This article represents a seminal work on the application of the arm’s length principle and provides comprehensive analysis of the 1968 US Transfer Pricing regulations. The authors maintain that effective application of the arm’s length principle critically depends on appropriate functional and economic comparability adjustments that fully reflect the effect of economies of integration often present in the related party transactions. The article discusses the rationale and methods of such adjustments applicable to gross margin methodologies such as Cost Plus or Resale Price Method. In addition, an innovative profit split method based on Economic Capital Employed is developed. The method is based on economic principles that are fully consistent with the arm’s length principle dictated by the regulations.

This article was published in 42 Tax Law Review.