Transfer pricing: legislation: rules: the arm's length principle
OECD member countries have agreed that to achieve a fair division of taxing profits and to address international double taxation, transactions between connected parties should be treated for tax purposes by reference to the amount of profit that would have arisen if the same transactions had been executed by unconnected parties. This is the arm’s length principle.
For a variety of reasons, the trading arrangements and pricing policies under which multinational groups operate can result in terms considerably different from those which would have been seen between independents engaged in the same or similar transactions. The terms which would be expected to be seen between independents are referred to as being at `arm’s length`.
The arm’s length principle is applied to a controlled transaction by:
* the actual terms (price, etc.) under which a transaction was done
* arm's length terms
and (for tax purposes)
* recalculating the profits accordingly.
The arm’s length principle is endorsed by the OECD and enshrined in Article 9 (the Associated Enterprises Article) of the OECD Model Tax Convention on Income and on Capital (usually referred to as the OECD Model Treaty or Model Convention). Chapter 1 of the OECD Transfer Pricing Guidelines (which HMRC readers can access via the left hand links on this page) has more detail about the arm’s length principle. See INTM420010 for further information on the Associated Enterprises Article of the OECD Model Convention.
The OECD Transfer Pricing Guidelines advise on the choice and application of the most appropriate transfer pricing methodology in any given case. The guidelines are discussed at INTM421000 onwards.
The complexities of applying the arm’s length principle in practice should not be underestimated. Because of the closeness of the relationship between the parties there can be genuine difficulties in determining what arm’s length terms would have been - especially where it is not possible to find wholly comparable transactions between unconnected parties. There are many factors to take into account.
It should be noted that transfer pricing legislation does not apply to calculation of a chargeable gain (or allowable loss) except to facilitate a claim made under TIOPA10/S174 where there has been a transfer pricing adjustment on the other party. See INTM480020.