Multinational corporations are supposed to treat their subsidiaries as if they are separated by an arm’s length. This is an arm’s length transaction, and tax authorities accept it because it is the result of a real negotiation. The gist of it is this: When two unrelated parties trade with each other, they’ll decide on a market price for the goods sold. The arm’s length principle states that two commonly controlled entities that are negotiating transfer pricing must operate as if they are independent companies, holding each other “ at arm’s length.” There are real numbers that define what “arm’s length” is it’s an international standard designed to allow governments to collect a fair share of taxes while multinationals avoid double taxation. What is the arm’s-length principle in transfer pricing? To try to prevent base erosion and profit shifting (BEPS) due to transfer pricing schemes, the Organization for Economic Co-operation and Development ( OECD) laid out “ the arm’s length principle” in Article 9 of the OECD Model Tax Convention. But even smaller businesses may use this practice - and they could get in trouble because of it. A recent significant court case between the IRS and Coca-Cola is a compelling example. Major multinationals, including Amazon and Microsoft, have courted conflict by using the practice to adjust income numbers, sometimes by as much as a billion dollars. The IRS focuses an eagle eye on transfer pricing, and the possibility of audits can make this practice a risky one. However, when the parties that negotiate a transaction are related, they may set an artificially lower price with the intention to minimize their taxes. Here’s why it’s attracting government scrutiny: In ordinary pricing, if two independent, unrelated parties negotiate with one another in a financial transaction and eventually reach a price, the transaction will reflect the correct market price. While the act of transfer pricing itself is not illegal, there are several restrictions on the practice that can vary widely between tax jurisdictions. It can be used both domestically and across borders when used internationally, it can take advantage of varying tax rates in different countries. The transfer pricing practice can cover not only goods and services but also intellectual property such as research, patents, and royalties. By using transfer pricing, companies can move tax liabilities to jurisdictions with low taxes to reduce corporate tax bills. This can provide tax savings for the larger enterprise, as the companies are able to divide earnings among subsidiaries and affiliates. Transfer pricing is an accounting practice in which a particular division or subsidiary of a company charges a second division or subsidiary of the same company for goods or services.
In fact, a global effort is underway to tighten the restrictions and increase the documentation requirements for this practice, adding a significant amount of work and responsibility to the task of the corporate tax professional. The practice is being increasingly regulated to ensure that profits are taxed at the place where value is created. Multinational corporations often use transfer pricing to allocate earnings among subsidiary and affiliate companies that are part of the parent organization.
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