The arm's length principle is an instrument used in financial management to determine whether a legal relationship between a GmbH and its shareholders is appropriate or whether it leads to a hidden distribution of profits. Thus, one always compares such actions with the case in which the focus is placed on foreign third parties as an alternative reference value instead of the shareholders: would the framework conditions chosen for the shareholders, such as the manager’s salary or a private loan, also apply to foreign third parties? If the answer is positive, the action is relieved of the suspicion of a hidden profit distribution. Otherwise, the comparison leads to the conclusion that the shareholders use their relationship with their GmbH to their personal advantage in order to save taxes in an unreasonable amount. Therefore, the arm's length principle is, in principle, acceptable. But when it comes to the concrete comparisons, there are often discrepancies between GmbH shareholders and third parties. However, the arm's length principle cannot reliably eliminate these discrepancies. We are critical of that.

1. On the arm's length principle - Introduction

With this contribution we want to stimulate a discussion. We question whether the arm's length principle, which both case law and the financial administration have applied for decades in the taxation of corporations and their shareholders, is realistic. We find that it often seems remote from reality. And we want to prove that here. If that is the case, should the arm's length principle be abolished without replacement? In certain cases this would probably go too far. But you should take a closer look at the actual conditions. Because it is the assumptions on which the arm's length principle has been based so far that we criticize.

2nd arm's length principle - what is it?

But before we get into our discussion, let’s first explain what the arm’s length principle is and what effects it has on taxation.

2.1 The arm's length principle is easily explained

The arm's length principle is intended to ensure that shareholders of a corporation do not abuse the design. Because the integration of GmbH shareholders with their GmbH has the potential to achieve one or the other tax advantage. To a certain extent, this should also be legitimate. So what you want to avoid with the arm's length principle is that you exaggerate it.

In jurisprudence as well as in practice, it is assumed that only arrangements can be recognized that would also be accepted as GmbH shareholders in legal relationships with third parties. For example, if you want to pay a managing director salary as a GmbH shareholder, this must be comparable to a salary that an employee managing director in the same industry would receive in a company with similar sales. Therefore, in order to apply the arm's length principle as a benchmark, for example in operational tests, it is necessary to research relevant comparative data.

2.2. The arm's length principle in practice

This brings us to the external comparison of how he meets us in everyday life. Every time we find ourselves in a relationship between a GmbH and its shareholders, we have to ask ourselves what the decision would be if third parties were affected instead of the shareholders.

In terms of managing director salary, this obviously concerns its amount and some other modalities, especially with regard to retirement provision. The economic situation of the company is less significant, at least when it comes to an economically healthy company. More decisive for the financial administration is often just how big the desired tax advantage is. In addition to the classic example of managing director salary, there are many other aspects in which the arm's length principle plays a central role. This includes, for example, the salaries you would pay to employed family members or friends. Or the design of the conditions that a GmbH would agree upon when granting a loan with its shareholders or with third parties. But also the payment of donations to charitable associations in which the shareholders may have a private interest.

Therefore, the arm's length principle is always associated with the issue of hidden profit distributions (§ 8 (3) sentence 2 KStG). Because whoever as a GmbH shareholder exceeds the limits of the external usual, is regularly confronted with the assumption of a hidden profit distribution. This has happened, for example, to the beverage manufacturer Lemonaid. For him, the tax office regarded his contributions to a non-profit association as incompatible with the arm's length principle. The fact that, for once, a purely altruistic motive could have led to the high donations was obviously irrelevant.

2.3 Principle of arm's length comparison: Delimitation to international business relations

For our understanding of the arm's length principle, we need to add one more comment. This is because the term ‘arm's length principle’ is also known in connection with the determination of international transfer prices and other business relationships. This is also about appropriate values, because comparable with foreign third parties. If there are dependencies between affiliated companies operating in Germany and abroad (for example through an organization), then the assumption that this dependency relationship could be abused for an inappropriate tax reduction is quite realistic. However, precisely this topic should not play a role in our criticism. This only concerns the arm's length principle for companies and their shareholders in Germany.

Unrealistic assumptions in the arm's length principle?

Now we come to our criticism of the arm's length principle. As mentioned above, this is only the benchmark used for the arm's length principle. To do this, we are examining two examples to demonstrate the shortcomings of applying this principle so far.

