The arm’s length principle is the overarching standard considering the subject of transfer pricing. This internationally accepted standard for allocation of taxable income to associated enterprises is defined as:
(a) An enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or
(b) The same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State
And in either case conditions are made or imposed between the 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
This definition was already introduced in Article 9 of the 1963 Draft Model Tax Convention on Income and Capital.
Moreover, the arm’s length principle is adopted by OECD member countries and other countries alike, as it places both associated as well as independent enterprises on an equal footing for tax purposes by way of avoiding the creation of tax (dis)advantages that would otherwise distort the relative competitive positions of either type of enterprise. In addition, it has been found to work effectively in the vast majority of cases. In some cases, however, the arm’s length principle is difficult to apply because associated enterprises may engage in transactions that independent enterprises would not undertake. A non-exhaustive list of such transactions is provided below:
Nevertheless solutions exist to deal with such transactions. Furthermore, although such transactions not necessarily are made to avoid taxes, they may occur because in transacting business with each other, members of a multinational enterprise (“MNE”) face different commercial circumstances than would independent enterprises. (reference: OECD TP Guidelines, Chapter 1, 1.8-1.11)
However, critics of the arm’s length principle noted that the separate entity approach may not always account for economies of scale and interrelation of diverse activities created by integrated business. Therefore, some critics propose to use a global formulary apportionment method as a means of determining the proper level of profits across national tax jurisdictions. This method would allocate global profits of an MNE group on a consolidated basis among the associated enterprises in different countries on the basis of a predetermined and mechanistic formula. In this respect, in 2016, the European Commission re-launched its proposal to use a common consolidated corporate tax base (“CCCTB”). This would entail that companies operating across borders in the EU would no longer have to deal with 28 different sets of national rules when calculating their taxable profits. Consolidation means that there would be a 'one-stop-shop' – the principal tax authority – where one of the companies of a group, that is, the principal taxpayer, would file a tax return. To distribute the tax base among Member States concerned, a formulary apportionment system would be introduced. However, even the OECD Transfer Pricing Guidelines (reference: OECD TP Guidelines, Chapter 1, 1.10; 1.16-1.17 & this link).
An additional attention point regarding the definition of the arm’s length principle is the fact that it refers to “commercial or financial relations” instead of transactions. Hence, not only direct observable transactions, but also relations between associated enterprises are to be taken into account with respect to determining transfer prices as well as using transfer pricing methods related to those transfer prices.