The arm’s length principle: a fiction or merely a different perspective?

I suspect that most of us in the transfer pricing and legal community would agree that the arm's length principle is an imperfect instrument. It requires us to collaborate in a fiction – to pretend that two entities are independent when they are not. And it may not fairly allocate taxing rights in the digital economy (let alone the metaverse), hence initiatives such as Pillar 1.

But, like it or not, the arm's length principle is fundamental to current tax rules. And it seems that the anticipated complexities of Pillar 2 will be an overlay built on the existing structure of transfer pricing. So, unless and until changes are introduced in the future, we have to work with it.

And, in fact, the arm's length principle does not actually demand that we take a false perspective. Rather, it coincides with a legal view of the world that focuses on each entity's individual interests, rights and obligations.

Therefore, it is not enough for intercompany agreements merely to align with and implement the TP intentions; they must also make sense from a commercial, legal and regulatory perspective.

To give an example in relation to intercompany loans: fundamental terms such as repayment dates, interest rates (fixed or floating) and security or ranking cannot be deduced from merely observing the actions of the respective parties. One financial instrument cannot be compared with another for pricing purposes unless there is clarity on the associated legal rights and obligations of the respective parties in each case.

In an insolvency situation, it’s not the TP policies which determine the outcome for creditors of a particular entity. It’s the legal rights, obligations, assets and liabilities of that specific entity. The ‘cord’ of common control has been cut.

Failure to appreciate this point can lead people to the (entirely incorrect) view that intercompany agreements are inherently fictitious. On the contrary, they have their own ‘reality’ which is entirely independent of transfer pricing – but which can be shaped in a way that complements and substantiates the intended TP analysis and the arm’s length principle.

We recently saw an illustration of this in HMRC v BlackRock 5 LLC. The Upper Tribunal stated that the transfer pricing issue would have been decided in favour of the taxpayer if covenants has been in place with the relevant entities in addition to the borrower. The reason: that the presence or absence of covenants had the effect of “materially altering the economically relevant characteristics of the transaction.”

What does all this mean for the arm’s length principle?

No doubt its role in transfer pricing will continue to evolve, along with the proliferation of tax rules. But from a legal perspective, it’s hard to imagine a situation in which directors are not the guardians of the interests of individual legal entities – in which case the arm’s length principle (or a close variant of it) will remain foundational to the operation of group structures.