Transfer Pricing is more commonly defined as the transaction between related parties (i.e. another member of the same organisation) for the acquisition of goods, services or intangible properties. The transfer pricing allocated profits between the same members of the organisation.
From a taxation perspective, transfer pricing is extremely important and relevant. Transfer pricing could potentially lead to a distortion of profits allocated between the related parties, whereby it consequently could result companies not remitting their fair share of taxes in one or more tax jurisdiction. Thus, enjoying the tax advantage.
The arm’s length principle is a leading principle that explores and pursues to eliminate the factors that would affect the transfer price between two related parties. The concept of the arm’s length principle was defined by the Article 9 of the OECD Model Tax Convention. The Article 9(1) provides:
“[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
The rationale of arm’s length principle is where most transactions, prices and conditions applied by the related parties should be determined by the market forces, regardless of the transactions occurred. This similar applies to the conditions of inter-company transactions as well (i.e. terms and conditions of the payments, delivery, etc.)