Transfer prices are charged by one company to affiliates for the cross-border transfer of property, including sale, license, lease, or the provision of services.  Tax authorities require that affiliated companies report their transfer prices according to the “arm’s length” standard in order to avoid the loss of fiscal revenue to low-tax jurisdictions, through the manipulation of intercompany prices, including royalty rates.  In the United States (US), transfer prices are regulated by Section 482 of the Internal Revenue Code (IRC), and in other countries belonging to the Organization of Economic Cooperation and Development (OECD), they are governed by the OECD Transfer Pricing Guidelines.

The authority for the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD member countries.  Article 9 provides:  “[When] conditions are made or imposed between ... two [controlled] enterprises ... which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

A major reason that OECD member countries (and other non-member countries) have adopted the arm’s length principle (which is an international tax standard) is that it provides “tax parity” between multinational members of a controlled group and independent enterprises.  US Treasury Regulations Section 1.482-1(b)(1) define the arm’s length standard for tax purpose:  “In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case [i.e., there is no exception] is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.  A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in [comparable transactions under comparable circumstances].”  For this purpose, comparable transactions and comparable circumstances are determined according to Section 1.482-1(d)(2)(Standard of comparability).  In this regard, controlled and controlled taxpayer are defined terms under Section 1.482-1(i) (Definitions), and include any kind of control, direct or indirect, whether legally enforceable or not, and however exercised.  Unfortunately, “arm’s length” is a colloquial expression.  One useful interpretation is that “arm’s length” is equivalent to a “comparability principle” with respect to products or services, functions performed, assets employed, risks assumed, contractual terms, geographic market, and profit potential.