In the United States, transfer pricing is governed by Internal Revenue Code (IRC) Section 482 and the related Treasury Regulations. These rules require related companies to price their transactions as though they were independent businesses dealing with each other in the open market. This is known as the arm’s length principle.
To determine whether a transfer price is reasonable, businesses cannot simply choose a price they believe is fair. Instead, they should follow a structured approach. This generally involves understanding what each company contributes to the transaction and selecting an appropriate transfer pricing method. Thereafter, they should compare the results with similar transactions between unrelated businesses.
By following this process and maintaining proper documentation, businesses can support their transfer pricing positions. This will help reduce the risk of IRS adjustments by enabling businesses to demonstrate that their cross-border transactions comply with U.S. tax law.
In the following sections, we explain each step of the transfer pricing determination process in simple terms.
First, let’s understand the arm’s length Principle.