Transfer pricing has grown dramatically from a specialized niche practice in the 1980s to what is commonly viewed as the most important area of tax risk at the present time.  As transfer pricing has grown in importance, the definition of the key principle governing transfer pricing — the arm’s length standard — has evolved as well.  As will be discussed, the arm’s length standard started with the simple premise that the prices charged in a transaction between two controlled parties should be set at the same levels as the prices that were charged in a comparable transaction between two unrelated parties.  However, this simple premise has been difficult to implement, in part because of data limitations and in part because of tax authority concerns over whether or not the application of the arm’s length standard leads to appropriate tax outcomes (e.g., that it does not lead to outcomes in which income is never subject to tax).  Some of the key steps in the evolution of the arm’s length standard have been:

1)     The adoption of profit-based methods, and in particular the CPM/TNMM;

2)     The growing emphasis on the need to consider “reasonable alternatives”;

3)     The treatment of synergies among group companies; and

4)     The focus on decision-making and control by the employees of the local entity.

As will be discussed in this series of blogs, the cumulative effect of these changes has been to shift the definition of what is or is not arm’s length from the simple question of whether the prices charged in a controlled transaction are the same as those that are charged in a “comparable” uncontrolled transaction to the more complex questions of (i) is the behavior and decision-making of the parties to the transaction consistent with that which would be expected at arm’s length and (ii) do each of the legal entities that are parties to the transaction have attributes that are consistent with those that would be found in uncontrolled entities participating in the same types of transactions?

Blog Posts in this Series:

Evolution of the Arm’s Length Standard: Introduction

Evolution of the Arm’s Length Standard: Part 2 – Entering a Market Through Sales v Investment

Evolution of the Arm’s Length Standard: Part 3 – The Introduction of Profit-Based Methods

Evolution of the Arm’s Length Standard: Part 4 – Reasonable Alternatives

Evolution of the Arm’s Length Standard: Part 5 – An Increasing Focus on the Location of Decision-Makers


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