What Is the Transfer Pricing Arm’s Length Principle?

When a company’s divisions or subsidiaries in different countries transact with each other, they must establish a price for the goods or services exchanged. This is known as transfer pricing. The governing standard for these transactions is the arm’s length principle, an international consensus established by the Organisation for Economic Co-operation and Development (OECD). This principle mandates that the price set between these related entities must be the same as it would be if the transaction occurred between two independent parties in the open market.

The purpose is to ensure fair taxation and prevent multinational enterprises (MNEs) from manipulating their profits for tax advantages. Without this standard, a company could artificially shift profits from a high-tax country to another in a low-tax jurisdiction by distorting the prices of their internal transactions. The arm’s length principle provides tax administrations with a guideline to verify that the profits reported in their jurisdiction are an accurate reflection of the economic activity that occurred there.

The Core Concept of Comparability

Applying the arm’s length principle relies on a comparability analysis. This process involves comparing a “controlled” transaction between related parties with a “comparable uncontrolled” transaction between independent parties. A transaction is deemed comparable if any existing differences between it and an uncontrolled transaction would not materially affect the price or profit margin being examined. If differences do exist, reasonably accurate adjustments must be made to eliminate their impact.

The OECD has identified five factors of comparability that must be examined. The first is the characteristics of the property or services being transferred, such as a product’s physical attributes and quality, or the nature and extent of services provided. For intangible property, this includes the transaction’s form and the anticipated benefits from its use. A functional analysis, often referred to as a FAR analysis, is an assessment of the Functions performed, Assets used, and Risks assumed by each party in the transaction.

Functions

Functions are the economically significant activities and responsibilities undertaken by each entity, such as research and development (R&D), manufacturing, marketing, and distribution. Identifying which entity performs these activities is fundamental to understanding its contribution to the overall value chain.

Assets

The Assets component considers both tangible assets, like manufacturing plants and equipment, and intangible assets, such as patents, trademarks, and brand names. The type and value of assets used by each party are linked to the profit potential of the transaction. For instance, a subsidiary that owns and utilizes valuable manufacturing patents would be expected to earn a higher return than a simple assembly operation.

Risks

The Risks element evaluates the economic risks assumed by each party. These can include market risks, inventory risks, and financial risks. The party that bears more of the substantial risks in a transaction would, in an arm’s length scenario, expect a greater potential return as compensation. A detailed FAR analysis provides a clear picture of the economic substance of the transaction.

The final two comparability factors are the contractual terms and the economic circumstances of the transaction. Contractual terms define the legal rights and obligations of each party. Economic circumstances refer to the market conditions in which the transaction takes place, such as the geographic market and the level of competition.

Establishing an Arm’s Length Price

Once a comparability analysis is complete, a company must apply an appropriate transfer pricing method to determine the arm’s length price. The OECD outlines five primary methods, which are broadly categorized into traditional transaction methods and transactional profit methods. The choice of method depends on the nature of the transaction, the availability of reliable data, and the results of the comparability analysis.

The Comparable Uncontrolled Price (CUP) method compares the price charged for property or services in a controlled transaction to the price charged for the same property or services in a comparable uncontrolled transaction. For example, if a company sells widgets to its subsidiary, it would identify the price it charges for identical widgets sold to an independent customer. This method requires a high degree of comparability.

The Resale Price Method (RPM) is used for the purchase and resale of tangible property by distributors that do not add substantial value to the goods. This method starts with the price at which a product is resold to an independent customer. This price is then reduced by a gross margin, which represents the amount a reseller would need to cover its expenses and make a reasonable profit. The remainder is considered the arm’s length price for the initial purchase.

The Cost Plus Method (CPLM) is applied to the transfer of goods or services from a manufacturer or service provider. This method begins by identifying the costs incurred by the supplier and adds a markup that reflects the profit an independent supplier would earn for similar functions and risks. The total becomes the transfer price.

When comparable uncontrolled transactions are difficult to find, companies may use transactional profit methods. The Transactional Net Margin Method (TNMM) examines the net profit margin relative to an appropriate base (such as costs, sales, or assets) that a taxpayer realizes from a controlled transaction. This net margin is then compared to the net margins realized in comparable transactions by independent enterprises.

The Profit Split Method is used in situations where related parties engage in highly integrated transactions where their contributions cannot be reliably evaluated in isolation, such as in joint ventures involving unique intangible assets. The method identifies the combined profit from the controlled transaction and then divides it between the parties based on their relative contributions.

For fiscal years beginning on or after January 1, 2025, an update known as Amount B of Pillar One provides a streamlined process for determining the arm’s length return for baseline marketing and distribution activities. This simplifies compliance and increases tax certainty for these specific transactions.

Required Documentation and Reporting

To demonstrate compliance with the arm’s length principle, tax authorities require MNEs to prepare and maintain extensive transfer pricing documentation. The OECD has established a standardized, three-tiered approach to this documentation: a Master File, a Local File, and a Country-by-Country (CbC) Report.

The Master File provides a high-level overview of the MNE group’s global business. It includes its organizational structure, a description of its business lines, and its overall transfer pricing policies concerning intangibles and intercompany financial activities.

The Local File provides the detailed information necessary to support the arm’s length nature of transactions specific to a particular country. It must contain a detailed functional and economic analysis for the local entity, the selection and application of the most appropriate transfer pricing method, financial data, and copies of the intercompany agreements.

For the largest MNEs, with consolidated group revenue exceeding €750 million, a CbC Report is also required. This report provides a high-level overview of the global allocation of the MNE’s income, taxes paid, and other indicators of economic activity. The CbC Report includes data for each jurisdiction on:

• Revenues from both related and unrelated parties
• Profit or loss before income tax
• Income tax paid and accrued
• Stated capital and accumulated earnings
• Number of employees
• Value of tangible assets

Consequences of Non-Compliance

When a tax authority determines that a company’s transfer pricing does not adhere to the arm’s length principle, the consequences can be significant. The authority can issue a primary adjustment, recalculating the company’s taxable income in its jurisdiction to reflect what it would have been if the transactions had been priced correctly. This adjustment increases the company’s tax liability for the audited years.

A primary adjustment in one country can lead to economic double taxation if the corresponding country where the other related party is located does not make a corresponding adjustment. In this case, the same profit is taxed twice within the multinational group. Many bilateral tax treaties provide a mechanism, known as the Mutual Agreement Procedure (MAP), to resolve such disputes, but this can be a lengthy process.

In addition to the increased tax liability from an adjustment, companies are required to pay interest on the underpaid tax. Tax authorities can also impose substantial penalties for non-compliance, often calculated as a percentage of the tax underpayment. These penalties can reach 20% or even 40% of the underpayment, depending on the size and nature of the misstatement. Penalties can also be levied for failing to prepare or provide adequate documentation upon request.