3.1. Comparison of the Managing Director's salary

Suppose you wanted to hand over the management of your GmbH to another person. This could be an experienced authorized representative. His or her career so far has been exemplary. There are therefore no technical complaints. But even with the best possible remuneration, this person lacks an element that only GmbH shareholders have: the personal connection to their company. As a GmbH shareholder, the company was built up from scratch. One may have had to overcome various difficult situations in order to finally lead it to success. However, this has usually not found any monetary response. But can such an outstanding commitment in case of doubt also be expected from an external managing director? If we are honest, this is only self-evident if we have established a personal connection to the GmbH.

This applies with certain weakenings probably also in the case that the own children or other family members should take over the management. Here, too, there is a risk that the commitment for the company will be lower than for the founders of the GmbH.

One more consideration: Let’s assume that as a shareholder you have to hand over the management of your own GmbH for private reasons as soon as possible. So you are under time pressure to find a suitable replacement. If we only oblige an average talented and motivated external managing director, we must nevertheless assure him or her of a comparatively high managing director salary, which is comparable to his or her own before. This may stand up to a comparison with other managing directors, but from a comparable consideration one is probably far away. However, this comparison with the below-average managing director would also satisfy the arm's length principle. In other words, if the tax office wanted to check the former managing director’s salary, it would invoke the new managing director’s salary, although his performance is lower.

3.2.Lending by our own GmbH

The second example highlights the conditions that you would enter into if you were to receive a loan from your own GmbH as a GmbH shareholder. Here, the financial administration regularly focuses on conditions that usually go hand in hand with taking out a bank loan at a private level. For example, a bank would check the credit rating. In addition, it would demand collateral to compensate for a possible credit default. If you want to use the loan for a business project, banks also like to ask for a personal guarantee and a business plan.

But if the GmbH grants a loan to the bank – and every deposit into a fixed-term account corresponds exactly to this – then in this converse case neither a guarantee of the managing directors of the bank nor the provision of collateral or any other of the conditions can be expected in practice. So if all these framework conditions are so different, why should the level of interest serve as a reference to the arm's length principle?

Let’s take this one step further: If a lender other than a bank does not expect collateral or other terms from us, how high would interest rates be? Probably quite high, because one would expect an increased credit default risk. But this comparison also lags behind. Unlike foreign lenders, the management of a GmbH would by no means trust its own shareholders that they will cause damage by improper handling of the loan of the GmbH. The logic here is that the connection of the shareholders to their own GmbH creates a special relationship of trust. And this relationship of trust should then also be combined with particularly favorable conditions without opposing the arm's length principle.

4. Why the arm's length principle is flawed in the approach

The two examples have shown that the comparison between a GmbH shareholder and an arbitrarily postulated alternative is often only superficial in nature. In many cases, if the arm's length principle were to be applied seriously, one would have to admit that the standards previously regarded as comparable are often disadvantageous for GmbH shareholders in reality. If, for example, a managing director’s salary has so far been considered appropriate for an external managing director in the light of a generally higher stake, a shareholder-managing director should be allowed to earn more than this amount without running the risk that the exceeding part constitutes a hidden profit distribution.

The external comparison is therefore only a strongly generalizing instrument. But he regularly fails because it is difficult to compare GmbH shareholders with third parties. If the arm's length comparison were carried out only with other GmbH shareholders, the arm's length comparison principle would probably still be comprehensible because it is realistic. But even with the example with the loan, we encounter almost insurmountable limits. Therefore, the arm's length principle is fundamentally flawed in its conception.

General criticism of the arm’s length principle – our conclusion

No matter how sophisticated the arm's length principle may be applied in practice, if even the comparison to foreign third parties causes difficulties because it is only conditionally realistic, then it is worthy of criticism. We have demonstrated this here. The core of our criticism is that the claim of the arm's length principle to orient itself on reality often misses this very reality. In certain circumstances, the arm's length principle may be conditionally justified according to previous ideas, namely if one can make a comparison 1:1 without causing distortions. But this is actually only given in certain exceptional cases.

So it is about much more than legal-tax-legal trickery. It is a principle which is widespread in practice and whose validity must be put to the test. In this context, it should not be irrelevant that the arm's length principle is an easily applicable and often unreflected financial management tool for distinguishing reasonable situations from hidden distributions of profits. We should clear this up. Better still, we should develop it further, because the core idea is quite logically understandable. Only the actual comparison to reality leaves much to be desired.