1.Introduction of the Arm’s Length Principle(ALP)
Arm’s length principle is a very important principle as applying transfer pricing methods, it has been accepted by all the OECD member countries and almost all the other developed countries, most of the developing countries have adopted this principle as well[1] . We should make sure the meanings of “ arm’s length transaction” at first to fully understand this principle. Generally, A transaction which is viewed as an arm’s length transaction would accord with the rules of market economy. As we know, competence is the essence of market economy, therefore, only a transaction which comprises competence can be viewed as an arm’s length transaction. From the other point of view, in order to judge a transaction is an arm’s length transaction or not, we can examine its price. In other words, if the price of the transaction were up to snuff, this transaction is an arm’s length transaction, contrarily, it is not[2] . So when associated enterprises manipulate the transaction price improperly, this transaction is not an arm’s length transaction. As to the glossary of the “ OECD Transfer Pricing Guidelines”(1995), arm’s length principle is “The international standard that OECD Member countries have agreed should be used for determining transfer prices for these purposes. It is set forth in Article 9 of the OECD Model Tax Convention as follows: 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, the any profits which would, but for those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly’[3] .”
Arm’s length principle based on the market economy rules, it also accords with the tax sovereignty principle and tax equality principle of tax law. Hence from a theoretical view, this principle is easily to apply, for which reason many countries have accepted this principle.
On the other hand, this principle ignores the large size economy effect which is not reasonable. Moreover, people think ALP is easily to be applied based on the assumption that the comparable transaction is easily to be found, but in practice, comparable transaction is hard to find, such as intangible properties transactions discussed below.
2.Applying the ALP in intangibles transactions
The characteristics of intangible properties decide that it is difficult to find comparable transactions of this kind. Even though we can find comparable transaction, the uncertainty of intangibles transfer pricing makes it is difficult to decide the arm’s length price. All these are difficulties in applying ALP in intangibles transfer pricing. However, that doesn’t mean we should give up this principle, what we need to do is to adjust it and make it better.
A.Ascertaining the comparabilities of intangibles transactions
In the U.S tax reform in 1986,it pointed out that we should analyze the intangible properties comparabilities and the comparabilities of transaction conditions to ascertain the comparabilities of intangible transactions[4] .
OECD Transfer Pricing Guidelines said, deciding the arm’s length price of intangibles transaction has to take both seller and buyer into account.
B.The exercise of Profit Methods and the disagreement on it
Countries and international organizations developed the profit methods while they use the traditional comparable price methods. The essence of profit methods is to decide the deserved profit gained by associated enterprises based on the profit of the independent enterprises instead of their uncontrolled price. The reason to do this is that even the prices of comparable transactions are different, their profits are similar.
U.S. put forward four methods relevant to intangibles transfer pricing in their 1994 regulations. Among which the comparable profit method and the profit split method are two kinds of profit methods. OECD Guidelines also have profit methods, which are transactional net margin method and profit method. Obviously, profit split method is adopted by both U.S. and OECD. That because this method is deemed to be based on transaction which makes it complies with the arm’s length principle. However, comparable profit method which is adopted by U.S. is objected by OECD member countries because they think this method isn’t based on a transaction which makes it violates the ALP. As a response to this viewpoint, U.S. said comparable profit method is accordance with the ALP, because arm’s length price do produce reasonable profit, whereas, a reasonable profit do lead to a arm’s length price, as a result, although comparable profit method isn’t based on a transaction, it does accord with the ALP.
In view of the intense argument about the comparable profit method, OECD adopts the transactional net margin method instead. However, as many scholars point, comparable profit method and transactional net margin method are the same in nature[5] . Transactional net margin method just add “transactional” literally in order to make clear that, this method is applied to a single transaction instead of the tax payer’s global profit.
The real difference between U.S. and OECD member countries regarding the profit methods is the ranking of applying comparable price methods and profit methods. U.S adopts “the best method” principle, but OECD applies profit methods only in the case of other methods can’t be applied. On this point, I think the principle USA adopted is more practical.
3.Conclusion
As emphasized by OECD Guidelines, the general guidance for applying the arm’s length principle pertains equally to the determination of transfer pricing between associated enterprises for intangible property. The arm’s length principle is sound in theory since it provides the closest approximation of the workings of the open market in cases where goods and services are transferred between associated enterprises. A move away from the arm’s length principle would abandon the sound theoretical basis described above and threaten the international consensus, thereby substantially increasing the risk of double taxation[6] . As discussed above, no matter a country adopts profit split method or comparable method, or transactional net margin method, it tries to prove these new methods still accord with the arm’s length principle. Therefore, the characteristics of intangible property and intangibles transactions challenge the applying of arm’s length principle, but these challenges don’t lead to give up the ALP but to perfect it. In a long time from now on, the arm’s length principle would remain be the core principle which is accepted by most countries in the world, as well as in the intangibles transfer pricing. The new transfer pricing methods should be based on the ALP, other principles are just pertain to the arm’s length principle.