Definition and Meaning of the Arm’s Length Principle
The term “arm’s length principle” plays a central role in German tax law, particularly in international tax law and corporate law. It describes the principle that transactions between related parties, especially within corporate groups, must be structured as if they were agreed upon by independent third parties. The aim is to prevent tax shifting and ensure appropriate taxation.
Arm’s Length Principle in Tax Law
Basic Principle of the Arm’s Length Principle
The arm’s length principle requires that the terms of contracts or transactions between related companies (“related parties” within the meaning of Section 1 (2) of the German Foreign Tax Act (AStG)) correspond to those that would have been agreed upon by unrelated third parties. If the actual terms deviate from those customary between independent third parties, the tax authorities may make tax adjustments (so-called “adjustment according to the arm’s length principle”).
Application in International Tax Law
The arm’s length principle is of particular significance in an international context. Multinational corporate groups often structure supply relationships, services, and financings across borders within the group. To prevent the erosion of a high-tax country’s tax base by shifting profits to low-tax jurisdictions, the Foreign Tax Act (AStG) in Section 1 requires the application of arm’s length principles (“arm’s length principle”).
The OECD Transfer Pricing Guidelines form the international foundation in this context. They define how prices between related companies are to be determined and which methods (e.g., comparable uncontrolled price method, resale price method, or cost-plus method) are permissible.
Arm’s Length Principle under Section 8 (3) KStG
The German Corporate Income Tax Act (KStG) also requires the arm’s length principle, e.g., in Section 8 (3) KStG regarding the treatment of hidden profit distributions. Payments from a corporation to its shareholders (or their relatives) that do not correspond to what an independent third party would have received are, for tax purposes, considered profit distributions and not business expenses.
Arm’s Length Principle in Corporate Law
In corporate law, the arm’s length principle is particularly relevant for legal transactions between the company and its shareholders or related parties. Especially in GmbHs and AGs, there is often the question of whether contracts have been concluded on terms that would also be agreed with unrelated third parties. If this is not the case, it may constitute a hidden profit distribution or a transfer of assets to the detriment of the company.
Example: Shareholder Loans
If a shareholder grants a loan to the company at an interest rate below the market rate, the “arm’s length” interest rate is the benchmark. Only the market-rate portion of the interest payment will be recognized as a business expense; the difference may be treated as a hidden profit distribution.
Methods for Arm’s Length Testing
Comparable Uncontrolled Price Method
With this method, the prices for comparable services or goods between related companies are compared to market prices for the same or similar services or goods between independent third parties.
Resale Price Method
With this approach, the price at which a company sells a product acquired from a related company to an independent third party is used as a basis. An appropriate profit margin is deducted from this price to determine the arm’s length transfer price.
Cost-Plus Method
This method examines the actual costs incurred by a related company and compares the applied markup to the markup that independent companies would charge for similar goods or services.
Profit Comparison Method
The profit comparison method is used particularly when direct price comparisons are not possible. Here, the profit generated from the transaction is used as a benchmark and compared with profits from comparable transactions between independent companies.
Legal Consequences of Violations of the Arm’s Length Principle
Tax Adjustments
If a violation of the arm’s length principle results in advantages for related companies (e.g., due to low transfer prices), the tax authorities pursuant to Section 1 (1) Sentence 1 AStG will adjust to the arm’s length price. The inflated or too low price becomes tax-neutral, thereby adjusting the tax base.
Interest and Penalty Payments
If back taxes are assessed due to non-arm’s length contractual arrangements, additional interest charges and, in some cases, tax-related penalties (e.g., for tax evasion) may also be imposed.
Documentation Requirements
According to Section 90 (3) of the Fiscal Code (AO) and the Profit Allocation Documentation Regulation (GAufzV), companies with cross-border transactions are subject to extensive documentation requirements. This enables the tax authorities to verify whether the arm’s length principle has been observed. Violations may result in estimates and substantial penalties.
International Harmonization and OECD Guidelines
The OECD Transfer Pricing Guidelines are the international standard for structuring arm’s length principles and are adopted by numerous countries. They specify the requirements for determining arm’s length prices and the necessary documentation.
Significance for Corporate Practice
Compliance with the arm’s length principle is essential for internationally active companies to minimize tax risks. Mistakes can lead to significant back taxes, fines, and reputational damage.
Summary
The arm’s length principle ensures that corporate relationships are treated for tax and corporate law purposes as if they were concluded between independent parties. Violations of the arm’s length principle generally result in tax adjustments. Given the principle’s central importance, careful contract drafting and documentation is paramount in both national and international corporate contexts.
Frequently Asked Questions
Which legal foundations govern the arm’s length principle in German tax law?
