How can you determine the arm's length price of a transaction?

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If you are involved in cross-border transactions with related parties, such as subsidiaries, affiliates, or parent companies, you need to comply with the transfer pricing rules of the relevant jurisdictions. Transfer pricing is the process of setting the price of goods, services, intangibles, or loans exchanged between related parties. The arm's length principle is the international standard for transfer pricing, which requires that the price of a transaction between related parties should be the same as the price of a comparable transaction between independent parties. But how can you determine the arm's length price of a transaction? In this article, we will explain the main steps and methods for transfer pricing valuation and benchmarking.

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1 Identify the transaction

The first step is to identify the transaction that you want to price and the related parties involved. You need to collect and document relevant information about the transaction, such as the nature, terms, conditions, and volume of the goods, services, intangibles, or loans exchanged. You also need to identify the functions performed, assets used, and risks assumed by each related party in the transaction. This will help you to determine the appropriate transfer pricing method and the comparability criteria for benchmarking.

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Linda Geter

Salesperson | Bachelor's in Finance, CRM, Communication
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Analyze similar transactions between unrelated parties in similar situations to ascertain the arm's length pricing of a given transaction. Make use of techniques like cost plus, resale price, and similar uncontrolled pricing. Examine functional and risk profiles while taking the state of the economy and the used assets into account. In order to ensure accuracy and compliance with transfer pricing requirements, adjust comparables to coincide with the regulated transaction.

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2 Select the transfer pricing method

The second step is to select the most appropriate transfer pricing method to determine the arm's length price of the transaction. There are five main methods recognized by the OECD and most tax authorities: the comparable uncontrolled price (CUP) method, the resale price method, the cost plus method, the transactional net margin method (TNMM), and the transactional profit split method. Each method has its own advantages and disadvantages, depending on the availability and reliability of comparable data, the nature and complexity of the transaction, and the degree of functional similarity between the related and independent parties.

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3 Search for comparable transactions

The third step is to search for comparable transactions between independent parties that can be used as benchmarks for the arm's length price of the transaction. You can use internal or external sources of data, such as databases, market reports, contracts, or invoices. You need to apply the comparability criteria, such as the characteristics of the goods, services, intangibles, or loans, the functions, assets, and risks of the parties, the contractual terms and conditions, the economic circumstances, and the business strategies. You need to select the most relevant and reliable comparables and adjust them for any material differences with the transaction.

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Daniel Medvedovsky

Transfer Pricing Senior Associate - BaseFirma
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For establishing arm's length prices, it's essential to: 1. Know the legislation: country regulations may impact the choice of methods, years considered, and result calculations. 2. Know your transaction: Understanding the functions, assets, and risks of the transaction is crucial for determining the best method. 3. Know your tools: Use specialized databases and familiarize yourself with their manuals to maximize potential and avoid errors. 4. Read thoroughly: Don't rely solely on vendor descriptions. Investigate in-depth, access company websites, contracts, and review annual reports. 5. Document the process: Record each step so it can be replicated and understood by others, facilitating validation by tax authorities.

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4 Calculate the arm's length price

The fourth step is to calculate the arm's length price of the transaction based on the selected transfer pricing method and the comparable transactions. You need to apply the appropriate profit level indicator (PLI), such as the gross margin, the mark-up, the net margin, or the return on assets, to measure the profitability of the transaction. You need to calculate the range of arm's length prices or margins from the comparables and determine the point within the range that reflects the arm's length outcome of the transaction.

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5 Document and report the transfer pricing

The final step is to document and report the transfer pricing of the transaction to the relevant tax authorities. You need to prepare a transfer pricing documentation that explains and supports the transfer pricing method, the comparability analysis, the arm's length price calculation, and the allocation of profits or losses among the related parties. You also need to comply with the reporting requirements of the jurisdictions where the related parties operate, such as filing the annual tax returns, the country-by-country reports, or the master and local files.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you determine the arm's length price of a transaction?

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1 Identify the transaction

2 Select the transfer pricing method

3 Search for comparable transactions

4 Calculate the arm's length price

5 Document and report the transfer pricing

6 Here’s what else to consider

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