Arm's Length Principle (ALP)

Companies in the same group can set any price between themselves, and a price that shifts profit to a low-tax country would cut tax in the other. The principle removes that room by asking what unrelated parties would have agreed in comparable circumstances. To test it, tax advisers look for comparable transactions or companies, analyse the functions performed, assets used and risks taken by each side, and pick a method such as comparable uncontrolled price or transactional net margin. The result is often a range, not a single figure. Nearly every country with transfer pricing rules uses the principle, as do tax treaties. A few jurisdictions have debated alternatives such as formulary apportionment, but those are not the international standard. Every transfer pricing adjustment, and most treaty disputes over one, ends up asking whether the price matched what strangers would have agreed.

A parent company lends 50 million to its subsidiary at an interest rate of 1%, while banks would charge that subsidiary about 6%. The tax authority of the parent's country finds the rate below the arm's length level and adds the missing interest income to the parent's taxable profit.