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Arm‘s length principle

EcovisAfter the conclusion of sale-purchase contracts taxpayers are obliged to keep documents proving that while concluding contract between associated persons arm‘s length principle was respected. Tax administrator has a right to evaluate so called controlled contracts by referring to this principle. What is the definition and meaning of the arm‘s length principle?

Arm‘s length principle states that contracts must be economically reasoned and concluded as it would be concluded between independent and rational persons under the conditions of free market with a view to get an economic profit from this contract.

This principle is determined in Lithuanian Law on Corporate Income Tax and Lithuanian Law on Individual Income Tax.

Art. 40 point 2 of the Law on Corporate Income Tax and art. 15 point 2 of the  Law on Individual Income Tax state that where the conditions created or prescribed by mutual transactions or economic operations between associated persons are other than those created or prescribed by a mutual transaction or economic operation between non-associated persons, any profit (income) that would be attributed, if no such conditions existed, to one of such persons but due to such conditions is not attributed to him, may be included in the income of that person and taxed accordingly.

For a better understanding of the arm‘s length principle it is necessary to know how the definition of associated persons and definition of contract should be applied.
The both laws are clear enough about these definitions. Art. 2 point 8 of Law on Corporate Income Tax and art. 2 point 32 determine that associated persons shall mean persons (entities or natural persons) where they meet at least one of the following criteria:
1) they are related persons;
2) they may have an influence over each other resulting in the conditions of their mutual transactions or economic operations being other than those where a maximum economic profit is sought by each of the said persons.

Examples of related persons might be an entity and its members or an individual, who is a member of an entity, and that entity; an entity and members of its management bodies or an individual, who is a member of the managing bodies of an entity, and that entity; an entity and the spouses, fiancés and cohabitants of its members or members of its management bodies or an individual whose spouse, fiancé or cohabitant is a member of the managing bodies of an entity, and that entity etc. The exact definition of related persons might be found in art. 2 point 33 of the Law on Corporate Income Tax and in art. 2 point 19 of the Law on Individual Income Tax.

So associated persons are persons one way or another related between them and capable to influence each other’s decisions.
Definition of the contract in these provisions should be understood not only as an agreement but also as any other commercial activity.

Tax administrator by its comments on the arm‘s length principle explained that this principle is a principle according to which price of the contracts concluded between associated persons cannot differ from the market price and the economic profit from these contracts or income received from it cannot differ from the economic profit or income which would be received if this contract would be concluded between non-associated persons.

A method of comparison shall be applied for the determination if the price of a contract corresponds to the price of the market: controlled and non-controlled contracts (i.e. contracts concluded between associated and non-associated persons) are compared to each other. The purpose of this comparison is to evaluate if indicators, which are important for the application of the chosen method of pricing, in these contracts are not so different that might have important influence for the price or profitability of a contract or the influence of this difference might be evaluated and accordingly adjusted. For an appropriate comparison of these contracts it is necessary to understand how contracts are concluded between non-associated persons. All pricing methods of the contracts are based on the idea that non-associated persons acting under the conditions of the market and seeking after a maximum profit usually evaluate all differences of the possibilities which may have influence to the value of a contract.

Methods of the comparison of controlled and non-controlled contracts are established in the Rules on the implementation of art. 40 point 2 of the Law on Corporate Income and art. 15 point 2 of the Law on Individual Income Tax (hereafter – Rules).

Rules state that while evaluating the contract its object’s characteristics, functions of parties of the contract, conditions of a contract, economic circumstances and business strategy shall be evaluated.

Every contract concluded between associated persons shall be evaluated separately. For the determination if a price corresponds the arm‘s length principle one of these pricing methods shall be applied: comparable uncontrolled price, resale price, ‘costs plus’, profit split or transactional net margin method. Even if one of these methods is sufficient for the determination of a price and profit of controlled contract several methods might be applied. When it is possible the method of comparable uncontrolled price should be applied.

So the arm‘s length principle seeks to assure that contracts between associated persons are concluded under the same conditions as between non-associated persons and thus associated persons wouldn’t get a non reasoned advantage over other market participants.

Akvilė Bužinskaitė

ECOVIS Miškinis, Kvainauskas ir partneriai advokatų kontora
E-mail: akvile.buzinskaite@ecovis.lt - Internet: www.ecovis.lt