Definition of the arm's length principle

The arm's length principle is a fundamental concept in international tax law and is used to assess transactions between associated companies. It states that agreements between associated companies must be structured in such a way that they correspond to the conditions that would also be usual between independent third parties. This means that the tax treatment of transactions between associated companies should be based on market prices or market conditions and thus stand up to third-party comparison.

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Relevance of the arm's length principle

The arm's length principle serves to prevent tax avoidance and profit shifting. It ensures that companies are taxed on a fair and objective basis. By applying the arm's length principle, distorting tax effects that can result from inappropriate pricing or conditions in transactions between affiliated companies are avoided. If companies adhere to the arm's length principle, they also ensure that the agreements between affiliated companies are recognized for tax purposes.

Typical situations for the application of the arm's length principle

1. Sales of goods: When related companies trade goods with each other, the arm's length method is used to determine the price of these transactions. The prices of the goods that independent companies would agree in comparable transactions are used as a benchmark.
2. Services: When services are provided between affiliated companies, the arm's length method is used to determine the price for these services. This may include, for example, the provision of management services, IT support or consulting services.
3. License fees for intellectual property: If affiliated companies license intellectual property such as patents, trademarks or copyrights to each other, the arm's length method is used to determine the appropriate license fee. The prices that independent companies pay for comparable licenses are used as a reference.
4. Financing and loan agreements: The arm's length method is also used to determine market interest rates and terms for financing and loan agreements between affiliated companies. This involves comparing the conditions that independent third parties would receive for similar loans or financing. Credit spreads serve as an important benchmark here in order to take into account the additional interest premium that investors would demand for taking on a credit risk. This contributes to the objective determination of transfer prices. An important example of the use of the price comparison method is the determination of arm's length loan interest rates, as the BFH also clarified in its landmark ruling in case no. IR 4/17.

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Guidelines on the arm's length principle

The arm's length principle is the basis of the price comparison method, which is used to determine transfer prices between affiliated companies. When applying the arm's length method, the prices or price ranges of comparable transactions between independent third parties are used to determine a reference value for the transfer prices between affiliated companies. The focus of this third-party comparison is on finding comparable transactions that have similar economic conditions and risks. The OECD Transfer Pricing Guidelines are an internationally recognized and authoritative source for the application of the price comparison method in tax law. They provide clear guidelines on comparability analysis, selection of comparator groups and documentation to enable a consistent and objective determination of transfer prices. Compliance with these guidelines helps companies to ensure that their transfer pricing policy is in line with international standards and tax requirements.

Recommendations for tax consultants

1. Comprehensive analysis of corporate structures: Tax consultants should conduct a thorough analysis of business relationships and transactions between related parties to identify potential risks and deviations from the arm's length principle.
2. Documentation of agreements: It is crucial that all agreements between related parties are recorded in writing. The documentation should include the business basis of the transactions, the market conformity of the prices or conditions and other relevant information.
3. Comparative data and benchmarking: Tax consultants should have access to reliable sources of comparative data to check the appropriateness of prices and conditions in transactions between related companies. Benchmarking enables comparison with similar independent companies and supports compliance with the arm's length     principle.
4. Expertise in international tax issues: As the arm's length principle also applies to cross-border transactions, it is important for tax consultants to have in-depth knowledge of international tax issues. The complexity of international tax laws requires specialized expertise.
5. Regular review and adjustment: The arm's length principle is subject to constant change and development. Tax consultants should therefore regularly update their knowledge and monitor agreements between related parties to ensure that they comply with current requirements.

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Conclusion

Through comprehensive analysis, proper documentation, the use of comparative data, sound expertise and regular reviews, tax consultants can ensure that their clients implement the arm's length principle correctly. Careful application of this principle helps to avoid tax risks and ensure tax compliance.

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