When Arm’s Length Isn’t Really Arm’s Length: Issues in Application of the Arm’s-Length Standard
15 July 1998
By Harlow Higinbotham with Marc. M. Levey
This article discusses arm's length transfer pricing under different contractual structures that often arise in practice due to unique nature of economic transactions between related parties. On the one hand, principal-agent problems associated with incentive formation and moral hazard constrain the arm's-length transaction to make it a poor template for how related parties may choose to structure their division of functions and risks. On the other hand, even with appropriate adjustments to account for these differences in functional responsibilities and accountabilities, differences in the fundamental bargaining situation can have an important influence on the results negotiated by arm's-length parties, and further adjustments may be necessary to approximate the related-party arm's-length result.
This article considers some of the more important distinctions that arise between related-party and arm's-length situations that may require attention in any arm's-length pricing analysis, including economies of integration, differences in the allocation of functions and risks, ownership of intangibles (either directly or as "embedded" in tangible property sales), termination risk, and the impact of agreements to adjust pricing for tax purposes. Given the broad range of transaction structures that related parties may in fact choose to adopt, authors maintain, a key principle is to respect these structures provided that the underlying assignment of functions and risks is realistically capable of providing objective valuation. And, because related-party transactions are so often structured differently from their arm's-length counterparts, taxpayers should document these structures explicitly in writing and in advance of the transactions to avoid the uncertainty and the confusion within the existing body of regulations.
This article was published in Tax Management Transfer Pricing Report.
