Doctrine of Arm's Length

Introduction

The "arm's length principle" is a fundamental concept in various fields, including taxation, business, and finance. It's a guiding principle that transactions between related parties or entities should be conducted as if they were unrelated, independent parties. It is a fundamental principle in transfer pricing, which is the set of rules that governments use to determine the appropriate tax treatment of transactions between related parties.

Origin?

The arm's length principle has a long history, dating back to the early 20th century. It was first introduced in the United States in the Revenue Act of 1928, and it has since been adopted by most countries around the world. The principle is also reflected in international tax treaties, such as the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention. The principle is significant because it helps to ensure that multinational enterprises pay their fair share of taxes. By requiring that related parties charge each other arm's length prices; the principle prevents these enterprises from shifting profits to low-tax jurisdictions.

Applicability in India

In India, Section 92F of the Income Tax Act, 1961 mentions arm’s length price to be the price proposed or applied in a transaction between unrelated persons in uncontrolled conditions. Unrelated persons are defined in Section 92A of the same Act i.e. persons that are not associated or deemed to be of an associated enterprise.?

Here's a breakdown of the principle in different contexts:

• Taxation: In taxation, the arm's length principle ensures that transactions between related entities, such as subsidiaries of a multinational corporation, are priced at fair market values. The principle states that the price charged in a transaction between two related parties should be the same as the price charged in a comparable transaction between two unrelated parties. This principle is used to prevent multinational companies from shifting profits to low-tax jurisdictions by artificially inflating or deflating the prices of goods and services transferred between related entities.
• Business Transactions: In business, the arm's length principle applies to contracts, partnerships, and negotiations. It means that parties involved in a transaction should act in their own self-interest, without any undue influence or conflict of interest. This ensures that deals are fair and not skewed in favor of one party.
• Finance and Investments: When evaluating investments, the arm's length principle suggests that investors should make decisions based on objective analysis and without any undue influence or insider information. It emphasizes fairness and transparency in financial transactions.
• Legal Context: In legal matters, the arm's length principle may be invoked to assess whether contracts or agreements are valid and enforceable. It ensures that agreements are made without coercion, fraud, or any other factors that might compromise the independence and fairness of the parties involved.

Elements?

Several aspects are taken into account when establishing the arm's length price for a transaction, which include the following:

• The functions performed by each party to the transaction
• The assets used by each party to the transaction
• The risks assumed by each party to the transaction
• The market conditions at the time of the transaction

Some examples of arm's length transactions are:

1. A parent company selling goods to its subsidiary at the same price that it would sell them to an unrelated customer.
2. A subsidiary paying rent to its parent company for the use of office space.

Case Law

According to the Supreme Court, High Courts have the authority to individually assess whether transfer pricing regulations have been adhered to and if there are any significant errors in the Income Tax Appellate Tribunal's determination of the arm's length price for controlled transactions. This implies that the Tribunal's decision is not conclusive, and it can be subject to judicial review in High Court appeals under Section 260A of the Income Tax Act. In the 2018 Softbrands India Private Ltd. case, the Karnataka High Court ruled that issues related to the selection of comparable data and criteria for transfer pricing benchmarking do not constitute a "substantial question of law."

However, in the 2023 SAP Labs India Private Ltd v. The Income Tax Officer I.T.A.No.10/2011 case, the Supreme Court overturned this ruling.

Conclusion

The arm's length principle is not without its critics. Some argue that it is too difficult to apply in practice, especially in complex transactions. Others argue that the principle is too inflexible and does not take into account all of the factors that may affect the price of a transaction. It is a complex and evolving area of law.

It is a foundational concept that helps prevent conflicts of interest and ensure equitable outcomes. Overall, the arm's length principle promotes fairness, transparency, and integrity in various types of transactions, whether they are related to taxation, business dealings, finance, or legal matters.