The Arm’s Length Principle: The Rays of Transfer Pricing Adjustments

The IRS uses transfer pricing rules to govern negotiations between subsidiaries of the same company. Entities that violate these rules may be penalized through transfer pricing adjustments, whereby the IRS reallocates income between the parties involved. Just as sunscreen blocks ultraviolet rays from reaching the skin, companies can use the arm’s length principle to help shield themselves from transfer pricing adjustments. According to this rule, businesses must transact with each other independently and without pressure from other entities.

The IRS’ Standard Protection Factors

IRS regulations state that taxpayers must adopt an arm’s length standard when making business arrangements with another controlled company. A controlled transaction satisfies the arm’s length principle if the agreement results are the same as those occurring under the same circumstances between two independent parties.

The IRS does not mandate that companies use a particular method for implementing the arm’s length standard. However, entities should note that if the IRS calls their chosen method into question, then they – not the IRS – bear the burden of proof. Companies should also document and maintain their processes when they file their tax returns to avoid possible penalties. Finally, companies should keep transfer pricing documentation readily available at all times. During an audit, the IRS will most likely request this paperwork first. Failing to issue transfer pricing documents could result in penalties.

In some instances, the IRS may offer safe harbors to protect companies from transfer pricing adjustments. The safe harbors are typically limited to the areas of interest charged on loans (in U.S. dollars) and certain intercompany services.

Leverage CRI’s Radiating Expertise to Take Maximum Advantage of the Arm’s Length Principle

Transfer pricing adjustments can have significant effects on an entity’s finances. Therefore, abiding by the arm’s length principle may help safeguard your company from tax penalties – and keep it in good standing with the IRS. Contact us if you have any “burning” questions regarding your organization’s compliance with this rule.