Background

Transactions between related parties account for a large share of world trade. ¹ Members of a multinational group engage in a wide range of intercompany activities, including the transfer of tangible goods, provision of services, extension of loans, licensing of intangibles, and rental of property between related entities. ^{2 3} The pricing—or more broadly, the consideration—applied to these transactions is a matter of concern for society and governing bodies, as it directly affects the allocation of profits and, consequently, the tax base among countries.⁴ Transfer pricing is the domain dedicated to determining these prices in compliance with regulatory standards and economic principles.

By the early nineteenth century, transfer pricing and other aspects of international taxation were already recognized as significant issues requiring resolution. As international trade expanded, principles needed to be established to prevent disputes over the same tax base, alleviate the burden of double taxation for multinationals, and address unrealized taxing rights caused by double non-taxation. In the 1920s, the League of Nations—the first global intergovernmental organization—developed core principles that now form the foundation of the modern international tax regime. Since then, the arm’s length standard has remained the dominant method for determining intercompany prices.

Although the arm’s length standard has long been embodied in tax treaties, clarifying provisions enacted by governing bodies into local tax laws and detailed guidance on its application only began to emerge in the 1960s. Over time, tax authorities introduced more extensive regulations and rules and moved toward much stricter enforcement.⁵ These transfer pricing rules⁶ almost universally follow the arm’s length standard and are largely based on the practical guidelines issued by the Organization for Economic Cooperation and Development (OECD).⁷

The arm’s length standard states that the allocation of income between related entities within a multinational group should mirror how the income would have been divided if the entities were separate and operating as unrelated parties at arm’s length. Compared to other income allocation methods—such as formula-based apportionment used in intra-national contexts between U.S. states or Canadian provinces—the arm’s length standard provides a theoretical framework that allows for far greater interpretation.⁸ In our view, the quote that best captures the essence of the arm’s length standard is:

“In spite of general agreement on the arm’s length standard, there is often disagreement on how to apply it and what constitutes arm’s length in individual cases.” —Robert T. Cole

Preparing an interest rate analysis for an intercompany loan provides a useful example. While the general approach under the arm’s length standard is widely accepted, differences often arise in how tax examiners across tax jurisdictions review the analysis or interpret specific aspects of it. ⁹ According to the arm’s length standard, the interest rate should align with what independent parties would negotiate in free capital markets. However, some tax authorities may prioritize different methodologies. For instance, examiners in one jurisdiction might prefer an analysis based on potentially comparable loans, while others may argue that such loans rarely meet comparability standards, favoring instead an approach based on adjusted bond yields to determine the arm’s length interest rate.

Similarly, jurisdictions may diverge in evaluating specific parts of the analysis. One jurisdiction might favor a borrower-centric approach to determining a subsidiary’s credit rating, whereas another might argue that a lender-centric perspective is more accurate. Even when jurisdictions agree on the general approach, disagreements can arise over the choice of financial models, the parameters used, and how industry, circumstances, or other individual factors are accounted for in the analysis.

A transfer pricing professional evaluates the options available for conducting an analysis. These options are derived from knowledge of transfer pricing rules, insights gained from prior disputes in case law, and assessments of rulings issued by tax authorities regarding the application of rules in specific contexts. The choice of method and its execution are then weighed against practical experience with certain approaches, the feasibility of using the available data, the materiality of the transaction, and the time and resources at hand—all to assess the robustness of the analysis and its likelihood of withstanding scrutiny in a tax audit.

The output of knowledge work in transfer pricing is inherently case-dependent. Data, analyses, and deliverables must be tailored extensively to achieve the highest level of defensibility, taking into account the jurisdictional environment, specific circumstances, and available resources. The quality of a company’s policies, documentation, and implementation is crucial. A case-specific deliverable, prepared by a knowledge worker with deep expertise, offers the most optimized compliance outcome by minimizing the risk of price adjustments, double taxation, and penalties.

This is largely why knowledge work in the transfer pricing domain continues to rely heavily on standard word processing and spreadsheet software. One-size-fits-all digital solutions represent a small portion of the market because they fall short of delivering the level of tailored output required to meet quality expectations. However, other industries have demonstrated how customizable software can successfully enhance knowledge work. In recent years, significant advancements have been made in the availability of tool stacks, the feasibility of composable architectures, and methods for building, running, and maintaining software. We believe transfer pricing is now primed for the next stage of technological evolution.

Footnotes

1. The terms parties, entities, and members are used interchangeably throughout this document. ↩

2. Cost sharing arrangements are also considered as a form of intercompany transaction. ↩

3. The terms intra-group and intra-company are also frequently used. ↩

4. The terms country and tax jurisdiction are used interchangeably throughout this document. ↩

5. Tax authorities are also commonly referred to as tax administrations or tax agencies. ↩

6. The term transfer pricing rules is used throughout this document to collectively refer to transfer pricing laws, regulations, guidance, and other related provisions. ↩

7. Since 1979, the OECD has developed practical guidance for the implementation of the arm’s length standard. Updated versions of this guidance were published in 1995, 2010, 2017, and most recently, in 2022 (accessible at doi.org/10.1787/0e655865-en) ↩

8. There are compelling reasons not to apply formulary apportionment in an international setting. ↩

9. For this example, assume no safe harbor interest rates apply. ↩