INTM431030 - What is transfer pricing all about?

How does the arm’s length principle solve the transfer pricing problem?

There is a general international consensus that, to achieve a fair division of taxing profits and to address international double taxation, transactions between connected parties should be treated for tax purposes by reference to the amount of profit that would have arisen if the same transactions had been executed by unconnected parties. This is the arm's length principle.

For a variety of reasons, the trading arrangements and pricing policies under which multinational groups operate can result in prices and terms considerably different from those which would have been seen between independents engaged in the same or similar transactions. The pricing terms which would be expected to be seen between independents is referred to as ` arm's length`.

The arm's length principle is applied to a controlled transaction by:

replacing (hypothetically)

with

and (for tax purposes)

The arm's length principle is endorsed by the OECD and enshrined in the Associated Enterprises Article of the OECD Model Tax Convention on Income and on Capital (usually referred to as the OECD Model Treaty). It enjoys general international consensus. See INTM431040 for further information on the Associated Enterprises Article of the OECD Model Treaty.

But the complexities of applying the arms' length principle in practice should not be underestimated. Because of the closeness of the relationship between the parties there can be genuine difficulties in determining what arm's length terms would have been - especially where it is not possible to find wholly comparable transactions between unconnected parties. There are many factors to take into account. Consequently, the exercise can be as much an art as a science.