Australia's double-tax agreements and domestic law require that pricing of goods and services and allocation of income and expenses between related parties comply with the arm's length principle.
The arm's length principle uses the behaviour of independent parties as a guide or benchmark to determine in international dealings between related parties:
- the pricing of goods and services
- how income and expenses are allocated.
It involves comparing what a business has done and what an independent party would have done in the same or similar circumstances. This principle is supported by all Organisation for Economic Co-operation and Development (OECD) countries.
Many factors may influence prices or margins, so you need to closely examine the dealings you're comparing and the circumstances of the parties involved. This comparison with arm's length activity means it is difficult to achieve absolute precision and certainty.
For dealings to be comparable:
- none of the differences between the situations should be material
- reasonably accurate adjustments can be made to eliminate the effect of any such differences.
The materiality of any differences depends on the facts and circumstances of each case and recognising that there's likely to be some uncertainty in the judgments that must be made.
In assessing compliance with the arm’s length principle, you should exercise commercial judgment about the nature and extent of documentation appropriate to your circumstances. Both the ATO and the OECD state that businesses only need to reasonably assess whether their dealings with related parties comply with the arm’s length principle. They should not be expected to prepare or obtain documents beyond the minimum needed to do this.
Businesses should consider the level of certainty they wish to achieve, taking into account the impact of international dealings with related parties on their overall business. This assessment will determine the level of risk to which a business is exposed.
Businesses risk having a transfer pricing audit if they do not have proper processes to determine arm's length prices and cannot demonstrate to us the methods they've used to determine their prices. They also risk a transfer pricing adjustment and penalties as a consequence of any audit.
There are several internationally accepted methodologies that your business can use to comply with the arm's length principle. Australia's transfer pricing rules do not prescribe any particular methodology or preference to arrive at an arm's length outcome. You should seek to adopt the method that is best suited to the circumstances of each case.
Whatever method you use should give a commercially realistic outcome. It is generally expected that a reasonable business person would seek to:
- maximise the price received for supplying property or services, considering their business strategy, economic and market circumstances, and minimise the costs associated with acquiring property or services
- be adequately rewarded for any activities carried out.
You must keep documentation that can substantiate compliance with the arm's length principle.
Taxation Ruling TR 2014/8 Income tax: transfer pricing documentation and Subdivision 284-E provides information on how to demonstrate that you have complied with the principle.
There are reasons why you must document compliance with the arm's length principle, namely to:
- reduce the risk of audit by us, and dispute with us
- help explain your position to us
- minimise penalties in the event of an audit adjustment, as any penalties will take into account the extent and quality of the documentation kept.