How can you tell if prices are at arm’s length?

The fundamental rule in transfer pricing is the arm’s length principle. When applied correctly, it ensures that related parties conduct transactions under terms that are consistent with those which would be agreed between independent parties. But how do we know that the conditions established in a given transaction are market-based? How can this be verified? We invite you to the third post in the “Akademia Pana Taxa” series. And if you want to revisit the previous ones to remind yourself of what transfer prices are (and what they definitely are not), and return to the glossary with basic transfer pricing concepts, here’s the link (1 and 2).

Transfer pricing analysis

Let’s put it straight: To know whether the conditions of a given transaction are at arm’s length, they must be verified. How? Through a proper analysis called transfer pricing analysis. Let’s stop here for a moment because we want to highlight how important a tool transfer pricing analysis is.

Do you remember how in previous posts we mentioned that over 80% of global trade happens between related entities? That related entities should set transfer prices on terms that unrelated entities would have set among themselves? The basis for determining or verifying the market nature of transfer prices is exactly the transfer pricing analysis. And do you also remember how we said that through transfer pricing, profits of a group are allocated among its entities and countries, and that countries compete heavily in terms of taxes, with multi-million-dollar fines for failing to comply with transfer pricing obligations? That’s true, and that’s why it’s crucial to have a transfer pricing analysis prepared. More precisely, it’s not enough to just have it. The transfer pricing analysis must be tailored to the transaction. Furthermore, it must be of high quality (because only such analysis guarantees a real defense in case of an audit) and must be applied in practice.

In our “Pan Tax” glossary, we mentioned comparative analysis but didn’t say anything about compliance analysis. We also didn’t explain how these concepts relate to the transfer pricing analysis itself, right? Let’s do that now:

The most important concept is “transfer pricing analysis.” The way it is conducted and the elements of such an analysis are strictly defined by the transfer pricing regulations. It can take two forms:

1. A benchmarking analysis, where the terms of a controlled transaction are compared to terms actually established by unrelated entities.
2. A compliance analysis, where the terms of a controlled transaction are compared to terms that unrelated entities would have agreed upon (compliance analysis is prepared when a benchmarking analysis cannot be conducted or is not justified).

When to assess whether prices are market prices?

We know how to check whether the prices in a transaction are market prices, but the equally important question is “when” should this be checked? Here, again, we touch on a very important issue in transfer pricing. Because transfer prices are not so much something you check but primarily something you set.

In order for related parties to be sure that they are using arm’s length prices in a transaction, they must set them on market terms, i.e., prepare such an analysis themselves or with the help of a consultant before entering into the transaction. The results of such an analysis should be taken into account during the negotiation phase, when submitting an offer, or when entering into a tender. However, this is not the only moment when such analyses should be prepared. The economic market, both domestic and international, is changing, and with it, the terms of transactions that are carried out on it. As a result, there is a need to monitor and update transfer pricing analyses during the course of a transaction, so that its conditions also keep up with these changes (this can be compared to updating a smartphone, without which it would become less useful or outdated).

Data = the key to success

Transfer pricing regulations do not impose any restrictions on who can prepare a transfer pricing analysis. A company can prepare its own transfer pricing analysis. One thing is indisputable – the analysis must be based on reliable and accurate data. So where to get such data? The answer is simple – most often from the market. But does this mean that it’s necessary to collect data on your own? No. There are specialized databases available on the market that provide the necessary information. These databases, apart from quality and reliability, also ensure data comparability. This is a huge benefit, especially in the case of financial data, as it allows comparing the performance of companies both within the same country and across different geographic markets.

Are you familiar with databases like Bloomberg? Royalty Range? Amadeus / TP Catalyst? Maybe they were used by you during your studies? If so, know that these are examples of databases we use daily when preparing transfer pricing analyses. For example, Bloomberg, apart from being one of the largest news agencies in the world, specializes in providing information about financial markets. The data from this database is used to conduct comparative analyses for determining the terms of loan transactions, bonds, guarantees, or cash pooling. Of course, the choice of the right database depends on the nature and specifics of the transaction being studied and the limitations of the database itself, but one thing is certain – transfer pricing is one of the few areas of tax law that combines tax, legal and accounting knowledge with financial analysis. Moreover, it is an area that applies to every industry and every business. As transfer pricing advisors, one day we determine the market terms for the sale of real estate, the next day we verify the profitability of dairy product distributors, and the next we visit a car factory, talking to both management and operational departments. Therefore, in transfer pricing, every day is a new adventure.

We are slowly approaching the end of the first cycle on transfer pricing within the “Akademia Pana Taxa” series. The last fourth episode is up next. And since it’s the grand finale, we’ll talk about how transfer pricing models are determined, how they help scale businesses, and what a transfer pricing policy is. Stay with us next week! In the meantime, here’s your homework 😊

As transfer pricing advisors, every day we learn about a different industry, a different transaction, discovering fascinating things. For today’s homework question – do you know why ostrich feathers are used in car manufacturing?