Arm’s-length clause
The arm’s-length clause is a term from economic and tax law that plays a significant role in contractual arrangements between affiliated companies. It refers to the requirement that agreements between related parties (such as group companies or related individuals) must be concluded on terms that would also apply between unrelated third parties. The observance of the so-called “arm’s length principle” is legally secured by the arm’s-length clause.
1. Definition and Fundamentals
The arm’s-length clause (often referred to in English as “at arm’s length”) originally comes from Anglo-American law but has long since found its way into German and international tax law. The principle aims to exclude possible manipulations or preferences arising from personal or internal business relationships. Decisive are always the terms that unrelated third parties would agree upon.
Typical fields of application are transactions between parent and subsidiary companies or cross-border business relationships within an international group. However, the clause is also applied in general civil law to ensure the independence of contracting parties and the market conformity of contractual terms.
2. Legal Importance
2.1 Tax Law Context
The arm’s-length clause is most practically relevant in international tax law, especially in the area of transfer pricing between affiliated companies. National and international regulations, such as the OECD Transfer Pricing Guidelines, require the use of market prices to prevent profit shifting and the resulting erosion of national tax bases.
In Germany, the arm’s length principle is anchored in § 1 of the Foreign Tax Act (AStG). Transactions between related companies must comply with what unrelated third parties would have agreed under comparable circumstances. Otherwise, the tax authorities can correct and adjust the profits accordingly.
2.2 Corporate Law Context
The arm’s-length principle also plays a role in corporate law. For example, in transactions between board members (such as managing directors or directors) and the company they represent, § 112 of the Stock Corporation Act (AktG) or, for GmbHs, § 181 of the Civil Code (BGB), an objective standard of review must be applied to protect the company from unreasonable disadvantages.
2.3 Civil Law Context
In civil law, the arm’s-length clause serves as a means to ensure equal treatment and market conformity of contractual relationships. It is often included as a standard clause in contracts to exclude manipulative arrangements and avoid disputes over the appropriateness of contract terms.
3. International Significance and Legal Basis
3.1 OECD Guidelines
In international tax law, the guidelines of the Organisation for Economic Cooperation and Development (OECD) form the central regulatory framework for the application of the arm’s-length clause. The OECD Transfer Pricing Guidelines set out in detail how pricing between international entities should be assessed. Many countries base their approaches on these principles to ensure uniform and fair taxation.
3.2 EU Law
In the European context, the OECD principles have also been included in the so-called “Code of Conduct on Transfer Pricing Documentation” (Transfer Pricing Documentation, Code of Conduct, 2006/C 176/01). The EU member states have implemented measures aimed at interpreting and applying the arm’s length principle at the European level. Also noteworthy is European state aid law, which requires the review of market-standard terms within group structures.
3.3 Comparison of International Regulations
Different countries implement the requirements of the arm’s-length clause in various ways. While OECD member countries mostly follow the OECD standards, there are countries with deviating or stricter regulations, particularly regarding documentation requirements and sanctions for violations.
4. Fields of Application and Examples
4.1 Transfer Pricing
The most significant area of application is the determination of transfer prices. These must be set as they would be between unrelated third parties. Various methods are recognized for this purpose, such as the comparable price method, the cost-plus method, or the profit split method.
4.2 Loan Agreements
For intra-group loan agreements, the tax authorities examine whether the interest rates and other terms would withstand an arm’s length comparison. If, for example, an intra-group loan is granted interest-free, this can be corrected for tax purposes.
4.3 Licenses and Service Relationships
Licenses and other service relationships between affiliated companies are also subject to a market conformity review. Royalties that are far below the industry standard can be disallowed for tax purposes.
5. Methods for Reviewing Market Conformity
Internationally recognized methods are used to check compliance with the arm’s-length clause:
- Comparable Price Method: The agreed price is compared with prices for identical or similar services between independent third parties.
- Resale Price Method: The resale price is used as a basis and reduced by an appropriate margin for the selling company.
- Cost-Plus Method: The costs of the provided services are calculated and increased by a market-level profit markup.
- Profit Split Method: The total profit exchanged between the companies is allocated based on market conditions.
6. Legal Consequences of Violations
Violations of the arm’s-length clause can result in significant tax and civil law consequences:
- Tax Corrections: Non-arm’s length agreements are tax-corrected by adjusting the reported income to the arm’s length conditions.
- Sanctions/Penalties: In addition to back taxes, sanctions and interest may also be imposed.
- Civil Law Consequences: In corporate and civil law, inappropriate agreements can be declared void by courts, adjusted, or trigger claims for damages.
7. Documentation and Proof Requirements
Companies are required to comprehensively document compliance with the arm’s-length clause. In Germany, strict recordkeeping obligations apply pursuant to § 90 (3) of the Fiscal Code (AO). Internationally, the rules on transfer pricing documentation have been continuously tightened. Breaches of these obligations can lead to a reversal of the burden of proof with potentially adverse consequences in the event of a tax audit.
8. Current Developments and Trends
With increasing globalization and digitalization of business models, the importance of the arm’s-length clause will continue to grow. In particular, digital business models and intra-group transactions are subject to increasingly strict scrutiny. The international collaboration of tax authorities and the expansion of legal documentation requirements for transfer pricing shape current developments.
