Why must the price comply with the arm’s length principle?

Transfer pricing has long affected not only international groups but also local companies.

They have become a daily reality for Latvian businesses, especially in cases where a company cooperates with related parties: subsidiaries, board members, ultimate beneficial owners, relatives of officials, or foreign partners belonging to the same group.

The arm’s length principle is one of the key concepts in the field of transfer pricing, which determines how such transactions are evaluated.

Theoretically, it is a simple idea: transactions between related companies must be as fair as if they occurred between independent parties.

In practice, it often becomes a point of contention between companies and the State Revenue Service (SRS), as the “market price” is not a fixed number in a table, but an assessment that requires economic understanding and business logic.

The Arm’s Length Principle – Between Theory and Reality

OECD guidelines clearly state that the purpose of transfer pricing is to ensure that profits are taxed in the country where they actually arise.

This is a reasonable and fair principle – it prevents situations where companies “shift” profits to lower-tax countries.

However, applying this principle in practice is not so simple.

Every company’s business, product structure, and market position are different. Therefore, when the SRS evaluates whether a price corresponds to the market level, no single formula exists.

What is justified in the wholesale of automotive parts may be completely inappropriate in the field of software development or design services.

When market price becomes a matter of interpretation

The field of transfer pricing in Latvia has become one of the SRS priorities in recent years. This in itself is not surprising, as budget stability requires tax control. However, in reality, this control often takes a formal rather than an economically justified character.

In practice, this means that:

1. the company is told that its profitability “does not match the industry”,
2. general or outdated market data are used for comparison,
3. SRS assumptions lean toward the “safe side” – in favor of fiscal interests rather than the actual situation.

For example, a manufacturer specializing in the export of niche products may naturally operate with a lower profit margin than the market average. This does not mean their prices do not comply with the market principle – it means the market segment is different.

However, in practice, the SRS often applies a CIT adjustment and a penalty of up to 1% of the transaction value in such cases, interpreting the “arm’s length” principle too mechanically.

When Adjustments Become a Penalty, Not an Adjustment

Latvian regulations provide that if the transaction value does not correspond to the market level, the SRS may increase the taxable profit. At a 20% CIT rate, this can be a significant burden – even a €100,000 “adjustment” means a substantial amount in additional taxes.

Furthermore, a 1% penalty of the transaction value and 0.05% late payment interest per day are additionally applied.

What does this look like in numbers?

Suppose the SRS concludes that the value of a related party transaction does not correspond to the market level by EUR 100,000.

Then the following is applied:

Thus, a seemingly “small” adjustment of €100,000 can in practice mean almost €50,000 in additional costs.

Formally, it is an adjustment mechanism, but in fact, it is a significant penalty for an economic difference in interpretation between the company and the SRS.

The SRS Approach – Strict, but Not Always Economically Justified

There are areas where market data are available – for example, in financial loans or trade in goods. However, there are also industries where comparison possibilities do not exist, and it is precisely in these cases, where flexibility of interpretation would be needed, that the SRS often applies administrative rigor.

This practice is perhaps understandable from a fiscal point of view, but it creates uncertainty for entrepreneurs who operate honestly but cannot cope with the volume of documentation or formal requirements.

Furthermore, companies are often required to prove the “market price” in situations where a market does not exist in the classical sense – for example, in the provision of unique services within a group.

How to Achieve Balance

The arm’s length principle is not inherently a sanction – it is a means for fair taxation. For it to truly be so, a balanced approach is needed from both companies and the SRS. For companies: to document and justify their prices rather than just reacting to requests. For the SRS: to analyze the actual economic substance rather than just formal indicators.

For example, if a parent company in Latvia provides IT support to subsidiaries in Germany and Sweden, determining market prices cannot be based solely on a “sales margin” table – the content, quality, and risk distribution of the services provided between the parties must be taken into account.

The arm’s length principle is one of those tools that creates trust in the international tax system, but in Latvia, it still lacks consistent, economically justified application practice.

As long as the SRS approach remains more formal than analytical, transfer pricing control will not promote compliance but will instead create fear and uncertainty even for those companies that operate honestly.

Therefore, the goal should not only be to “audit and punish” but to create a predictable, dialogue-based environment where companies understand why the rules exist and how to comply with them, rather than just how to avoid them.