In this article, Dipti Khatri pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses Arm’s length Principle in Transfer Pricing.


The definition of “arm’s length pricing” relates to pricing where the amount charged by one of the party is not related to each other for a given product. Therefore, the price is charged in accordance with the open market. It makes the price of the product comparable to the other price as if the parties are not related to each other. However, when pricing of intangibles, proprietary goods are to be done it generally becomes difficult to arrive at arm’s length transactions.

US transfer principle generally applies the best method rule for determining the price of a given transaction. The official definition given by United States is as follows:-

  1. Arm’s Length standard- In determining the taxable income, the arm’s length transaction is applied.  However, as arm’s length transactions are rarely located, as it is difficult to determine whether it is an arm length transaction. Therefore, best rule method is applied to determine the same.
  2. Different methods are applied to the arm’s length transactions. Therefore, it becomes important to calculate the most appropriate types such as loans, advances, rentals, services and property. For example, if certain methods are applied for the transactions it is considered to be appropriate to select the most relevant method.
  3. Relevance of Arm’s length transactions and the real estate

In the real estate business, arm’s length transactions generally play a pivotal role. While determining the fair market value in the real estate of the property, the price of the property is generally determined by the potential buyer and the seller operating by an arm’s length transactions. Otherwise generally there can be ambiguity where the people know each other. The actual price may differ from the market value. The simple logic is where the parties have equal bargaining power, generally the buyers and sellers have the power to under influence each other. The sellers would generally like to have low price and buyers would like to seek high price. Generally, it is important to determine the arm’s length transactions as it has a direct impact on the different transactions, stamp duty, or the other municipal or local taxes. This in turn also affects the taxation structure of the parent company, and affects the transfer pricing of all the transactions.

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Different arm’s length method

There are different arm’s length method which are available. The different methods are:-

  1. The comparable uncontrolled price method (CUP);
  2. The resale price method (RPM);
  3. The cost plus method (CPM);
  4. The profit split method (PSM); and
  5. The transactional net margin method (TNMM).

1 Comparable Uncontrolled Price Method (CUP)

CUP method generally compares the price charged and that of paid for different products of similar nature. Therefore, it is also required that the different accounts be adjusted so as to accrue from the International transaction. It is also required to take into account the price in the open market. The adjusted price is required to be as per the arm’s length price applicable to International transaction.

2 Resale Price Method (RPM)

The Resale Price method requires the product acquired from within the Associated Enterprises. This resale is generally reduced by the normal gross profit margin and incurred by the seller. The amount of gross profit margin has to be taken into consideration.

3 Cost Plus Method (CPM)

Cost Plus Method, helps in discovering the transferred or services by an associated enterprise. The amount should be determined as comparable uncontrolled transactions. The costs are therefore to be increased by the adjusted profit mark-up, which are to be taken as per the arm’s length property.

4 Profit Split Method (PSM)

Profit Split Method has to be described as per unique tangibles and inter-related multiple transactions. It is also required to be separately evaluated. For further applying the method, the combined net transaction is required. The relative contribution has to be considered taking into account the functions performed, assets employed and the risks which are resumed. The relative contribution has to be employed in similar circumstances.

5 Transactional Net Margin Method (TNMM)

This method is applied to net profit margin from an International transaction which is applied for incurred sales, assets employed etc. Also, the net profit margin is to be applied through incurred sales, assets employed etc. The net profit is to be realized as per the adjustment margin:-

  • The uncontrolled transactions and International Transaction; or
  • The enterprises should enter into transactions, which should materially affect the opposite transactions and the open market net profit margin.

Optional remedies advance pricing agreements (APA)

An Advance pricing agreements are between the taxpayer and BIR to consider an appropriate set and determine the transfer prices for a fixed period of time. Where transfer pricing document is required to include the following:-

  1. Organizational structure;
  2. Different industry/ business and market conditions;
  3. Different cost contribution arrangements;
  4. Application of the different transfer pricing methods;
  5. Different comparable, risk and functional analyses;
  6. Index to documents.

