In the aftermath of the second world war, the global trade has continued to develop and has resulted in globalization of trade. In the era of globalization, the fixed boundaries within which a firm used to operate have transcended and firms have integrated their operations around the world, taking advantage of cheap labour and technological advances. As a result of which, today 60% of the global trade is transacted between the units which are closely associated with each other[1]. Thus, in this light it becomes important for the tax officials in different countries to come up with the regulations which are able to regulate the the flow of trade between multinational units and also tax the appropriate gains out of it.

To briefly define what regulates the trade between intra firms is the concept of transfer pricing. It stipulates that whenever there there is a trade between two related parties the price at which such trade is transacted should reflect the fair market price that would have been transacted between a comparable unrelated party. The assumption behind the transfer pricing regulation is that a trade between two special parties ought to be based on a value that would be distorted for the purposes of profit shifting and avoiding taxes.

In order to give transfer pricing regulations some teeth, one of the most important principle that has been laid down by the OECD group is the principle regarding ‘Arm’s Length transaction’. Arm’s length transaction states that the price arrived upon in a related party transaction should be such which is comparable to a transaction which would have been conducted between two uncontrolled parties. Thus, the central premise of the Arm’s length principle is that of comparability[2]. There are various methods that have been branched under the arm’s length principle which are based on comparing similar transactions which are conducted by uncontrolled/independent third parties.

However, one of the main problems with the Arm’s length principle has been that of arriving at a price which can be comparable to similar transactions. In today’s world of global trade most of the business operations have been internalized so as to achieve the benefits of economies of scale and globalization, thus for certain highly specialized products or also intangible products it is sometimes very difficult to find ‘comparable’ transactions and to arrive at a fair market value. More often than not it has led to administrative inability to be able to find the appropriate data to arrive at a fair market value, which has added to the complexity of the transfer pricing regulations and have added to the list of cases pending around the world.

Through this paper, thus there will be an attempt to analyse that how arm’s length principle has remained insufficient in solving the transfer pricing problem and has more often than not created adverse incentives for the multinational organizations to structure their operations in a way which ensure tax avoidance or even double non-taxation at times. There will also be an attempt to analyse the alternate system of Global formulary apportionment, which is followed within the U.S and a case will be made to adopt the same.

Arm’s length principle

In order to analyse the inherent flaws with the arm’s length principle it is first important to understand the premise on which the principle is based. The central notion of the arm’s length principle is that the transaction between two controlled corporations should be in line with the comparable price at which two uncontrolled corporations would have transacted. The problem with the same has been acknowledged even by the OECD group, that more often than not it is difficult to find comparable transactions which are suitable to arrive at a fair market valuation. Arm’s length principle tries to account for subjectivities such as the nature of business, the type of business model or the economies of scale under which a corporation is structured but more often than not these calculations are based upon imaginary valuations and are quite often poles apart from the price at which the two controlled corporations have transacted[3]. Also, with the advent of globalization and free cross-border trade regulations, the corporations around the world have structured their businesses in such a way so as to internalize most of the transactions. But by allocating separate entity status to each associated enterprise, the arm’s length principle makes it more inefficient for the firms to function in a more integrated manner. The problem is exacerbated even further by the fact that in today’s era, most of the large multinational corporations derive their income/profits by the use of intangible properties that they develop through research and development. Most of the intellectual property is bundled in a manner which is only for use of or peculiar to a particular type of organization. Thus, to find data of comparable market transactions become even more difficult and it leads to methods and ways which are no more than subjective and ambiguous which make the tax administration more cumbersome and tedious. For e.g. Firm A which has developed a trade secret or a technology will enter into a license agreement for with other associated enterprises to use the same for the operations worldwide. In exchange, the associated enterprise, Firm B would have to pay royalty as part of license to use the intellectual property. In this scenario, before arriving at an arm’s length price the tax officials will need to look at the nature of intangible property that is in use, to find comparable transactions, if any, to look for a market price for such intangible. In such a scenario, it is unlikely that there will be enough or any data available regarding such sale of intangible property which is unique to the firm in question[4]. Thus in this scenario, the tax officials will resort to methods in which the value of the Intangible will be calculated based on the profits that will be generated or the future expected value it is able to provide to the business. Such valuation is not only subjective due to various assumptions, but it also increases the compliance cost of the businesses.

