The Arm’s Length Principle

The Arm’s Length Principle is the condition aiming that the parties to a transaction treat each other as independent and on an equal terms and conditions

It is broadly used in business law to establish equitable conditions to an agreement that will stand up to legal and tax scrutiny, even when the parties involved are related.

The arm’s length principle requires that any compensation happening between companies of the same group have the same economic value as if it has happen between unrelated parties.

It’s easier said than done. The actual determination and implementation of the arm’s length principle is highly complex and must consider diverse important factors that can influence and determine the fair market value of the compensation including the type of transaction under analysis, the amount of the payment, the form of payment, the time frame for the payment as well as the economic and regulatory environment surrounding the transaction.

The Organisation for Economic Co-operation and development (OECD) has included in its model of tax convention for avoiding double international taxation and promote the exchange of information, in the Article 9, the provision of the Arm’s Length principle when establishing that in such cases where an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or when the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

The above serves the purpose of providing It provides the legal framework for tax authorities and for enterprises and multi-national companies I order to avoid double taxation conflicts and get the proper taxes paid at the fairest rate.