Taxpayers must adapt to arm’s-length range’s varying local rules

Sowmya Varadharajan, Samuel Taieb

A diverse group of professionals engaged around a conference table, discuss how OECD member nations utilize the arm's-length principle for intragroup transaction pricing, addressing compliance challenges with local rules.

Originally published in Bloomberg Tax.

The arm’s-length principle presents challenges, but operational transfer pricing can help achieve compliance.

Organization for Economic Cooperation and Development member countries use the arm’s-length principle to determine pricing of intragroup transactions to ensure multinational enterprises and independent companies are treated equally for tax purposes.

To apply the arm’s-length principle, transfer pricing practitioners must identify and compare commercial and financial conditions of a controlled transaction to those that would have been made had the parties been independent and involved in a similar transaction under comparable circumstances.

In some cases, this comparability analysis will produce a single price or margin. However, given the unavailability of data on comparable uncontrolled transactions, most cases will involve a range of results, known as the arm’s-length range.

Application of the arm’s-length range might vary between different jurisdictions and practitioners. Taxpayers need to ensure awareness of local transfer pricing rules. These dissimilarities, and the potential adoption of Pillar One’s Amount B, impact transfer pricing policy and implementation.

Arm's-length range

When applying various transfer pricing methods, the interquartile range often is considered the international standard for establishing the arm’s-length range. Although most jurisdictions rely on the IQR, computation of the arm’s-length-range can vary due to differences in local transfer pricing rules and applications of the arm’s-length principle.

For example, the US computes quartiles in a slightly different manner from the standard statistical application, which uses the quartile function in spreadsheet software. Canada doesn’t use the IQR at all, instead relying on the full range of observations.

Some jurisdictions—such as Bangladesh, India, Malaysia, and Vietnam—apply other percentiles to measure central tendency and approximate their arm’s-length range.

For those jurisdictions, the arm’s-length range is narrower than the traditional IQR, which creates more risk for entities in these countries and less variability in the taxes paid locally. Those tax authorities might be able to propose more transfer pricing adjustments to increase the income and additional taxes to be paid in the local jurisdiction.

Transfer pricing adjustments typically will be targeted to the median. However, given the narrower range, there’s a higher likelihood a transfer pricing adjustment may be proposed, as it would be easier to fall below the range.

Because many countries establish more sophisticated transfer pricing rules designed to tackle tax avoidance, taxpayers must understand each jurisdiction’s requirements regarding construction of the arm’s-length range. This is important to ensure compliance with the arm’s-length principle, which can be burdensome and includes substantial documentation requirements.

Policy impact

The changing calculation of the arm’s-length range has started to create havoc for transfer pricing policy. With the narrowing of the arm’s-length range in certain jurisdictions, what might be considered arm’s length from one jurisdiction might no longer be so in another jurisdiction, leading to potential double taxation.

Consider a hypothetical example. USParentCo, a US-based manufacturer, sells finished products to MYSubCo, a subsidiary in Malaysia. MYSubCo’s principal activity is to distribute products purchased from USParentCo to customers in Malaysia. The transfer pricing analysis must determine the arm’s-length range of returns that MYSubCo should earn.

Based on a sample of Malaysian comparable companies, the IQR spans from 2% to 5%, with a median of 4%. The transfer pricing policy adopted is for MYSubCo to earn a 4% margin.

When the transfer pricing documentation is prepared, it’s noted that the actual operating margin earned by MYSubCo is 2.5%. Given that this result is within the IQR, no adjustment is required from a US transfer pricing perspective.

However, when the transfer pricing documentation is prepared for Malaysia, the arm’s-length range based on the 37.5th percentile is 3%. Given that this result is below the range, an upward adjustment is made to the Malaysian tax return to ensure the transaction is arm’s length from a local transfer pricing perspective. Double taxation will occur if a corresponding adjustment isn’t made to the US tax return.

Although tax return adjustments can be contemplated to mitigate potential double taxation, each jurisdiction has different timing for tax return submissions, and transfer pricing documentation should be prepared concurrently with submission of the tax return. Highlighting a transfer pricing adjustment in the tax return often is considered a red flag for inappropriate transfer pricing processes and might increase audit risk.

Operational transfer pricing

Tighter ranges will force taxpayers to make more frequent, and potentially larger, adjustments. If effectively employed, operational transfer pricing can help manage these differences in ranges across geographies and can mitigate transfer pricing adjustments.

Operational transfer pricing—an end-to-end process designed to implement, manage, and monitor transfer pricing policies within an organization—can aid compliance with the arm’s-length principle.

It ensures that intercompany transactions are consistently priced in accordance with their respective arm’s-length ranges. Operational transfer pricing can help with targeting arm’s-length results by:

Monitoring transfer pricing positions
Standardizing processes
Automating calculations
Facilitating integration with financial systems
Computing transfer pricing adjustments
Documenting arm’s-length outcomes
Collaborating with other departments in an organization
Modeling various scenarios for planning and decision-making purposes

Looking ahead

As some countries introduce more sophisticated transfer pricing rules and with possible adoption of Pillar One’s Amount B starting Jan. 1, 2025, taxpayers and practitioners must stay informed about these developments and their implications.

Taxpayers should also consider and model the impact these narrower arm’s-length ranges may have on their operating model, potentially through use of operational transfer pricing.

Contact us

Sowmya Varadharajan

Sowmya Varadharajan

Principal, Tax

+1 714 668 5374

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Samuel Taieb

Manager, Tax

+1 212 751 8157

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