The conventional international approach to dealing with transfer mispricing is through the “arm’s length” principle: that a transfer price should be the same as if the two companies involved were indeed two unrelated parties negotiating in a normal market, and not part of the same corporate structure. The OECD and the United Nations Tax Committee have both endorsed the “arm’s length” principle, and it is widely used as the basis for bilateral treaties between governments.
Many companies strive to use the arm’s length principle faithfully. Many companies strive to move in exactly the opposite direction. In truth, however, the arm’s length principle is very hard to implement, even with the best intentions.
Imagine, for example, that two related parties are trading a tiny component for an aircraft engine, which is only made for that engine, and not made by anyone else. There are no market comparisons to be made, so the “arm’s length” price is not obvious. Or consider the case of a company’s brand. How much is the Shell Oil logo really worth? There is great scope for misunderstanding and for deliberate mispricing – providing much leeway for abuse, especially with regard to intellectual property such as patents, trademarks, and other proprietary information.
The resulting damage from the prevalent “arm’s length” approach has been, and is, substantial. Governments around the world are systematically hobbled in their ability to collect revenues from the corporate tax system. Billions of dollars are wasted annually around the world on governmental enforcement efforts that have little chance of success, and on meeting expensive compliance requirements.