9. Summary
The arm’s-length clause is a central element in ensuring market conformity and fairness in economic and tax law for transactions between affiliated companies. Compliance ensures that tax and corporate interests are protected and abuses are prevented. It forms the backbone of many national and international regulations, with increasing demands for substantiation and documentation.
References and Weblinks
- OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
- Foreign Tax Act (AStG), in particular § 1
- Fiscal Code (AO), § 90
- European Commission information page on transfer pricing
- Federal Ministry of Finance: Transfer Pricing Documentation
(Note: The above literature and web links are merely listed as examples. For legal individual cases and specific applications, the relevant national laws and up-to-date regulations should be consulted.)
Frequently Asked Questions
What are the legal consequences of a violation of the arm’s-length clause in international business relationships?
A violation of the arm’s-length clause—that is, non-compliance with the arm’s length principle—can have significant legal consequences. In German and international tax law, especially in the context of affiliated companies, such a violation usually results in the tax authorities correcting prices set too low or too high in the context of transfer pricing. These corrections can lead to increased tax assessments, as taxable profits are adjusted. In addition, interest and, in some cases, penalties or tax-related fines may be imposed if the violation is deemed intentional or grossly negligent. Double taxation can also arise if the affected countries do not conduct mutual agreement procedures or these fail. Companies are therefore required to carefully document their business relationships and transactions between affiliated companies according to the arm’s length principle and to make them transparent both internally and externally.
To what extent must agreements between affiliated companies comply with the requirements of the arm’s-length clause?
Contracts between affiliated companies are subject to specific legal requirements. They must be structured in the same way as independent third parties would do in comparable business relationships. This means that contractual arrangements, terms, payment conditions, and other agreements must comply with what is usual in the open market. In the absence of such arm’s length arrangements, the contract terms must be adjusted or the tax consequences corrected in the tax return accordingly. In some jurisdictions, such as Germany (§ 1 AStG), these contractual principles are even explicitly enshrined in law. Documentation of such agreements is essential, as, in the event of a tax audit, it must be demonstrated what standard for arm’s length arrangements was used.
Which statutory provisions govern the arm’s-length clause in German law?
In Germany, the arm’s-length clause is primarily regulated by § 1 of the Foreign Tax Act (AStG). This provision defines and specifies how to deal with business relationships between related parties, especially with regard to transfer pricing between companies in a multinational group. In addition, guidelines and administrative instructions can be found, for example in the Gewinnabgrenzungsaufzeichnungs-Verordnungen (GAufzV) and transfer pricing guidelines issued by the tax authorities (BMF letters). The statutory provisions are supplemented by international agreements, such as the OECD Model Tax Convention and the OECD Transfer Pricing Guidelines. These rules are binding for national interpretation and the practical application of the arm’s-length clause and play a central role in mutual agreement and arbitration procedures related to double taxation disputes.
What is the significance of the arm’s-length clause for due diligence reviews in mergers and acquisitions?
As part of due diligence reviews, compliance with the arm’s-length clause is checked particularly carefully, as it can represent a significant tax and legal risk. When acquiring a company with international transactions between affiliated companies, possible irregularities in pricing and contract design must be identified to avoid subsequent adjustments or tax arrears. The review of the arm’s length principle is therefore a fixed part of the tax and legal assessment of a target company. Previous disputes with tax authorities, ongoing proceedings, or unclear contract structures pose the risk of significant financial burdens, which must be taken into account and, if necessary, priced in during the acquisition.
How does the arm’s-length clause affect the documentation obligations of companies?
The arm’s-length clause entails extensive documentation obligations. Companies that conduct cross-border transactions with related parties are required to demonstrate the appropriateness of their transfer prices and contractual arrangements through detailed transfer pricing documentation. This must cover the selection and application of methods for determining arm’s length prices, relevant market analyses, contracts and transaction descriptions, and legal and economic analysis. During a tax audit, this documentation serves as evidence and a basis for evaluating compliance with the arm’s-length clause by the tax authorities. Incomplete or incorrect documentation regularly leads to estimates and can result in significant surcharges or even trigger tax penal proceedings.
What role do mutual agreement procedures play in disputes related to the arm’s-length clause?
Mutual agreement procedures are an important legal mechanism to prevent or eliminate double taxation that may arise due to different interpretations of the arm’s-length clause by various countries. If, in the case of a cross-border transaction, a price adjustment is made by the tax authorities of one country, the other country may not recognize or may reject this adjustment, so that the corporate profit could be taxed twice. Through a mutual agreement procedure under double taxation treaties and, if applicable, the EU Arbitration Convention, the countries involved seek to reach an amicable solution and thus consistent taxation. Such procedures are legally complex, lengthy, and require precise documentation and convincing argumentation in accordance with the arm’s-length clause.
In which instances can the arm’s-length clause be relevant in civil law?
Although the arm’s-length clause is primarily relevant in tax law, it can also gain significance in civil law in certain cases. For example, the question of whether a contract between affiliated companies meets the requirements of the arm’s length principle can become relevant in insolvency challenges or in corporate law disputes (such as proper fiduciary management by directors). In the event of insolvency, it is examined whether considerations or counter-performances were appropriately valued, and whether this resulted in disadvantageous effects for creditors or the insolvency estate. Similarly, the clause can be relevant in the context of claims for damages or in identifying abuse of rights in corporate law in order to assess the adequacy of transactions.
