The Arm’s Length principle in transfer pricing (3)

…The concept of Arm’s Length Principle (ALP)  
The concept of transfer pricing is underpinned by some great principles which seek to ensure that the prices of goods and services exchanged or transferred between and among persons in a controlled relationship are closer to the prices that will be exchanged between and among unrelated persons interacting with market forces.
The Arm’s Length Principle (ALP), also known as Arm’s Length Standard (ALS), means that: “entities that are related via management, control or capital in their controlled transactions should agree to the same or similar terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions”. If this principle is met, we can say that the terms and conditions of the particular transaction are ‘at Arm’s Length’.
The main source of the ALP is Article 9 of the OECD Model Tax Convention, which is adopted in most bilateral tax treaties. The OECD has incorporated the ALP as part of transfer pricing rules which set forth the guidelines MNEs and tax authorities should apply to the determination of terms and conditions of controlled transactions.
Article 9 of the OECD Model Tax Convention on Income and Capital states” Where an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case 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”.
Most countries have adopted the ALP by incorporating the concept in their domestic legislation. The ALP is the condition or fact that the parties of a transaction are independent and on an equal footing. Such a transaction is known as an ‘arm’s length transaction’. It is also one of the key elements in international taxation, as it allows an adequate allocation of profit taxation rights among countries; mostly through Double Tax Agreements (DTAs). Transfer pricing and the arm’s length principle was one focal point in the Base Erosion and Profit Shifting (BEPS) project developed by the OECD and endorsed by the G20.
Maintaining the ALP as International Consensus 
While recognising the foregoing considerations, the view of OECD member-countries continues to be that the ALP should govern the evaluation of transfer prices among associated enterprises. The ALP is sound in theory since it provides the closest approximation to the workings of the open market in cases where property such as goods, other types of tangible assets or intangible assets are transferred, or services are rendered between associated enterprises.
While it may not always be straightforward to apply in practice, it does generally produce appropriate levels of income between members of MNE groups, acceptable to tax administrations. A move away from the ALP would abandon the sound theoretical basis described above and threaten the international consensus, thereby substantially increasing the risk of double taxation.
In summary, OECD member-countries continue to strongly support the ALP. In fact, no legitimate or realistic alternative to the ALP has emerged except, sometimes, the mention of Global formulary apportionment as a possible alternative.
The ALP in Ghanaian tax laws
As previously indicated, various jurisdictions have incorporated the ALP into their local tax laws, and Ghana is no exception: there are various provisions in our tax laws which emphasise the ALP, including articles in all the DTAs Ghana is a party to. Below are provisions of ALP in Ghanaian tax laws:
Section 31 of the Income Tax Act, 2015 (Act 896) as amended reaffirms the importance of ALP applications in transactions involving related persons as follows: “Where an arrangement exists between persons who are in a controlled relationship, the persons shall calculate their income, and tax payable, according to the arm’s length standard. The arm’s length standard requires persons who are in a controlled relationship to quantify, characterise, apportion, and allocate amounts to be included in or deducted from income to reflect an arrangement that would have been made between independent persons”. The minister may, by legislative instrument, make Regulations on matters relating to transfer pricing and the application of the arm’s length standard. The first TP regulations to ensure application of the ALP was issued in 2012 (L.I.2188) which has been repealed with the current regulation (L.I. 2412) being issued on 10th August 2020 and came into force from 2nd November 2020.
Since non-adherence to the ALP may lead to tax avoidance schemes, the Commissioner-General (CG) has been clothed with powers in section 31 of Act 896 and section 99 of the Revenue Administrative Act, 2016 (Act 915) to re-characterise transactions and make adjustments to tax returns when, in his opinion, he thinks a transaction between controlled persons does not meet the ALP and the arrangement will result in a tax benefit to the parties.
In such instances, the CG, may make adjustments consistent with the ALP; and may, in carrying out an adjustment, re-characterise an arrangement made between persons who are in a controlled relationship, including re-characterising debt financing as equity financing; or re-characterise the source and type of any income, loss, amount or payment, and/or apportion and allocate expenditure.
Criticism of the Arm’s Length Principle

The main complaint is that it leaves too much room for interpretation, which results in a lot of disagreements between taxpayers and tax administrations. This point is acknowledged even by the OECD. Not every product is the same and not every brand has the same value, making it difficult to compare. Therefore, discussions often focus on whether transactions are ‘comparable’ enough or whether all terms and conditions should be the same. Another complaint is voiced by lobby groups who argue that an ‘arm’s length’ price could still facilitate tax avoidance – by MNEs shifting profits to low-tax jurisdictions. Whether these and other complaints are well-founded or not, the international tax community so far hasn’t been able to come up with a workable alternative in the past few decades.

