Dr SHAKUNTALA MISRA NATIONAL REHABILITATION UNIVERSITY

Lucknow

Faculty of Law

PROJECT ON

[ARM’S LENGTH PRINCIPLE]

For

COURSE ON ‘INTERNATIONAL TAXATION:EMERGING

JURISPRUDENCE’

CLASS: B.Com. LL. B (Hons.) 7th Semester

Submitted by

[ANUJ PRATAP SINGH]

[Roll No - 164140009]

Academic Session: 2019-20

Under the Supervision of

Mrs. Sushmita Ma’am

Faculty of Law
Dr Shakuntala Misra National Rehabilitation University

ARM’S LENGTH PRINCIPLE Page 1

 ACKNOWLEDGEMENT

I would like to express my special thanks of gratitude to my teacher Mrs. Sushmita Ma’am,
who gave me the golden opportunity to do this wonderful topic Arm’s Length Principle, which
also helped me in doing a lot of Research and I came to know about so many new things I am
really thankful to him.

ANUJ PRATAP SINGH

ARM’S LENGTH PRINCIPLE Page 2

 TABLE OF CONTENT
1. Introduction ………………………………………………………..04
2. Definition …………………………………………………………...04
3. Why do we have an arm’s length principle? …………………05-06
4. Is the arm’s length principle flawed? …………………………….06
5. Arm’s Length Principle ………………………………………..06-07
6. Arm’s Length Transactions ………………………………………07
7. Non Arm’s Length Principle ……………………………………..08
8. Arm’s Length In Transfer Pricing……………………………….08
9. Arm’s Length Example Involving A Foreclosure Sale ……...09-10
10. Bibiliography ……………………………………………………...11

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 ARM’S LENGTH PRINCIPLE

INTRODUCTION: The arm's length principle (ALP) is the condition or the fact that the
parties of a transaction are independent and on an equal footing. Such a transaction is known as
an "arm's-length transaction". It is used specifically in contract law to arrange an agreement that
will stand up to legal scrutiny, even though the parties may have shared interests (e.g.,
employer–employee) or are too closely related to be seen as completely independent (e.g., the
parties have familial ties). An arm's length relationship is distinguished from a fiduciary
relationship, where the parties are not on an equal footing, but rather, power and information
asymmetries exist. It is also one of the key elements in international taxation as it allows an
adequate allocation of profit taxation rights among countries that conclude double tax
conventions, through transfer pricing, among each other. Transfer pricing and the arm's length
principle was one of the focal points of the Base Erosion and Profit Shifting (BEPS) project
developed by the OECD and endorsed by the G20

DEFINITION: The definitive statement of the ALP is set out in Article 9 (1) of the OECD
Model Double Tax Treaty. Broadly, this tells us that where “conditions are made or imposed”
between associated enterprises in their “commercial or financial relations” and these conditions
both differ from those which would be made between independent enterprises and also lead to a
shortfall in profits in one of those associated enterprises, the amount of that shortfall may be
taxed. The provision is unchanged since its first introduction into the OECD Model in 1963.

The idea of an arm’s length transaction relates to an agreement between two people or entities
that are independent of one another. This means that they do not have a prior relationship with
one another, such as being related to each other, having a prior deal with each other, or that one
party controls the other in some way. In certain situations, it is important to be able to prove that
an agreement was entered into freely by both parties, to prove that the price, requirements, and
conditions set within the transaction were fair and real at the time the transaction was made. To
explore this concept, consider the following arm’s length definition

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WHY DO WE HAVE AN ARM’S LENGTH PRINCIPLE?

The reason for establishing an arm’s length principle was to ensure that each tax jurisdiction will
get its fair share from an affected transaction between related parties. The OECD further states
that independent parties normally deal with each other within financial and commercial relations
which are determined by market conditions. These market forces that determine the price
between independent parties are comparable to the arm’s length principle. This means that two
independent parties do not have much choice in determining a price between them. If the price is
too high the one party will find someone else to contract with and if the price is too low the other
party may make losses and will not be interested in doing business under those terms.

When related parties transact with each other, the financial and/or commercial relations may not
affect a transaction in the same way as between independent parties. For example an MNE may
try to increase profits on a global basis rather than on a company to company basis, regardless of
where the companies are incorporated. This means that the MNE tries to be as profitable as
possible on a global level even if a single entity of the group has to make losses. This is one of
the reasons why it may be so difficult to ascertain an arm’s length principle for some
transactions. It is very difficult if not impossible to compare such an MNE transaction to an
independent party transaction because an independent party would not enter into a contract
which will only guarantee losses or fail to provide a proper return on investment. An MNE as a
whole can achieve savings overall due to the loss on one transaction and therefore the transaction
makes commercial sense from an MNE perspective. Usually tax jurisdictions would seek to
adjust such loss making cross-border related party transactions to profit making as the tax
jurisdiction is only concerned with the transaction and not the MNE as a whole (For example a
loss making product within a product range – if this still is not clear please ask me for further
clarification in the comment section).

