Arm’s length Principle

The OECD provides guidance for applying the arm's- length principle. These guidelines summarised herein below, provide a good understanding of how OECD expects each Person to determine the ALP of the covered transaction. It is recommended to identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attached to those, viz:

•      The contractual terms of the transaction;

•      The functions performed by each of the parties to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the MNE group to which the parties belong, the circumstances surrounding the transaction, and industry practices (FAR Analysis);

•      The characteristics of property transferred or services provided;

•      The economic circumstances of the parties and of the market in which the parties operate;

•      The business strategies pursued by the parties

Further, OECD prescribes steps for analyzing risk in a controlled transaction, in order to accurately delineate the actual transaction with respect to that risk. The same can be summarised as follows:

Step 1: Identify economically significant risks with specificity

•      Strategic risks or marketplace risks

•      Infrastructure or operational risks

•      Financial risks

•      Transactional risks

•      Hazard risks

Step 2: Identify the contractual assumption of the specific risk

•      Determine whether the contractual assumption of risk is consistent with the conduct and other facts and

•      whether the party assuming the risk is exercising control over the risk and has the financial capacity to assume the risk

Step 3: Functional analysis in relation to risk

•      Perform functional analysis identifying risks and other facts, including conduct of the parties, control functions and risk mitigation functions, and financial capacity to bear risks

Step 4: Interpreting steps 1-3

•      Whether the associated enterprises follow the contractual terms

•      Whether the party assuming risk exercises control over the risk and has the financial capacity to assume the risk

Step 5: Allocation of risk

•      If the party assuming the risk does not control the risk or does not have the financial capacity to assume the risk, allocate the risk to the group company having the most control and having the financial capacity to assume the risk

Step 6: Pricing of the transaction, taking account of the consequences of risk allocation

•      The actual transaction as accurately delineated by considering the evidence of all the economically relevant characteristics of the transaction, should then be priced taking into account the financial and other consequences of risk assumption, as appropriately allocated, and appropriately compensating risk management functions.

Computing an arm's-length price is a complex task; it requires a lot of groundwork and research. There is a variety of exceptions and set-offs that necessarily have to be applied to the system to provide useful results.