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

U.S. companies with a multinational presence often exchange goods, services, and property with related parties in foreign countries. Business leaders should be aware that tax authorities regulate how companies price these intercompany transactions. The United States relies on the principle of the “arm’s length standard” to determine whether a transaction between related parties is priced fairly. 

What is an Arm’s Length Transaction? 

An arm’s length transaction is a transfer of goods, services, or property conducted in a way and at a price that you’d expect independent, unrelated parties to do business.  

The arm’s length principle underpins international tax law in most countries, including the United States. U.S. transfer pricing regulations require that domestic companies exchange goods, services, and assets with their foreign subsidiaries as if the entities involved were completely unrelated. 

Why? The United States wants to ensure that U.S. entities with global operations aren’t trying to lower their U.S. tax liability by purposely overpaying their subsidiaries in lower-taxed countries. 

For example, a number of high-profile companies have made the news in recent years for limiting their U.S. burden by putting their valuable intellectual property in the hands of related companies in low-taxed countries, requiring royalty payments from related companies in high-taxed jurisdictions. The effect is high profits in low-taxed countries and low profits in high-taxed countries. 

Example: Arm’s Length Transaction 

USCO is a U.S.-based corporation that manufactures raw pulp for paper. It has customers all over the world, including FORCO, an unrelated corporation in Cyprus that creates finished paper out of USCO’s pulp. FORCO pays $100 per package of USCO pulp. 

USCO is considering opening a foreign branch in Cyprus that would process USCO’s raw pulp and sell finished paper in the European market. How much should USCO charge its Cyprus branch for its raw material? 

According to the arm’s length standard, USCO would charge its foreign branch the same as FORCO, $100 per package. Charging less could imply that USCO is trying to keep its U.S. profits artificially low. 

Regulatory Definition of an Arm’s Length Transaction 

According to regulations issued by the IRS and the U.S. Treasury Department, an intercompany transaction meets the arm’s length standard when the transaction’s results “are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.” 

If the IRS determines that a U.S. company’s transfer pricing practices don’t comply with regulations, it may adjust the company’s taxable income to align with the regulations and assess penalties. 

Pricing an Arm’s Length Transaction 

The arm’s length standard tells us that an intercompany transaction is at arm’s length when unrelated parties would’ve made the same deal. Given this guidance, it would appear simple to price intercompany transactions. 

Ideally, you’d determine an arm’s length transfer price by pointing to a virtually identical transaction between unrelated parties. Unfortunately, finding substantially similar transactions isn’t always easy; cross-border intercompany transactions are often complex, so each transaction’s facts and circumstances are unique.  

So, when the IRS evaluates whether a transaction is at arm’s length, it looks at comparable transactions under comparable circumstances, adjusting for the unique aspects of your company’s transactions.  

The IRS and Treasury provide several methods to ensure that your company’s intercompany transactions are at arm’s length, including: 

• Comparable Uncontrolled Price (CUP) 

• Resale Price 

• Cost Plus 

• Comparable Profits 

• Profit Split 

• Unspecified  

The CUP method generally produces the most reliable results, but it’s challenging to apply practically given the high degree of comparability required between the related and unrelated party transactions under assessment. 

Companies are ultimately free to choose the method that creates the “most reliable measure of an arm’s length result,” according to the regulations.  However, in practice, even when other methods may produce more reliable results and thus be preferred based on the specific facts and circumstances, the IRS often exhibits a bias towards methods that consider overall profit margin in the assessment of a transaction or set of transaction’s arm’s length position.  

This entity-level view towards profitability is generally achieved by comparing the taxpayer’s results under one or more profit-level indicators (PLIs) as defined in the comparable profits method (CPM). Some facts about the CPM: 

• The most common PLI is the ratio of operating profit to sales. This ratio allows companies to bundle the assessment of many related party transactions together. 

• A taxpayer’s business activities and the nature of its related party transactions, among other factors, drive the most appropriate PLIs to use for an arm’s length assessment under the CPM.  

Like many other aspects of transfer pricing, choosing the best method is easier said than done. International transfer pricing experts are trained to analyze the intricate details of intercompany transactions, compare the results of several transfer pricing methods, and select the method that creates the most reliable arm’s length result. 

Smith + Howard: Transfer Pricing Advisors within Arm’s Length 

International tax is perhaps the most complicated area of tax law. Clients with complex transfer pricing matters turn to Smith + Howard’s Specialty Tax Services team to ensure compliance with domestic and foreign regulations and extensive documentation requirements. 

Learn more about our transfer pricing services by contacting the Smith + Howard Specialty Tax Services team.