Definition
Arm's Length Principle
The arm's length principle requires that transactions between related parties be priced as if they were between independent, unrelated parties.
The arm's length principle is the cornerstone of transfer pricing: a price is acceptable if it matches what unrelated parties would have agreed in comparable circumstances. Tax authorities test this using prescribed methods that compare prices, margins or profit splits against independent benchmarks.
Applying the principle is inherently judgemental because perfect comparables rarely exist, which is why benchmarking studies and disputes are common. Tools such as Advance Pricing Agreements let a company and the tax department agree an arm's length methodology in advance to avoid future conflict.
Related terms
- DTAA (Double Taxation Avoidance)A Double Taxation Avoidance Agreement is a treaty between two countries that prevents the same income from being taxed twice and allocates taxing rights between them.
- Transfer PricingTransfer pricing rules govern how transactions between related entities, often across borders, must be priced to reflect fair market value for tax purposes.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.