Also, other problem that has been a topic of debate between tax professionals is that of tax evasion and tax avoidance. The current arm’s length principle does not take into account the economic reality of the business, instead it seeks to regulate transactions that are recorded on the books of account of the corporation. This provides incentive to the corporations to shift their profits to low tax havens and to further reduce their tax liability by the way of tax avoidance. Most of the cases that involve large multinational firms like Apple, Google, Microsoft have been able to successfully structure their business in a manner so as to avoid billion dollars in taxes, while still remaining within the letter of the law.

For the reasons discussed above, it becomes important to look at the alternatives which exists to the transfer pricing regime. One of the more controversial regime that is followed within U.S is that of Global formulary apportionment approach[5]. The principle takes into account the real economic activity of the corporation and then by the way of formula that takes into account factors such as sales, payroll and assets, sought to distribute the taxable income throughout the jurisdiction. Though the above approach has been largely criticized by the OECD group for being arbitrary and also creating double taxation problem, it is worth comparing the approach with the already implemented arm’s length principle to look at the warranting of concerns raised regarding this approach.

As discussed above, the formulary apportionment takes into account the real economic activity that the corporation is undertaking around the world. It factors into account the amount of sales, assets and payroll that are attributed to different associated enterprises and then apportions the profits based on that. This prima facie, counters one problem that is recurrent with the current Arm’s length regime, that is, of the shifting of profits to the low tax haven countries. Under the formulary apportionment system, even if the firm decides to artificially shift the profits to low tax jurisdictions, only that part of profit will be attributed to that enterprise, which corresponds with the factors such as sales, assets and payroll. Thus, only a fraction of income will be attributed to such low tax jurisdictions, thus removing the incentive to avoid taxes.

However, while recognizing the intended benefit, it is also reasonable to point out that without uniformity in international standards and co-operation, such a system would be difficult to achieve intended benefits as each country would then have different rules for how to calculate profits and also there would be a need to account for the increased double taxation cases, in case of regulatory differences.

However, it has been noted that the top 5 countries in terms of number of cases filed for transfer pricing is in those jurisdictions, which follow the arm’s length principle, whereas as within the U.S which follows the formulary apportionment system there are only 6 cases per year regarding the transfer pricing issues. Also, the kind of complexity the arm’s length principle brings in, increases the cost of compliance for the corporations and also make its administration very difficult. Thus, it runs antithetical to the basic tax principles which are espoused by the BEPS action plan of the OECD, which provides that tax regulations should be such which reduces the compliance cost of the business and also makes it easier for the tax officials to administer the transactions for the purposes of taxation.


In the recent observations regarding transfer pricing, even the OECD, has recognized that arm’s length regulations have not been effective to curb the problem related to transfer pricing. There have been discussions over the alternate transfer pricing systems to counter the same but largely till date the formulary apportionment system remains at the sidestep. Though, there are possible advantages in adopting the formulary apportionment approach, but with the possible advantage of reduced tax evasion, there will be certain challenges which pervades the international tax system on a whole. The challenges include greater international co-operation and standardization of tax rules. Thus, in order to counter the increasing problem of tax avoidance and tax evasion, it is imperative to create an international tax system which reduces compliance and administrative costs, which in turn induces an environment of low taxation and high compliance. Transfer pricing, being one of the major source of revenue for the countries, it becomes even more necessary to adopt approaches which are able to maximize the revenue for various tax jurisdictions and at the same time making it simpler and more efficient for the large corporations to comply with the regulations.

[1] John Neighbour, ‘Transfer pricing: Keeping it at arm’s length’, OECD Centre for Tax Policy and Administration, pp. 29, 2008

[2] ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration’, OECD, 2001

[3] OECD (2014), Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing

[4] OECD (2010), ‘Review of Comparability and of Profit Methods’

[5] Avi-Yonah, Reuven S. “Between Formulary Apportionment and the OECD Guidelines: A Proposal for Reconciliation.” World Tax J. 2, no. 1 (2010): 3-18

Author Bio

Qualification: Student- Others
Company: Jindal Global Law School
Location: Chandigarh, Chandigarh, IN
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January 2021