it. The current BEPS Action Plans could potentially exacerbate transfer pricing disputes, emphasizing the need for a balanced approach.