2.1 Meaning Of Arm`s Length Principle
The arm`s length approach, which is internationally accepted as the preferred basis for determining the transfer price of a transaction between associated persons, will be the basis adopted by IRBM. This is consistent with the objective of minimizing the possibility for double taxation. According to the arm's length principle, a transfer price is acceptable if all transactions between associated parties are conducted at arm's length price. Arm's length price is the price which would have been determined if such transactions were made between independent entities under the same or similar circumstances.
The arm`s length principle is stated in paragraph 1 of Article 9 of the OECD Model Tax Convention as:
" Where ... 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."
When associated persons enter into a transaction, the element of control which one party has over the other may exist. Under this circumstance, bargaining power rarely comes into play. Unlike independent companies, multinational corporation group or multinational enterprises (hereinafter referred to as an "MNE Group") usually operate based on its own set of conditions which normally do not reflect the market forces. While independent enterprises are concerned with maximizing individual profits, by aiming for the lowest costs and highest returns, an MNE Group is concerned with overall group profits which may result in unequal distribution of profits within the group.
An example to illustrate the difference between controlled and uncontrolled transactions is as follows:
Company A purchases raw material to make furniture. Under an arm's length transaction, Company A would make the best effort to obtain its raw material at the lowest price possible in order to minimise its costs and maximise its profits. This will entail extensive bargaining between Company A and its suppliers.
However, in a controlled transaction, there usually exist elements of control that dictate the price and manner in which raw material is to be purchased. The likelihood of bargaining for the best price is minimal, and Company A may be expected to accept the price as dictated by its controlling entity. It is not impossible to witness prolonged losses in cases like Company A that has little say in the price it is willing to pay for raw material.
In essence, the application of the arm`s length principle:
(a) treats associated persons as not dealing at arm`s length and as if they operate as separate entities rather than as inseparable parts of a single unified business; and
(b) is generally based on a comparison of:
(i) prices, margins, division of profits or other indicators of controlled transactions; with
(ii) prices, margins, division of profits or other indicators of uncontrolled transactions.