Introduction
The arm’s length principle (ALP) is the backbone of transfer pricing regulations. It ensures that transactions between associated enterprises reflect the pricing that would be agreed upon by independent entities under comparable circumstances.
What is the Arm’s Length Principle?
ALP requires that related parties price their intercompany transactions as if they were unrelated. This ensures that profits are taxed where the actual economic activities occur.
Application of ALP
The application of ALP involves:
Identifying the controlled transaction
Conducting a functional and risk analysis
Selecting the most appropriate transfer pricing method
Performing comparability analysis
Transfer Pricing Methods Under OECD
Comparable Uncontrolled Price (CUP) Method
Resale Price Method (RPM)
Cost Plus Method (CPM)
Transactional Net Margin Method (TNMM)
Profit Split Method (PSM)
Challenges in Applying ALP
Finding appropriate comparables
Adjusting for differences in economic circumstances
Handling unique intangibles
Valuing services and financing transactions
Recent OECD Updates
Increased emphasis on economic substance
DEMPE analysis for intangibles
Application of ALP in hard-to-value intangibles and financial transactions
Conclusion
Applying the arm’s length principle correctly is crucial for managing transfer pricing risks. With increasing scrutiny from tax authorities, MNEs must ensure robust documentation and justification of their intercompany pricing.
