An Initial Look Into Transfer Prices and Arm's Length Doctrine
Background & Arm's Length
Transfer pricing happens when two relevant companies, that occupy a similar market, trade with each other. When a US-based subsidiary of Company A decides to purchase something from its UK-based subsidiary and the two entities agree on a cost for the deal, transfer rates takes place. In essence rates between two associated companies should be constant with pricing either entity would charge a third party.
Limitation of Arm's Length
Since transfer rates occurs between two associated companies there is capacity for price distortion to happen. 2 business may wish to misshape or control the rate of the deal that struck decrease general tax liability if one or both of the business undergoes a significant corporate tax. Price distortion is specifically attractive in 'tax sanctuaries' or countries with low or no business tax rates and collection agency merchant account. Transfer rates has actually been under the microscope over the last few years for this reason.
In theory, the 'arm's length' strategy is expected to stop misuse by making sure that deals in between related companies are treated as if the two entities are not relevant and priced appropriately. Picture, for a moment, that two associated companies are trading a tiny component for an MRI machine that is just made for that certain machine and is not manufactured by any other company.
Hardly any market contrast would exist for this transaction, so the appropriate cost is not obvious. The issue with this is two-fold. This circumstance might provide leeway for abuse because without any market contrast the business might merely set their own cost. It might also develop unnecessary problem on companies that are obedient and follow 'arm's length' however are lacking a market-based guideline. Presently, 'arm's length' is a preferred technique to figuring out transfer rates; however in this case it is problematic. Possibly other ways of identifying transfer costs have to be developed and executed.