Arm’s Length Principle – The Challenging Controversial Approach

The determination of price for transferring goods, services, and assets beyond the national borders of a parent company, known as transfer pricing, remains a controversial challenge.
Along with increasing globalization, international transactions between related parties (between parent company and their affiliates or between affiliates) are playing an increasingly significant role in world trade and economy. As multinational enterprises are said to account for about 60% of world trade, transfer pricing has become the number one issue in the international tax arena (Ping and Silberztein 36).
There are several different methods utilized to determine transfer pricing. There are strong opinions on the most accurate method to document and report transfer pricing. The most preferred is the arm’s length principle, stating, “it should reflect the prices that would have been set, had those transactions taken place among independent entities” (Houston and Gracon 12). In this paper, I will discuss the difficulty in comparable pricing, the differences of direct tax and customs rules, and firms costly transfer pricing documentation that are all controversial challenges with the arm’s length principle.
The Arm’s length principle, most preferred for many years, lacks the ability for a firm to acquire accurate comparable pricing.
As Gareth Green, director of Transfer Pricing Solutions in the UK says: ‘Often the only real comparisons are commercially proprietorial transactions, which competing companies will do their utmost not to disclose. So, often a company will simply use its own transactions with third parties, or a database of the financial results of third-party companies, which are sold commercially (Armstrong 48).
There is great difficulty in determining an accurate comparable transfer price to report in the transfer price documentation when there are material differences between them. Making reasonable variations to reduce the effects of differences leaves room for tax evasion as well as potential misrepresentation of financial success.
The OECD conducted several years of research on comparability issues and stated in the guidelines released in July 2010 that “taxpayer’s can show that an agreement is arm’s length by either 1.) showing that there are comparable third-party arrangements with a similar allocation of risk, or 2) demonstrating that, while not seen in a third party arrangement per se, the allocation of risk is in fact on that could be expected among independent parties.” The most important outcome of this work is a strong reaffirmation that the pricing of transactions among associated enterprises should be based on the arm’s length principle (Houston and Gracon 13).
The arbitrary differences of transaction versus bottom line approaches lead to very different results in transfer pricing causing a controversial challenge for the OECD guidelines.
There are some common purposes between international transfer pricing and custom valuation rules; there are variances that cause costly and complicated international trading. Customs assess the value of a product or import transaction at the time of importation allowing the accurate collection of duties.
The transaction value of the imported goods is not acceptable; customs determines the customs value by applying, in hierarchal order, one of the following alternate valuation methods: transaction value of identical or similar goods, deductive value, computed value and fall-back method. Enforced by revenue authorities, transfer pricing is grounded in Article 9 of the OECD which establishes the arm’s length principle (Ping and Silberztein 37).
The information provided to the revenue authorities is on a yearly basis. The revenue and customs authorities do not have to accept the value of the other resulting in a lack of standards for firm compliance. The customs authority will want to ensure that the product or transaction is not undervalued ensuring collection of maximum duties. Whereas, the revenue authorities will question the valuation to ensure there was not an over estimation in deduction for the firm. The customs and revenue authorities have a similar approach comparing a value of a transaction or arm’s length principle but this approach presents a conflict of interest. The conflict of interest in the valuation of transaction provides a question of credibility in the arm’s length principal for transfer pricing and custom valuation resulting in the arm’s length principal having another challenging controversial issue.
In a survey of seventy-seven foreign owned companies in New Zealand, the results indicated that the highest external factor considered when selecting a transfer price method was compliance of tax laws and regulations. This survey is an example of why companies spend a large amount of resource and cost to document their transfer pricing method for compliance with tax laws and regulations. There are countries that require specific documentation packages for transfer pricing compliance.
Transfer pricing documentation typically covers, quite extensively, the economic context (industry and taxpayer’s), a description of the controlled transaction (terms and conditions), an explanation of the choice and application of the transfer pricing method, the comparability analysis (including data on uncontrolled transactions that are used as comparable) (Ping and Silberztein 37).
The revenue authorities have access to this information through tax audits and the custom authorities do not have to use the transfer pricing documentation prepared for revenue authority audits but have requirements dependent on the country. The arm’s length principal introduces a controversial challenge because the OECD’s guideline most important of factors is to demonstrate a transaction is arm’s-length.
In conclusion, the arm’s length principle utilized as well as analyzed as a preferred method for many years causing a great length of discussion on the most accurate way to report transfer pricing. The majority of opinions argue the arm’s length principle is subjective and raises the question of credibility. However, the OECD guidelines establish the arm’s length principle that requires a comparison of controlled transaction conditions with those transactions that are uncontrollable. Arm’s length is here to stay. As Dodge says, it ‘has proven to be rigorous over a number of decades, during which people predicted its imminent demise’ (Armstrong 48). This difference in opinion makes the arm’s length principle a very challenging controversial approach.

Works Cited

Armstrong, Paul. "'Transfer Pricing' http://www.tpsolutions.co.uk/TaxBiz10%20p42-48%20TP.pdf." Tax Business. November/December 2005. PDF. 23 June 2012.
Houston, David and Tamara Gracon. "’Transfer-Pricing-for-High-Tech-Companies’ http://www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/Pages/Transfer-Pricing-Topics-for-High-Tech-Companies.aspx." 14 March 2011. www.kpmg.com. Document. 23 June 2012.
Ping, Liu and Caroline Silberztein. "Transfer Pricing, Customs Duties and VAT Rules: Can We Bridge the Gap?" WCR 2010: 36