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The arm’s length principle: fact or fiction?

Group Reorganisations

Intercompany Agreements

29 November 2021

We hope you enjoyed our recent interview with Philippe Paumier. We found it very thought-provoking, and in fact we'd like to share some of those thoughts with you here. The starting point is Philippe's statement:

“TP is a construction. It's a theoretical construction. The very basic and fundamental point of transfer pricing is that parties have to behave as if they were not in the situation that they actually are. It's pretty odd, when you think about it.”

Philippe is referring to the arm's length principle in TP, which in effect says that if associated enterprises (e.g. companies within a group) enter into arrangements which differ from those which would be made between independent enterprises, then they should be taxed according to the profits they would have made on an arm’s length basis.

In other words, you should ignore the fact that the companies involved are related.

This certainly is a ‘theoretical construction’. That said, it also aligns to a great extent with the legal rights and duties affecting legal entities, and their directors, under most legal systems.

From a UK perspective, the leading case on this point was the House of Lords decision in Salomon v Salomon in 1897. (Yes, 1897... that's not a typo.) The case established and confirmed the principle that companies (and other legal entities) have a legal personality which is separate and distinct from their owners and managers.

In the 1990 case of Adams v Cape Industries plc, Lord Justice Slade LJ referred to Salomon v Salomon when he said: “Our law, for better or worse, recognises the creation of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.”

Some TP commentators don't fully appreciate this point, and go to the extreme of regarding intercompany agreements as ‘fictional’. For example, in this otherwise extremely erudite article by Andrew Hickman (former Head of the OECD’s Transfer Pricing Unit) in MNE Tax earlier this year:

“The concept of a legal entity in the MNE group deciding whether or not to take on risk may seem nonsensical to its CEO, but is an essential fiction to be adopted under a version of the arm’s length principle based on transactional comparability.”

From a legal perspective, this is not a fiction: it’s reality. If a business wants the privileges of separate legal entities (including the benefit of limited liability and asset protection), then it needs to play by the legal rules. These rules include having regard to the interests of individual legal entities, and respecting the decision-making processes for those entities. Failure to do so can entail various unpleasant consequences, such as personal liability for directors and invalidity of transactions.

There's no question that this is all rather inconvenient. It takes a certain amount of effort to create and maintain structures which genuinely work from the perspectives of TP, legal, customs, IP protection, VAT / GST, data protection. But for those of us who really care about protecting our clients and colleagues, there’s no real choice other than to try to work collaboratively on a cross-functional basis. All the while recognising that none of us individually has all the answers.

And that's a fact.

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Article by
Paul O’Regan

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