Arm’s length principle

The arm’s length principle is defined explicitly by the OECD in its model tax treaty. It states that “where conditions are made or imposed between two associated 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 these conditions have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

The main benefits of the at arm’s length principle are

a. the arm’s length principle provides broad parity of tax treatments for members of MNEs group and independent enterprises. It therefore puts these enterprises on an equal footing for tax purposes and it avoids the creation of tax advantages

b. the arm’s length principle is objective and has been found to work effectively in the majority of cases

c. most importantly though the arm’s length principle is very sound in theory and provides the closest approximation to the workings of open market forces

Despite the above, however, the arm’s length principle has some shortcomings

a. in a number of cases the arm’s length principle may result in an administrative burden for both the taxpayer and the tax administrators of evaluating significant numbers and types of cross border transactions

b. secondly both tax administrators and tax payers have difficulty in obtaining suitable information to apply the arm’s length principle. Because the ALP required parties to evaluate uncontrolled transactions, and to compare these transactions with independent parties it required a substantial amount of data which can be particularly burdensome.

The at arm’s length principle is implemented in the Dutch corporate income tax act.