There may be justifiable reasons for losses from a tax jurisdiction’s perspective. For example,
during the start-up stage of an MNE there may have been high capital costs for the new
manufacturing plant and/or manufacturing equipment or if the MNE plans to penetrate a new
market, and therefore offers its products at a lower price to gain a niche in the market. The
OECD (2001) further acknowledges that this is one of the reasons why tax administrations

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should not automatically assume that related parties of a global MNE have sought to manipulate
their profits, but should recognise that the MNE does have certain loss-leaders for valid
economic and commercial reasons.

IS THE ARM’S LENGTH PRINCIPLE FLAWED?

Some argue that the arm’s length principle is inherently flawed. This is mainly due to the fact
that the arm’s length principle does not account for the economies of scale related to integrated
systems when compared to independent parties. MNEs are known to have great cost savings
through centralised management structures and cost centres (as discussed previously in ‘The
reason for the existence of MNEs’). These savings are, however, not considered in the
determination of the arm’s length range.

The OECD Guidelines (2001) acknowledge that the arm’s length principle may not always be
simple to use in practice but it is sound in theory and gives the closest approximation to a fair
price between related parties. The arm’s length principle usually allocates appropriate levels of
income between off-shore related parties and is therefore accepted by tax administrations. There
may be instances when the arm’s length principle is flawed but it is the closest method of
establishing a fair principle for each tax administration. There are no other acceptable principles
or methods to determine values for cross-border related party transactions that are fair and sound
in theory. The arm’s length principle has been accepted internationally by the major corporations
and tax administrations and the experience with the arm’s length principle has become
“sufficiently broad and sophisticated to establish a substantial body of common understanding
among [them]” (OECD, 2001:I-6). This understanding ensures that each tax administration
receives its fair share of taxes and in addition the corporation does not suffer double taxation.

ARM’S LENGTH PRINCIPLE: The arm’s length principle is a condition in which the
parties to a transaction have no prior relationship with each other, and that they are equal parties
to the transaction. In consideration of the arm’s length principle, parties are considered
independent of each other when they are not related to each other in the familial sense, nor have

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they engaged in any prior deals with each other, and have no side deals with each other. The
arm’s length principle also helps guide transactions insofar as appropriate taxation is concerned.

An example of the arm’s length principle at work involves a supervisor’s use of the company’s
human resources department to fire an employee. While the employer and the employee do have
a prior relationship with each other, the termination itself is conducted by a neutral third party
who is not a party to that relationship. This is done to protect the employer from any lawsuits
that the employee may be able to bring upon being terminated, should he be terminated in a way
that deviates from the labor laws within that jurisdiction. The arm’s length principle here ensures
that the employer and the employee each have an unbiased and qualified advocate on his side.

ARM’S LENGTH TRANSACTIONS: Arm’s length transactions are transactions

wherein the buyers and sellers to the transaction have no prior relationship with each other.
Arm’s length transactions ensure that each party is acting in his own self-interest, and that
neither party is being pressured by the other party to go ahead with the transaction. This also
reassures any potential third parties to the transaction that no collusion exists between the buyer
and the seller.

Arm’s length transactions must be conducted in real estate transactions to ensure that the price
being offered for the property is consistent with the fair market value for that property. For
instance, when two strangers are parties to a real estate transaction, the seller wants to charge the
highest possible price for that property, and the buyer wants to pay the lowest possible price for
that property. Therefore, it is more likely that the final agreed-upon price is at, or close to, fair
market value.

However, in situations where the parties are not strangers, which are referred to as “non-arm’s
length transactions,” it is less likely that the price offered and/or obtained for the property is
close or equal to fair market value. For instance, a mother who is selling her house to her
daughter is more likely to give her daughter a discount on the property, rather than charge her a
price at or close to fair market value, which may be significantly higher.

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NON ARM’S LENGTH PRINCIPLE: Non-arm’s length transactions are transactions
that exist between people who already have an existing relationship. The relationship in a non-
arm’s length transaction can be of a personal or professional nature, and it can exist between the
buyer and the builder, the developer, or the seller. It may seem easier to purchase a house from a
friend or a relative, but risks still exist within such a transaction.

