transactions between related parties
A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an inter-company transaction. Although inter-company transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for preparation of individual tax returns each entity (or a tax consolidation unit of more than one entity in the group in one and the same tax jurisdiction) prepares stand-alone (or a tax consolidation unit) tax returns.
Transfer prices directly affect the allocation of group-wide taxable income across national tax jurisdictions. Hence, a group’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.
Arm’s length transaction principle
Most OECD countries rely upon the OECD TP Guidelines for Multinational Enterprises and Tax Administrations, that were originally released in 1995 and subsequently updated in 2017 (OECD TP Guidelines). The OECD TP Guidelines reaffirmed the OECD’s commitment to the arm’s length transaction principle.
In fact, the arm’s length transaction principle is considered “the closest approximation of the workings of the open market in cases where goods and services are transferred between associated enterprises.” The arm’s length principle implies that transfer prices between related parties should be set as though the entities were operating at arm’s length (i.e. were independent enterprises).
The application of the arm’s length transaction principle is generally based on a comparison of all the relevant conditions in a controlled transaction with the conditions in an uncontrolled transaction (i.e. a transaction between independent enterprises).