Background & Arm’s Length

by

Transfer pricing happens when two related companies, that occupy a similar industry, trade with each other. When a US-based subsidiary of Company A decides to buy something from its UK-based subsidiary and the two entities agree on a price for the transaction, transfer pricing occurs. A principle comparable to transfer pricing is the “arm’s length” doctrine. The arm’s length doctrine states that the amount charged between two related parties for a given transaction must be the same as if the parties were not actually related. In essence pricing between two related companies must be consistent with pricing either entity would charge a third party. The doctrine also states that two companies must act as though they are negotiating in a normal market since the market would provide a guideline for the ‘fair’ price of a particular transaction.

Limitation of Arm’s Length

Since transfer pricing occurs between two related companies there is potential for price distortion to occur. Two companies may wish to distort or manipulate the price of the transaction that occurred to minimize overall tax liability if one or both of the companies is subject to a substantial corporate tax. Price distortion is especially appealing in ‘tax havens’ or countries with low or zero corporate tax rates. Transfer pricing has been under the microscope in recent years for this reason.

Government appointed agencies work to ensure that companies are not abusing it to avoid taxation. In theory, the ‘arm’s length’ approach is supposed to stop misuse by ensuring that transactions between related companies are treated as if the two entities are not related and priced accordingly. However, in practice, implementing ‘arm’s length’ proves to be bothersome if not impossible for highly specialized companies. Imagine, for a moment, that two related companies are trading a tiny component for an MRI machine that is only made for that particular machine and is not manufactured by any other company.

Hardly any market comparison would exist for this transaction, so the appropriate price is not obvious. The problem with this is two-fold. This situation could provide leeway for abuse because with no market comparison the companies could simply set their own price. It could also create undue burden on companies that are law-abiding and follow ‘arm’s length’ but are lacking a market-based guideline. Currently, ‘arm’s length’ is a favored approach to determining transfer prices; however in this case it is problematic. Perhaps other ways of determining transfer prices need to be developed and implemented.

649 thoughts on “Background & Arm’s Length”

  541. It’s really a cool and helpful piece of information. I’m glad that you shared this helpful information with us. Please keep us up to date like this. Thanks for sharing.

  576. After I originally commented I clicked the -Notify me when new comments are added- checkbox and now every time a comment is added I get 4 emails with the same comment. Is there any method you can remove me from that service? Thanks!

  579. Today, I went to the beach front with my kids. I found a sea shell and gave it to my 4 year old daughter and said “You can hear the ocean if you put this to your ear.” She placed the shell to her ear and screamed. There was a hermit crab inside and it pinched her ear. She never wants to go back! LoL I know this is totally off topic but I had to tell someone!

  612. I think this is among the most important information for me. And i’m glad reading your article. But want to remark on some general things, The web site style is perfect, the articles is really nice : D. Good job, cheers

  621. After study a few of the blog posts on your website now, and I truly like your way of blogging. I bookmarked it to my bookmark website list and will be checking back soon. Pls check out my web site as well and let me know what you think.

Leave a Comment

Copyright © 2024Â