A large proportion of international trade in goods and services is conducted between what are known technically as related parties. In practice, most of this trade is between different companies forming part of the same transnational corporate grouping. This is typically highly integrated in economic and financial terms, while legally appearing as a set of separate companies incorporated in a wide range of countries.
For accounting, customs and general tax purposes, any two related companies engaging in cross- border transactions need to decide the price that they will set for the goods and services they exchange – ideally they will not make a profit off each other, as would be the case with unrelated companies. Inevitably, however, these are not market prices but administered prices. The process of setting these prices is known as transfer pricing (TP). In principle there is a standard mechanism, agreed internationally, to guide transfer pricing – the arm’s length principle. This means that cross – border transactions between related parties should be booked at the prices that would have applied had these been open competitive market transactions between unrelated parties (arm’s length transactions). It can be extremely difficult – and sometimes impossible – for revenue authorities to apply the arm’s length principle in daily operations.