The arm’s length principle in German tax law is primarily governed by Section 1 (1) of the Foreign Tax Act (AStG). According to this, income between related parties must be determined as if agreed between independent third parties. This rule serves both to prevent profit shifting abroad and to ensure appropriate domestic taxation. It is supplemented by various administrative guidelines, such as the “Principles for the Review of Profit Allocation between Internationally Related Enterprises” (so-called Transfer Pricing Administrative Principles), as well as by international agreements such as Article 9 of the OECD Model Tax Convention. Moreover, the arm’s length principles are also relevant within other tax regulations, for instance in Section 8 (3) of the Corporate Income Tax Act (KStG), which examines hidden profit distributions based on the arm’s length standard. Practical implementation is therefore always carried out in consideration of these statutory provisions, administrative interpretations, and relevant tax case law.
Which groups of persons are typically subject to the arm’s length test?
The arm’s length test primarily focuses on legal relationships between so-called related parties. According to Section 1 (2) AStG, this includes in particular corporations, partnerships, and individuals and their relatives, provided they can influence the business relationship. Companies connected by majority shareholdings are also subject to the arm’s length test, as are subsidiaries or companies within an international group. The test applies not only to cross-border cases but also to purely domestic cases, for example, if hidden profit distributions within affiliated companies are suspected. What matters is always whether there was the ability to influence the terms of the business relationship in a way that leads to an inappropriate allocation of profits for tax purposes.
Which types of transactions are subject to the arm’s length principle?
All transactions between related parties that can affect the tax base are subject to the arm’s length principle. This includes, for example, supplies and services of all kinds, the granting of rights (e.g., licenses), financing relationships (e.g., loans, guarantees), use or transfer of assets (e.g., leasing, letting), services (e.g., management fees, consulting), and intra-group allocations of overhead costs. Transactions related to restructurings, transfers of business units or participations, and reorganizations also fall within its scope. The benchmark is always whether and how the transaction would have been agreed upon between independent third parties (“dealing at arm’s length”).
What rules of evidence apply in disputes over the appropriateness of terms under the arm’s length principle?
In disputes over the appropriateness of terms agreed between related parties, the objective burden of proof generally lies with the tax authorities. However, the taxpayer has an increased obligation to cooperate under Section 90 (2) AO and is required to document and substantiate its internal transfer prices. If the taxpayer does not adequately meet this obligation, the tax authorities may estimate the basis of taxation—subject to formal and substantive obligations to cooperate. Case law requires the taxpayer to plausibly demonstrate and document the contractual framework and price setting customary among independent third parties, for example, through price comparisons, cost-plus methods, or suitable economic reports. Without sufficient documentation, however, the authority may deviate from the tax bases, resulting in a “secondary” burden of proof for the taxpayer.
What are the legal consequences of a determined violation of the arm’s length principle?
If, during an audit, the tax authorities determine that terms agreed between related parties do not withstand the arm’s length test, income is adjusted “by exclusion” according to Section 1 AStG. This means income is determined as it would have been achieved between independent third parties. This can lead to additional tax liabilities, such as corrections of income or expenses, or the assumption of hidden profit distributions or withdrawals. In an international context, there is also a risk of double taxation, as the adjustment may not be equally recognized by both involved countries. Furthermore, a violation of documentation obligations under Section 162 (3) AO may result in estimates and substantial penalties (Section 162 (4) AO), as well as criminal consequences for tax evasion under Section 370 AO.
To what extent has the case law of the Federal Fiscal Court (BFH) clarified the arm’s length principles?
The Federal Fiscal Court (BFH) has clarified the application of the arm’s length principle through numerous decisions. In particular, it has established that arm’s length terms are determined not only by price, but also by the actual structuring of contractual relationships (contract content, contract practice) (see, for example, BFH ruling of 17.12.2014, I R 23/13). The BFH consistently requires that contracts between related parties be concluded, executed, and, if necessary, enforced in the same way as between unrelated third parties, both in substance and form. Furthermore, the case law always takes into account the circumstances at the time the contract is concluded; subsequent developments have no decisive significance for the assessment. Finally, the BFH emphasizes that, alongside national regulations, international standards such as the OECD Transfer Pricing Guidelines must also be considered in interpreting the arm’s length principle.
What is the significance of the OECD Transfer Pricing Guidelines for the interpretation of the arm’s length principle in Germany?
The OECD Transfer Pricing Guidelines (“Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”) are important interpretive aids for the German tax authorities and the courts. They significantly influence the interpretation of arm’s length principles in German law, as they provide internationally recognized valuation and documentation standards. According to the BFH, the guidelines are not directly applicable law, but are used as interpretive guidance in cross-border transactions to avoid international double taxation conflicts. The OECD Guidelines define, among other things, the permissible methods for price determination (comparable uncontrolled price method, resale price method, cost-plus method, etc.), provide guidance on handling intangibles, and evaluate the role of economic analyses. The German Administrative Principles (VWG Transfer Prices) explicitly refer to these guidelines, making their observance practically indispensable for companies with international operations.
