When unrelated enterprises transact with one another, market forces generally determine the commercial terms of their transaction—e.g., price and conditions of transfer.  But where associated enterprises transact with one another, the terms of their dealing may not be directly determined by external market forces.  When transfer pricing (the pricing between or among the entities) does not reflect objective market forces, the tax liabilities of the enterprises may be distorted.

Over time, a generally (though not universally) accepted consensus has developed in the international tax community of a concept of an “arm’s-length” transaction—a hypothetical measuring stick against which to measure the pricing and terms used by the related parties.  Where the actual terms deviate significantly from the terms that would have transpired if the transaction had been an “arm’s-length” transaction, tax authorities generally have the authority to recast the transaction and use the “arm’s-length” pricing.

In the tax treaty context, the United States generally interprets the arm’s length standard in a manner consistent with the OECD Transfer Pricing Guidelines.  The arm’s-length principle is also reflected in U.S. domestic transfer pricing provisions, particularly Code section 482. It provides that when related enterprises engage in a transaction on terms that are not arm’s-length, the taxing authorities (including the IRS) may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them.

Article 9 of the OECD’s Model Tax Convention provides an authoritative statement of the arm’s length principle:

conditions are made or imposed between the two 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.

This principle effectively adjusts profits according to what they would have been between independent enterprises engaging in comparable transactions under comparable circumstances.  In other words, it treats members of a related multi-national enterprise group as operating as separate entities rather than part of a single unified business.

The arm’s length principle is considered by many to provide broad parity with respect to tax treatment, avoiding the creation of tax advantages or disadvantages that may otherwise distort transactions and allowing economic considerations to drive decisions.  Others have objected, however, where it inadequately accounts for certain considerations, such as economies of scale, the benefits of integrated businesses, or the fact that associated enterprises may (for non-tax reasons) engage in transactions that 0ther independent enterprises would not undertake.  The standard may reflect other shortcomings, such as imposing an undue administrative burden in some circumstances.

Nonetheless, the arm’s length standard generally has a fairly broad international consensus as a principle and standard against which to evaluate transfer pricing among associated enterprises.  Among its virtues, in many contexts it provides an approximation of relative pricing that would obtain on the open market.