A non-arm’s length approach: Global Formulary Apportionment

Global formulary apportionment has sometimes been suggested as an alternative to the ALP, as a means of determining the proper level of profits across national taxing jurisdictions. The approach has not been applied as between countries, although it has been attempted by some local taxing jurisdictions. Global formulary apportionment would allocate the global profits of an MNE group on a consolidated basis among the associated enterprises in different countries on the basis of a predetermined and mechanistic formula. There are three essential components to applying global formulary apportionment, as stated below:

  1. determining the unit to be taxed – i.e., which of the subsidiaries and branches of an MNE group should comprise the global taxable entity;
  2. accurately determining the global profits; and
  3. establishing the formula to be used in allocating the unit’s global profits

The formula would most likely be based on some combination of costs, assets, payroll, activities or sales.

For those with knowledge in transfer pricing methods, the global formulary apportionment should not be confused with the transactional profit methods – which will be discussed as part of the series although they have similarities.

Global formulary apportionment uses a predetermined formula for all taxpayers to allocate profits, whereas transactional profit methods compare, on a case-by-case basis, the profits of one or more associated enterprises with the profit experience that comparable independent enterprises would have sought to achieve in comparable circumstances. Global formulary apportionment also should not be confused with the selected application of a formula developed by both tax administrations in cooperation with a specific taxpayer or MNE group after careful analysis of the particular facts and circumstances; such as one which might be used in a Mutual Agreement Procedure (MAP), Advance Pricing Agreement (APA) or other bilateral or multilateral determination. Such a formula is derived from the particular facts and circumstances of the taxpayer, and thus avoids the globally pre-determined and mechanistic nature of global formulary apportionment.

Comparison with the arm’s length principle

Global formulary apportionment has been promoted as an alternative to the arm’s length principle by advocates who claim that it would provide greater administrative convenience and certainty for taxpayers, and its apportionment is more in keeping with economic reality.

But the most significant concerns with global formulary apportionment are:

  1. The difficulty of implementing the system in a manner that both protects against double taxation and ensures single taxation.
  2. Even if some countries are willing to accept global formulary apportionment, there would be disagreements because each country may want to emphasise or include different factors in the formula based on the activities or factors that predominate in its jurisdiction.
  3. Each country would have a strong incentive to devise formulae or formula weights which maximise that country’s own revenue.
  4. In addition, tax administrations would have to jointly consider how to address the potential for artificially shifting the production factors used in the formula (e.g. sales, capital) to low tax countries.
  5. There could be tax avoidance, to the extent that components of the relevant formula can be manipulated.

The transition to a global formulary apportionment system would therefore present enormous political and administrative complexity, and require a level of international cooperation that is unrealistic to expect in the field of international taxation.

Rejection of non-arm’s-length methods

OECD member-countries do not accept these propositions, and do not consider global formulary apportionment a realistic alternative to the arm’s length principle. From the foregoing, OECD member-countries reiterate their support for the consensus on use of the ALP that has emerged over the years among member and non-member countries; and agree that the theoretical alternative to the arm’s length principle represented by global formulary apportionment should be rejected.


Although with difficulties and some challenges with the ALP, it’s no surprise that there is a universal consensus on acceptance and adoption of the ALP by OECD members and international communities; because, to date, there is no formidable alternative to the ALP as the global formulary apportionment principle cannot hold the fort. It’s no surprise that Ghana, just like other jurisdictions, has fully adopted the ALP in its tax architecture.

This series of articles is my contribution to tax literacy in Ghana as a professional tax practitioner in the discharge of my duties as a Ghanaian Citizen who seeks the success of Ghana. The next edition will be on an overview of applying the ALP to derive the arm’s length price.

Reference is made from the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, local laws, and other sources.              

The author is a Chartered Tax Practitioner- a Member of ICAG and a Member of the Chartered Institute of Taxation Ghana).  [email protected]; 0244 423 960


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