The arm's length principle
The arm's length principle, also referred to as the principle of distance or the market price principle, is an international standard agreed by the OECD member states and is to be applied by them in setting transfer prices for tax purposes. 1 It is a key concept in international tax law, referring to the market price according to which the prices set between related companies should correspond to those that would be agreed between independent parties.
This principle is set out in Article 9(1) of the OECD Model Tax Convention, which forms the basis of the bilateral tax conventions concluded between OECD member states and with non-member countries. 2
The definition of the market price is of fundamental importance here, since it ensures that transactions between related parties are priced fairly and transparently.
Article 9 provides that:
"where [...] conditions are made or imposed between two 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 those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly" 3.
The market price in Polish law
The arm's length principle as expressed above was transposed into Polish law and set out, in almost unchanged wording, in Article 11(1) of the Corporate Income Tax Act. 4 (Under the current legal regime, Article 11c(2) of the Corporate Income Tax Act.) The definition of the market price in Polish law reflects the international principles and is applied in order to ensure fair competition and the proper settlement of taxes by businesses.
Full competition and the market price
The principle of full competition treats the members of a multinational group as separate entities independent of one another, rather than as interconnected parts of a single enterprise. For that reason its main emphasis is on the substance of the transaction carried out by such parties and on whether the terms they have agreed can be regarded as being at arm's length. This entails the requirement to carry out a benchmarking analysis, which is the core of applying the principle of full competition.
The benchmarking analysis in determining the market price
The benchmarking analysis makes it necessary to compare the terms agreed or imposed between related parties with those that would have been agreed between independent enterprises. For such a comparison to be regarded as sound, none of the possible differences between the situations compared may materially affect the condition under consideration from a methodological point of view, or it must be possible to make reasonably accurate adjustments in order to eliminate the effect of any differences on the transaction analysed.
Why is the principle of full competition applied?
The main purpose of applying the principle of full competition is to arrange the commercial and financial relations between related parties in such a way as to reproduce in their dealings the dynamics of market forces. This approach allows the principle to ensure equal tax treatment of related enterprises and independent entities. The arm's length principle therefore supports the development of international trade and investment and is a key element in securing fair competition and proper taxation in global markets.
The arm's length principle: challenges and counterarguments
The arguments used by its opponents rest above all on the fact that attempts to create the illusion that the entities forming part of a group are unrelated are unfair to them, since they do not take sufficient account of the savings arising from the scale of operations and from the close cooperation between such entities. It is also pointed out that related enterprises frequently take part in transactions that independent entities would not undertake, and that this does not necessarily follow from a desire to engage in tax optimisation. Where related parties conclude a transaction that is rarely encountered on the market and for which there is little or no comparable data, it is difficult to apply the principle of full competition, since it is not possible to state unequivocally what terms independent entities would have accepted. The mere fact that no such transaction can be found between independent parties cannot mean that the transaction does not comply with the principle of full competition.
Notes
1 J. Wyciślok, Ceny transferowe. Przedsiębiorstwa powiązane. Przerzucanie dochodów, C.H. Beck, Warsaw 2014, p. 1. 2 Corporate Income Tax Act of 15 February 1992, Journal of Laws 1992 No. 21 item 86, as amended, Article 11a(1)(1). 3 Prepared on the basis of: OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Chapter I, Paris 2010. 4 Corporate Income Tax Act of 15 February 1992 (Journal of Laws No. 21, item 86).
Article 11(1): "Where:
an income taxpayer having its seat (management) or place of residence in the territory of the Republic of Poland, hereinafter referred to as the domestic entity, takes part directly or indirectly in the management or control of an enterprise situated abroad or holds a share in the capital of that enterprise, or a natural or legal person having its place of residence or seat (management) abroad, hereinafter referred to as the foreign entity, takes part directly or indirectly in the management or control of the domestic entity or holds a share in the capital of that domestic entity, or the same legal or natural persons simultaneously take part directly or indirectly in the management or control of the domestic entity and the foreign entity or hold a share in the capital of those entities, and if, as a result of such relationships, terms are agreed or imposed which differ from the terms that independent parties would have agreed between themselves, and as a result the entity reports no income or reports income lower than that which would be expected had those relationships not existed, the income of that entity and the tax due are determined without regard to the terms arising from those relationships."