The arm’s length principle is the foundation of modern transfer pricing laws, which have been enacted by various jurisdictions around the globe to ensure fairness and consistency in pricing intercompany transactions.
In this second article of the series, we delve into the origins of the concept, its application and challenges with particular attention to Malawi’s tax environment.
Origins and evolution of the arm’s length principle
The arm’s length principle traces its origins to Article 9 of the Organisation of Economic Cooperation and Development (OECD) Model Tax Convention, which establishes that transfer prices for controlled transactions must reflect what would have been agreed upon between independent enterprises.
The OECD Guidelines represent internationally agreed principles; provide guidelines for the application of the arm’s length principle; seek to reduce incidents of double taxation and provide a framework for international cooperation.
However, the OECD Guidelines do not override domestic laws on transfer pricing that the countries may legislate.
Today, the arm’s length principle is the global standard endorsed by the OECD Transfer Pricing Guidelines and the United Nations Practical Manual on Transfer Pricing for Developing Countries.
It has gained prominence around the globe as governments seek to address profit-shifting and tax base erosion by multinational enterprises. Malawi’s transfer pricing regulations align with these international norms, underscoring the country’s commitment to fair taxation and economic integrity.
Key concepts underpinning the arm’s length principle
Independent entity principle: The arm’s length principle follows the approach of treating members of an MNE group as if they were independent entities for purposes of determining taxable income.
Comparability analysis: The concept of comparability is at the heart of the application of the arm’s length principle. It focuses on identification of the commercial relations between the associated enterprises and comparison of the conditions of controlled transactions with the conditions of comparable transactions between independent enterprises.
Substance over form: The arm’s length principle emphasises the economic substance of a transaction over its legal form. This implies that tax authorities do not only examine the written contracts between associated enterprises, but they also analyse whether the intercompany arrangement reflects economic reality or it represents a sham. For example, if a loan between associated enterprises carries an unusually high interest rate, the transaction will be examined to determine whether it reflects an arm’s length arrangement.
Applying the arm’s length principle in practice
To apply the arm’s length principle effectively, taxpayers and tax authorities must follow a systematic approach.
Conduct a functional analysis: A functional analysis is conducted to clearly identify the economically significant activities undertaken by each party to the controlled transaction and then compare them with the functions undertaken by independent parties in potentially comparable uncontrolled transaction. It evaluates the roles performed, assets used, and risks assumed by each party to the controlled transaction.
Select the most appropriate transfer pricing method
The domestic law recommends five methods for determining arm’s length prices:
(a) Comparable uncontrolled price method: It compares the controlled price with prices in comparable independent transactions.
(b) Resale price method: It compares the gross profit margins earned in a controlled transaction with the gross margin in a comparable uncontrolled transaction. It is suitable for distributors that purchase goods from associated enterprises and resale to independent parties without significant value addition.
(c) Cost plus method: It evaluates whether the amount charged in a controlled transaction is at arm’s length by reference to the gross profit mark-up on costs realised in comparable uncontrolled transactions.
(d) Transactional net margin method: It examines net profit margins relative to an appropriate base for a particular transaction such as sales, costs or assets. It compares the net profit margin earned in a controlled transaction to the net profit margin realised in comparable independent transactions.
(e) Profit split method: It addresses transactions that are so interrelated that they cannot be examined on a separate basis or transactions in which both of the parties use valuable intangibles.
Identify potential comparable transactions or companies
In determining whether transactions are comparable, factors to be considered include the characteristics of the property or services transferred; functional analysis; contractual terms of the transactions and economic circumstances in which the transactions take place and the business strategies pursued by the parties to the transactions.
Adjust for differences
In circumstances where material differences exist in the conditions between the potentially comparable transactions and the controlled transaction, it is necessary to consider if reasonably accurate adjustments can be made to eliminate the effect of such differences.
Documentation
It is essential to document transfer pricing policies and practices to demonstrate that intercompany transactions are conducted in accordance with the arm’s length principle and comply with relevant tax laws.
Challenges in implementing the arm’s length principle
Lack of local comparables: The limited number of players in most industries in Malawi makes it difficult to identify local comparables. Furthermore, associated enterprises may sometimes engage in transactions that independent enterprises would not undertake. Such transactions may not necessarily be motivated by tax avoidance, but may arise due to different commercial circumstances. However, the mere fact that a comparable transaction may not be found between independent parties does not in itself mean that it is not arm’s length.
Economic differences: Comparables from other countries may not accurately reflect Malawi’s economic conditions. Therefore, the economic data of the selected foreign comparables may be adjusted to reflect the economic differences between the geographic markets.
Information asymmetry
Accessing detailed information about independent transactions can be challenging, especially when dealing with proprietary or confidential data.
Subjectivity: Transfer pricing is not an exact science. Therefore, the application of the arm’s length principle often involves subjective judgments, such as selection of transfer pricing method or determining comparability adjustments.
Conclusion
The arm’s length principle is the cornerstone of transfer pricing, ensuring fairness, consistency, and transparency in how intercompany transactions are priced. For Malawi, embracing the arm’s length principle is essential for protecting tax revenues, fostering economic integrity, and aligning with global standards.
In the next article, we will explore controlled transactions, focusing on their significance, types, and practical examples within Malawi’s business landscape. n
*Vilipo Muchina Munthali is managing consultant at Swift Resources, an international tax and transfer pricing consulting firm that specialises in developing, implementing and defending transfer pricing policies. Feedback: vilipo@swiftmalawi.com
