Transfer Pricing: What is an Arm’s Length Transaction?

If your company has multiple entities that buy and sell from one another, it’s particularly important for you to assess your transfer pricing program as part of your international tax planning strategy. Countries generally require transactions between related parties to meet an arm’s length transaction standard, which means the price is comparable to what it would have been if the parties weren’t related.

When comparing pricing for a transaction to similar transactions between unrelated parties, you must consider all applicable conditions, including the geographic market, related warranties and other terms of sale. Because comparable transactions can be difficult to find, particularly for intellectual property or other intangible goods, the resulting arm’s-length standard often is a range of prices, rather than a specific price.

There are several methods to test whether prices meet an arm’s-length standard. The United States and the Organisation for Economic Co-operation and Development, a Paris-based organization of 34 countries that issues global transfer pricing guidelines, require companies to use the method that produces the most reliable results. This means that companies may have to use more than one test to determine the correct pricing. In addition to transactional methods, companies can use profitability methods, which base appropriate pricing on the profit levels of similar companies in similar industries.

A growing number of countries, including the United States, China, India and Italy, require companies to prepare transfer pricing studies that show the basis behind their pricing. And after manufacturers prepare their studies, they need to stick to them — tax authorities will penalize companies whose actual pricing for transactions differs substantially from the pricing included in their studies.

For more information on transfer pricing services and arm’s length transactions, contact our international tax accountants in Michigan, Houston and Ft. Lauderdale.