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4 min read

What is the arm’s length principle in transfer pricing

arm's length principle in transfer pricing

Transfer pricing is a critical concept for multinational businesses and international contractors. Essentially, transfer pricing concerns the prices charged for goods, services, or intellectual property (IP) between related entities within an enterprise, such as between a parent company and its subsidiaries. While this might appear simple, it can become complex when transactions span international borders and involve various tax jurisdictions. This is where the arm’s length principle comes into play—a cornerstone of transfer pricing rules used by numerous countries and integral to understanding international taxation.

Key Takeaways

  • The arm’s length principle is a standard dictating that transactions between related parties should be priced as if they involved unrelated parties, each acting in their best interest.
  • Adhering to the arm’s length principle is crucial in preventing profit shifting and tax evasion by multinational enterprises.
  • MNEs can employ various methods to ensure their transfer prices adhere to the arm’s length principle, including comparable uncontrolled price (CUP), resale price method, cost plus method, profit split method, and transactional net margin method.

What is the Arm’s Length Principle

Established by the Organisation for Economic Co-operation and Development (OECD), the arm’s length principle is a standard dictating that transactions between related parties (like a parent company and its subsidiary) should be priced as if the transactions involved unrelated parties, each acting in their own best interest. Essentially, the transfer price should match the market price under similar conditions, with both parties remaining independent of each other.

The Importance of the Arm’s Length Principle

This principle is crucial in preventing profit shifting and tax evasion. Multinational enterprises (MNEs) might be tempted to manipulate transfer prices to transfer profits from high-tax jurisdictions to low-tax jurisdictions, thereby reducing their overall tax burden. By adhering to the arm’s length principle, MNEs must price their internal transactions as if they were between unrelated parties, making it more challenging to manipulate prices for tax advantage.

Arms Lenght Transaction

Case Study: Apple Inc. and Ireland’s Tax Treatment

Apple Inc. is one of the world’s largest tech companies, producing a wide range of products like iPhones, iPads, and Mac computers. Apple established its operations in Ireland in the 1980s, and over time, significant profits from international sales (outside the Americas) were channeled through its Irish subsidiaries.

Situation

The European Commission (EC) started an investigation in 2013 into the tax treatment of Apple in Ireland. The primary concern was whether Ireland had given Apple special tax treatment that enabled the company to pay substantially less tax than other businesses, thus providing them an unfair advantage.

The Arm’s Length Principle and the Issue

Apple’s Irish structure involved two main subsidiaries: Apple Sales International (ASI) and Apple Operations Europe (AOE). These subsidiaries were receiving significant profits from Apple’s sales outside the Americas.

The EC claimed that the profits allocated to the “head offices” of ASI and AOE were not in line with the ALP, as these head offices had no physical presence or employees and thus could not have generated such significant profits. The substantial profits attributed to these “head offices” were not subject to tax in any country under specific provisions of the Irish tax law, leading to a minimal effective tax rate.

Resolution

In 2016, after the investigation, the European Commission concluded that Ireland’s tax benefits to Apple were illegal under EU state aid rules. They had allowed Apple to pay an effective corporate tax rate of 1% on its European profits in 2003, which decreased to 0.005% by 2014.

Consequently, the EC ordered Ireland to recover up to €13 billion (plus interest) in back taxes from Apple for the years 2003-2014.

Both Apple and Ireland disagreed with the EC’s decision and chose to appeal. They argued that the tax treatment was consistent with Irish and European Union law and that the company’s profits were aligned with the value created.

Aftermath

While the case went through appeal processes, it shed light on international transfer pricing practices and pressured jurisdictions to ensure transparency and adherence to the Arm’s Length Principle.

In July 2020, the General Court of the EU annulled the EC’s decision, saying the Commission had not demonstrated that the Irish tax rulings constituted state aid. However, by this time, both Apple’s tax structure and Ireland’s tax practices had undergone significant changes due to global scrutiny and changing regulations.

Lesson Learned

The Apple case underscores the complexities of international transfer pricing and the challenges in ensuring that profits are taxed where the actual value is created. It’s a testament to the importance of adhering to the Arm’s Length Principle and the global drive for more transparent and fair taxation practices for multinationals.

It’s worth noting that while the Apple case is one of the most high-profile instances, many multinational corporations have been examined for their transfer pricing practices, emphasizing the need for international cooperation and reform in this area.

Choosing Methods and Considerations for the Arm’s Length Principle

MNEs and international contractors can employ various methods to ensure their transfer prices adhere to the arm’s length principle, including comparable uncontrolled price (CUP), resale price method, cost plus method, profit split method, and transactional net margin method. The most suitable method depends on the specific circumstances of the transaction.

Wrapping Up

The arm’s length principle is an essential concept in international taxation and transfer pricing. Understanding and applying this principle is vital for international contractors and businesses to ensure they comply with tax laws and avoid potential disputes with tax authorities. To grasp the best approach to setting transfer prices for your particular situation, it’s always wise to consult with a tax advisor or a professional experienced in international tax law.

At RemotePad, Lech draws on his professional experience to write about employment taxes and payroll (both remote, and in-office). Lech holds a Bachelors’ degree from the University of Kent, a Master of Arts (MA) from Kings College London, and professional payroll and tax qualifications. He has 20 years experience advising on all manner of tax and business planning matters.

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