The arm’s length principle expresses that a business relationship between two parties is entered into against perfectly normal market prices and commonly negotiated terms and conditions. It refers to the test applied by national tax authorities to satisfy that the taxable entity does not avoid tax. In inter-company relations it may be attractive to apply transfer pricing structures resulting in a tax-optimised corporate structure that is most beneficial for the shareholders of the ultimate parent. In many multinationals, the business people from the business groups or business units involved in such intra-company arrangement will indeed be tough in their negotiations. For an outsider this is sometimes surprisingly tough. Many national laws require that inter-company supplies are reflected in writing.

The arm’s length principle is also required in the context of transactions that might not be fully and fairly negotiated. For example, a purchaser of a company that will continue business with the seller’s group would like to ascertain that the company it acquires, conducts such business on terms and conditions that are perfectly sound. This is usually reflected in a warranty of the seller, stating that all transactions are at an arm’s length basis.
If the warranty appears to be incorrect, the purchaser or acquired company should be entitled to damages, being the difference between market prices and the transfer prices possibly subject to an ebit- or ebida-multiplier. Alternatively, the seller may be able to negotiate a covenant by virtue of which all inter-company relationships terminate on completion date, with the exception only of certain identified, agreed contracts.

To refer to the arm’s length principle, a synopsis of the OECD-principles on transfer pricing may inspire the contract drafter[1]. Where any provision is qualified or phrased by reference to an arm’s length basis or principle such qualification or reference shall mean:

…the conditions which would be obtained between comparable, independent persons in comparable transactions (taking into account the assets used, the responsibilities and risks assumed and the division of benefits between the parties) and comparable circumstances (taking into account the times and places of performance and the parties’ business strategies), thereby providing the closest approximation of the workings of the open market.

The elements of the principle are self-explanatory. The reality of this principle may differ from country to country depending on the attitude of the national tax authorities. Likewise, the applicable tax regime and local enforcement policies may well influence a company’s decision to create a permanent establish­ment in one country or another. But more appropriately, companies would extrapolate the principle in their day-to-day practices such that employee bonus and other remuneration systems are targeted to reduce the cost basis of their products even at the expense of affiliated companies. Typically, this results in a competitive environment in which all tendering suppliers attempt to achieve an optimum of price-quality ratio, sometimes allowing the benefits to third party suppliers.

[1] In fact, the synopsis closely follows the chapter outline of the authoritative loose leaf of oecd, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD publishing 2001, 254 p..