Arm’s Length Principle in Transfer Pricing

Understanding the Arm’s Length Principle

What does the “arm’s length principle” mean in business?

The arm’s length principle means that transactions between related parties (e.g., subsidiaries of the same parent company) should be conducted as if the parties were independent, unrelated entities, under comparable conditions. 

Meaning of the arm’s length principle in taxation

In taxation and transfer pricing, the arm’s length standard is used by tax authorities to ensure that profits are fairly allocated and taxed in each jurisdiction. It helps prevent profit shifting, where related companies artificially manipulate prices to reduce tax burdens.

Arm’s Length Transactions

Definition of an arm’s length transaction

An arm’s-length transaction is a transaction in which the parties are operating independently and of their own self-interest, without a party exercising influence or domination over the other. This ensures that the terms of the transaction (price, liabilities) are similar to what would be agreed between unrelated entities on an open market.

Arm’s length transaction and non-arm’s length transactions example

For instance, if Company A transfers machinery to its wholly owned subsidiary at a very low price, much lower than the market value, then such a transaction won’t be at arm’s length. Non-arm’s length basis, on the other hand, are transactions between related entities (such as parent and subsidiary or controlled entities), which contain terms not according to market norms, resulting in the creation of tax advantages.

Arm’s Length Principle in Transfer Pricing

Role in international taxation

The arm’s length principle is the cornerstone of international cross-border transfer pricing rules. The arm’s length principle makes sure that profits are distributed on a fair note between countries by compelling related parties (e.g., multinational subsidiaries) to transact at arm’s length. This avoids profit shifting towards disputed tax havens or havens for tax optimization and saves the tax base of a state.

Arm’s length pricing explained

Arm’s length pricing means setting prices for goods, services, or intangible assets that are transferred between companies or entities from a multinational group at arm’s length prices that unrelated parties would agree upon in a similar transaction. 

Arm’s length Methods 

The OECD Guidelines set out five general ways of establishing if a price is at arm’s length:

• Comparable Uncontrolled Price (CUP) Method – compares the price charged in a controlled transaction with the price charged in a comparable uncontrolled transaction.

• Resale Price Method – starts from the resale price to an independent party and subtracts an appropriate margin.

• Cost Plus Method – imposes a mark-up to the supplier’s cost to reflect market conditions.

• Transaction Net Margin Method (TNMM) - involves comparison of the net profit relative to an appropriate base (costs, sales, assets) with independent companies.

• Transactional Profit Split Method – splits combined profits from related-party transactions on an economically valid basis that approximates an arm’s length division.

Compliance with OECD guidelines

The Organisation for Economic Co-operation and Development (OECD) has established comprehensive Transfer Pricing Guidelines on the arm’s length principle. The guidelines have been adopted by a majority of countries into their tax legislation, which necessitates compliance with the arm’s length approach for multinational companies to prevent disputes and penalties.

FAQ on Arm’s Length Principle

What is the arm’s length principle?

The arm’s length rule demands that related party transactions should be carried on between two entities as if they were between independent entities under comparable conditions.

What does arm’s length mean in taxation?

In tax, “arm’s length” requires that related parties establish prices and terms that reflect what unrelated entities would accept on the open market.

What is an example of an arm’s-length transaction?

If a holding company sells its goods at a price it would charge an unrelated purchaser, then that is an arm’s-length transaction.

What is arm’s length pricing?

Arm’s length pricing sets the value of goods, services, or intangibles sold or bought from one related party to the other one at similar market conditions.

Why is the arm’s length principle important in transfer pricing

It helps maintain fairness and consistency in global taxation by aligning profits with actual business activities.