Further, it is recommended that the transfer pricing should be contemptuous or it may raise transfer pricing review when they are preparing tax reviews. Generally, the failure to conduct transfer pricing leads to penalty. Moreover, in the case of certain deficiencies, surcharges are also to apply.

  1. OECD transfer pricing guidelines

The transfer pricing guidelines become important when associated enterprises are involved in the cross border transactions. To deal with the taxing requirement, MNE group’s income becomes relevant. Also, due to the increase in International Commerce an active interest in transfer pricing has become relevant as it generally helps to protect the general taxes which are enforced by the transfer pricing guidelines. The OECD principle is generally applied for establishing the intercompany prices i.e. to determine how the price allocation and transfer should be done while dealing with the arm’s length transactions with the unrelated parties. This also forms the important part of the OECD pricing guidelines and helps in allocating and enforcing the pricing legislation and enforcing in virtually every countries.

However, generally critics have argued that the rules relating to arm’s length transactions are usually manipulated towards the lower- tax jurisdictions for financial advantages. Developing countries generally express the concern relating the economic activities in those jurisdictions. Others critics have generally argued that the new approaches relating the arm’s length standard require further new approaches for the corporate tax pie among different countries. It helps in creating simpler rules, and also helps in protecting the local taxes more effectively and at the lower cost. It also becomes important in the globalizing world, to follow a particular standard in determining the different prices. Therefore, it becomes important for the country to follow a globalizing economy and also follow a consistent standard of transfer pricing. This also has the power of inhibiting the best standard in the transfer pricing. Also, proliferation of different taxing statute can lead to various transfers pricing which could easily lead to double non-taxation i.e. where corporate income can be furthered sheltered to individual country rules. Also, it has been in view that the arm’s length transactions provides the most effective and global approach to transfer pricing.

Need for improvement in the transfer pricing

  • Rules which are regarding the difficult transfer pricing needs to be regularly updated and clarified.
  • Different ways are to be formed to simplify the existing transfer pricing practices and to limit the administrative burdens.
  • Transfer pricing guidelines should continuously improve to achieve certain outcomes and get relieved from the double taxation system. It is also focused on different on different objectives. Therefore, pursuing the objective and developing the best of clearer rules becomes important for most of the transfer pricing guidelines. OECD has also recently published the guidelines on the pricing of intangible assets.

This discussion draft generally addresses the definition of intangibles, the manner in which the MNE arm length prices are to be determined and interest of both the parties in the intangibles. It also states separate income from the taxpayers, assets and risk involved.

The other discussion draft that has been initiated is relating to the revised guidance on the transfer pricing safe harbours. It emphasizes on how to resolve lower risk cases and limit administrative burdens. It also focuses upon the bilateral safe harbours and simultaneously protects the tax bases. Further work focuses upon the simplification project, assess transfer risk and deals with the pricing risk and heavy compliance for the taxpayers.

OECD also believes that the transfer pricing issues can be streamlined and become more effective. Success will require the active involvement of both the parties OECD members, taxpayers, development organizations and different interested groups.

The goals of the OECD are as follows

  1. To neutralize the mismatches;
  2. Improve or clarify the different pricing rules and address the current rules which in recent scenario provides undesirable results;
  3. Update solutions to the questions of tax jurisdictions in relation to the digital goods and services.
  4. Provide more effective anti-avoidance measures in domestic rules and anti-avoidance guidelines;
  5. Draft rules on the working of intra group finance transaction, include deductibility and withhold taxes;
  6. Propose better solutions to the harmful regimes more effectively, taking to the best of the account transparency and substance.


  1. Joseph Andrus, Transfer Pricing and the Arm’s length principle
  2. Transfer Pricing Guidelines, IRAS e- tax guide
  3. Arm’s length standard
  4. Saurabh Malhothra, Transfer Pricing: Arm’s Length And Alternative Methods



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