Transfer pricing: what "arm's length" means in practice

When two companies under common ownership trade with each other, the price they set is a choice, not a market result. Tax authorities therefore ask a simple question: would independent parties have agreed the same terms? That is the arm's length principle, and it is the foundation of transfer pricing.

Where it applies

Transfer pricing is not only a concern for large multinationals. Any business with related parties, whether a foreign parent, a sister company or a connected supplier, has related-party transactions. Typical examples are:

• Management fees and shared service charges
• Loans between group companies, and the interest charged on them
• Royalties and licence fees for brands or technology
• Purchases of goods from, or sales to, related companies
• Guarantees and other financial support

What good documentation looks like

Documentation is how you show that a price was reasoned rather than assumed. A sound file usually contains:

• A transfer pricing policy that states which method applies to each type of transaction and why.
• A functional analysis: who does what, which assets each party uses, and which risks each party carries. Returns should follow the functions and risks.
• A comparability analysis: evidence of what independent parties charge in similar circumstances, such as benchmarking against comparable companies or transactions.
• Written agreements that match how the parties actually behave. A contract that says one thing while the business does another weakens the whole position.

Where businesses commonly go wrong

• Management fees charged with no evidence that a service was provided or that it benefited the payer.
• Intercompany loans at rates with no reference to what a lender would charge an independent borrower.
• A policy that exists on paper but is not followed in practice.
• Documentation prepared only after an enquiry begins, rather than at the time the transactions took place.

A practical starting point

First, list every related-party transaction and its value. Second, decide on a policy for each category and write down the reasoning. Third, put the supporting analysis on file while the transactions are current. Finally, review it every year, because the facts, and the benchmarks, change.

This article is general information, not tax advice. Transfer pricing rules and documentation requirements change, so confirm what applies to your business.