For instance, the financial situation of the person selling the house in a non-arm’s length
transaction can change. Because the seller knows the buyer will be sympathetic to his situation,
he may end up asking the buyer for more money. This is especially true if the seller provided the
buyer with a loan, as opposed to sending the buyer to a mortgage lender.

The taxation on a piece of property also significantly varies between a non-arm’s length
transaction and an arm’s length transaction. For instance, using the example presented above, if a
mother sells her house to her daughter at a discounted rate, tax authorities are within their right to
force the mother to pay taxes on the gain she would have received if she had sold the house to a
neutral third party, rather than her son.

The taxes are based on the fair market value of the property, not the discount that one party may
choose to give to another. This then results in a loss that the seller is implying that he is willing
to accept in giving the buyer a discount on the property.

ARM’S LENGTH IN TRANSFER PRICING: The arm’s length in transfer pricing

principle states that the amount that is charged by one party to the other party in the transaction
must be the same as if the parties were not related. For example, the arm’s length price must be
the same as what the price would be on the open market. When dealing in commodities, arm’s
length in transfer pricing is rather straightforward, and can be as easy as researching comparable
transactions. However, if the transaction deals with trademarked goods or services, then settling
on an arm’s length price can be more complicated.

Parties engaged in arm’s length in transfer pricing transactions in the United States are guided by
the best method rule when determining the appropriate arm’s length price for the transaction.
The Best Method Rule requires that the method used to arrive at the best transfer price be the one
that offers the best precision in matching the price of a comparable transaction. IRS regulations

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can guide parties insofar as helping them with determining the best possible method for their
transaction.

ARM’S LENGTH EXAMPLE INVOLVING A FORECLOSURE SALE:

What follows is an example of an arm’s length transaction that was brought before the Ohio
Supreme Court. In March of 2007, Craig Fennel, president of Fenco Development Company,
filed a complaint on behalf of his company with the local Board of Revision (BOR) against an
auditor’s valuation of an apartment building that Fenco had purchased the year before.

The auditor’s valuation came in at nearly $480,000. Fenco, however, claimed the property’s
value was actually $135,000, which is the price that Fenco paid to the United States Department
of Housing and Urban Development (HUD) when it purchased the building at a foreclosure
auction.The BOR held a hearing in September of that year, at which Fennel testified that the
property had been vacant for two years, and provided photographic evidence that it was in run-
down condition. He also testified that he was holding on to the property, waiting to improve on it
until other properties had been improved first.

The auditor countered by submitting a report prepared by one of its staff appraisers that indicated
that no one had made a sufficient claim or submitted the appropriate documentation to show that
the valuation of the property should be reduced. The appraiser agreed that the condition of the
property was “deplorable,” however she testified that the foreclosure sale “[did] not indicate a
market sale.”

The BOR determined that the evidence proved that the run-down condition of the property had
made it difficult to sell through auction, and that the final sale price had proved the true value of
the property at the time that it was sold. The decision was appealed to the Board of Tax Appeals
(BTA). The BTA ultimately determined that an arm’s length sale must be voluntary, and that the
“public sale was carried out voluntarily by the seller.” Further, the BTA noted that the auction
contained “the elements of an arm’s length transaction.”

Because the BTA ruled that the sale was an arm’s length transaction “upon which the BOR
properly relied in valuing the property for tax year 2006,” the BTA affirmed that the sale price of
$135,000 should be considered the true value of the property at the time it was sold.

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The case was then appealed to the Ohio Supreme Court. The Court ultimately reversed the
BTA’s ruling, holding that a foreclosure sale of real property does not qualify as an arm’s length
transaction in an action whose sole purpose is to revalue the property before the BOR. The Court
came to this conclusion by applying the logic that a foreclosure sale is motivated by the desire to
satisfy one or more creditors. Therefore, this motivation could be considered a form of duress,
which negates the independence expected from the parties to an arm’s length transaction.

The Court disagreed with the BTA’s finding that the HUD sale of the property could be
considered “voluntary.” Instead, the evidence pointed to the fact that the HUD tried to sell the
property to another bidder for $506,000, and when that deal fell through, the HUD accepted
Fenco’s significantly lower bid. The Ohio Supreme Court’s ruling in this case was a landmark
decision that will impact all future BOR cases going forward, which involve the selling of
properties via foreclosure auctions.

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 BIBILIOGRAPHY

https://legaldictionary.net/arms-length/

https://www.transferpricing.co.za/category/transfer-pricing/arms-length-principle/

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