Imagine a company operating across several countries. Its subsidiaries sell goods to one another, provide services, share technology or other assets. The price attached to these transactions can influence where profits remain – and, ultimately, where taxes are paid.
For more than a century, the key principle used to address this issue has been the arm’s length standard. Its basic logic is relatively simple: related companies should deal with one another as if they were independent parties. But the global economy has changed dramatically since the standard first emerged.
In his doctoral dissertation in law, A Reimagined Arm’s Length Standard, dr. Ricardo Sergio Schmitz Filho at Mykolas Romeris University asks whether a century-old rule can still work effectively in today’s global economy. His answer is: not entirely. The dissertation is being developed within a double-degree doctoral arrangement between Mykolas Romeris University and the University of Lisbon, under the supervision of Prof. Dr. Ana Paula do Valle-Frias de Madureira e Piedade Dourado (University of Lisbon) and Prof. Dr. Solveiga Vilčinskaitė (Mykolas Romeris University).
From physical factories to integrated global networks
When the arm’s length standard was first developed, businesses were largely built around physical locations, products and tangible assets. Comparing transactions between independent companies was relatively straightforward. Today, the picture is very different. A multinational group may develop technology in the United States, manufacture products in Asia, manage data from Ireland and sell its products around the world. Legally, these may be separate companies in different countries. Economically, however, they can operate as one highly integrated organization.
And this is where the problem begins. The arm’s length standard relies on comparing transactions between related companies with what independent companies would have done under similar circumstances. But, as dr. Schmitz Filho explains, “the further the realities between the independent and group companies, the more stretched (or tested) this notion of comparability becomes.”
Consider a simple example. A multinational company has a manufacturing subsidiary in Lithuania and a sister company in Germany responsible for technology. The Lithuanian company pays the German company for those services. How much should those services cost? The answer matters. The higher the price paid to the German company, the less profit remains in Lithuania – and the more remains in Germany.
This is precisely the kind of question the arm’s length standard is supposed to answer.
When trying to fix the system makes it more complicated
The arm’s length standard has not remained unchanged. As the economy evolved, the international tax community repeatedly adapted the way the standard was applied. But dr. Schmitz Filho argues that these attempts to restore the “lost” comparability have also brought new layers of complexity: new rules, new methods and new questions about how individual transactions should be assessed.
In his view, results are increasingly unpredictable, random. Different comparables can be selected, different circumstances can be assessed and different interpretations can produce different outcomes. In his dissertation, dr. Schmitz Filho describes this phenomenon as “randomization.” In simple terms, companies in similar situations can end up with significantly different tax outcomes because of how the relevant circumstances and comparables are interpreted.
“That is exactly what it means,” he says when asked whether companies can end up paying very different taxes in similar situations.
For businesses operating across borders, the consequences are practical: less predictability, higher compliance costs and a greater risk of disputes with tax authorities. Dr. Schmitz Filho sums up the experience rather bluntly: “Headache.” And, he stresses, this is not necessarily a headache experienced only by companies deliberately trying to avoid taxes. It can affect businesses operating internationally simply because the rules are difficult to apply consistently. Ultimately, he argues, such uncertainty can become an obstacle to economic internationalization itself.
So why not simply abandon the rule?
If the system has so many problems, a natural question follows: why not replace it altogether? The answer, according to dr. Schmitz Filho, is partly legal – but also deeply political.
“Law (and tax law, for that matter) is not and should not be assessed disconnected from the world, from the political and economic environment in which it exists,” he explains.
The arm’s length standard is, in his view, ultimately a political agreement dating back roughly a century. The international community has had opportunities to move away from it, he argues, but has repeatedly chosen to modify the standard rather than abandon it altogether.
And there is another reason. “Feasibility. Political agreement,” dr. Schmitz Filho says when asked why the standard is still used globally.
A radical departure from the arm’s length standard is unlikely to be politically feasible in the short to medium term. Nor, he argues, is there currently a clearly more effective alternative that could command broad international agreement. That does not mean the system should remain unchanged.
Not a more precise answer – but a simpler system
This is where the central idea of dr. Schmitz Filho’s dissertation emerges. Rather than trying to make the arm’s length standard increasingly precise and technically sophisticated, he proposes changing the direction of reform.
“So far, the focus of the international tax community has been on attempting to design changes to arrive at more ‘correct’ arm’s length results,” he explains. “We understand that a much more achievable focus is to design changes towards making the arm’s length standard simpler.”
In practice, his proposal would introduce more structured and formula-based elements into the system, reducing the scope for interpretation and making tax outcomes more predictable. At the same time as coordinating the model with the need to pay greater attention to the actual logic of business decisions.
The latter is reflected in one of the dissertation’s concepts, Rational Business Conducts: when assessing how multinational companies structure transactions, authorities should look not only at the formal transaction itself, but also at legitimate economic reasons for why a business has chosen to operate in a particular way.
Importantly, dr. Schmitz Filho does not argue that such considerations are completely absent from current practice. “It shouldn't be,” he says when asked why rational business conduct has been missing from the standard. “Despite not being as open as the international community should about it, elements of what we call the ‘Rational Business Conducts’ can already be seen in practice.”
What exactly does the researcher propose?
The “reimagined” arm’s length standard rests on three main elements. First, account for real business logic. The proposed Rational Business Conducts would make legitimate economic reasons more visible when assessing intra-group transactions. Second, make greater use of formula-based elements. The dissertation proposes a Formulaic Approach Simplification Safeguard as part of the reimagined standard, aimed at making its application clearer and more predictable. Third, introduce a sequential approach to decision-making. The proposed Sequential Method Rule is intended to make the application of the standard more structured and predictable. Together, these elements are intended to make the system simpler, more predictable and less prone to disputes.
As dr. Schmitz Filho puts it, his proposal seeks “clearer methods for operationalization of the arm’s length standard, capable of providing more predictable (less ‘random’) results, with lower levels of complexity and disputes around the standard’s application.”
Why could the European Union lead the change?
Dr. Schmitz Filho sees a particular opportunity for the European Union. His reasoning is based on both need and means. First, the problem is particularly relevant to an integrated economic area such as the EU. If uncertainties in the application of tax rules create obstacles for businesses operating across borders, they may also raise questions about compatibility with the fundamental freedoms guaranteed by EU law. Second, the EU has something that can make coordinated change more realistic: a high degree of integration between its member states.
“The EU has potentially the best, most integrated, relations upon jurisdictions (i.e., its members) than anywhere else on the planet,” dr. Schmitz Filho argues.
That, in his view, gives the EU an opportunity not only to coordinate changes internally, but also to exert political influence on the wider international tax system.
What happens if nothing changes?
Asked about the risk of leaving the system as it is, dr. Schmitz Filho gives a strikingly short answer: “Collapse.” It may sound dramatic. But the issue is not confined to tax lawyers or multinational corporations. Tax revenues are one of the main ways governments finance public services and other state functions. At the same time, companies operating internationally need to be able to predict their costs and tax liabilities.
A system that is difficult to predict creates problems on both sides: governments may struggle to secure the tax revenue attributable to economic activity within their jurisdictions, while businesses face greater uncertainty and higher costs when expanding internationally. That is why, dr. Schmitz Filho argues, reforming international taxation is ultimately not just about finding the “right” price for a transaction between two companies.
It is about finding a system that can work in the economy we actually have. His proposal does not seek to erase a century-old standard and start from scratch. It is an attempt to rethink the arm’s length standard so that it can once again perform the function for which it was created – in a world that looks very different from the one in which it was born.
Written by Laura Stankūnė, Science Communicator at Mykolas Romeris University
