2.2 Guidance In Applying The Arm's Length Principle
The application of the arm's length principle will mainly focus on achieving the transfer pricing outcomes that is in line with value creation by:
(a) ensuring that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital, but align returns with value creation; and
(b) identifying circumstances in which transactions can be re-characterized.
The taxpayer need to ensure that:
(a) actual business transactions undertaken by them are identified, and transfer pricing is not based on contractual arrangements that do not reflect economic reality;
(b) contractual allocations of risk are respected only when they are supported by actual decision-making;
(c) capital without functionality will generate no more than a risk-free return, assuring that no premium returns will be allocated to cash boxes without relevant substance; and
(d) their transaction has commercial rationality and IRBM may disregard transactions when the exceptional circumstances of commercial irrationality apply.
The application of the arm's length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances (comparability analysis). There are two key aspects in such an analysis:
(a) to identify the commercial or financial relations between the associated persons and the conditions and economically relevant circumstances attaching to those relations, in order for the controlled transaction to be accurately delineated; and
(b) to compare the conditions and the economically relevant circumstances of the controlled transaction as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent persons.
Identifying the commercial and financial relations
The typical process of identifying the commercial or financial relations between the associated persons and the conditions and economically relevant circumstances attaching to those relations requires:
(a) a broad-based understanding of the industry sector (e.g. mining, pharmaceutical, luxury goods) in which the associated persons operates and the factors affecting the performance of any business operating in that sector. The understanding is derived from an overview of that particular MNE Group which outlines how they respond to the factors affecting performance in the sector, including its business strategies, markets, products, its supply chain, the key functions performed, material assets used, and important risks assumed. This information shall be provided by the taxpayer in support of the taxpayer's analysis of its transfer pricing and provides useful context regarding the commercial or financial relations between members of the MNE Group.
(b) identificatioan of how each MNE operates within the group, analysis of each MNE's activities (e.g. a production company, a sales company) and identification of its commercial or financial relations expressed in transactions between them. The accurate delineation of the actual transactions between the associated persons requires analysis of the economically relevant characteristics of the transaction.
Economically Relevant Characteristics/ Comparability Factors
The economically relevant characteristics or comparability factors that need to be identified in the commercial or financial relations between the associated persons, in order to accurately delineate the actual transaction can be broadly categorised as follows:
(a) the contractual terms of the transaction;
(b) the functions performed by each of the associated persons to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the group to which the persons belong (such as an MNE Group), the circumstances surrounding the transaction, and industry practices;
(c) the characteristics of property transferred or services provided;
(d) the economic circumstances of the associated persons and of the market in which the associated persons operate; and
(e) the business strategies pursued by the associated persons.