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.
