The fundamental paradox at the heart of international tax
Transfer pricing is one of the most contested and misunderstood areas of international taxation. Governments around the world treat it predominantly as an anti-avoidance tool i.e. a mechanism to prevent multinational enterprises from shifting profits to low-tax jurisdictions by manipulating the prices charged between related parties. Yet this framing captures only half the story. Transfer pricing is not a one-sided instrument wielded by tax authorities to recover revenue. It is, in its truest sense, two sides of the same coin and failing to appreciate both sides leads to disputes, double taxation, and an international tax environment that is neither fair nor efficient.
What the arm’s length principle actually means
The cornerstone of international transfer pricing is the arm’s length principle, enshrined in Article 9 of the OECD Model Tax Convention and adopted, in varying degrees, by tax treaties across the globe. The principle is deceptively simple. Transactions between related parties should be priced as if they had been conducted between independent parties dealing at arm’s length in the open market.
On its face, this is a neutral standard. It does not favour the taxpayer, nor does it favour any particular tax authority. It merely asks, what price would unrelated parties have agreed to? The arm’s length price is the same whether you are the buyer or the seller, whether you are a subsidiary in one country or the parent company in another. And this is precisely why transfer pricing must be understood as two sides of the same coin.
When a tax authority in Country A adjusts the price of a related-party transaction upward asserting that its resident entity should have charged more for a product, service, or intellectual property right, it is, by logical necessity, also asserting that the entity in Country B paid too little. The flip side of that coin is immediate and unavoidable. If Country A’s taxpayer receives more income, Country B’s taxpayer incurred more expense. The two positions are arithmetically inseparable.
The problem with a one-sided view
Revenue authorities, understandably focused on protecting their domestic tax base, often approach transfer pricing audits from a unilateral perspective. They scrutinise the transactions of their resident taxpayer, apply their preferred method, benchmark against comparable companies, and issue an adjustment. What happens across the border is, in this view, someone else’s problem.
But this approach is fundamentally at odds with the arm’s length principle itself. If the standard truly reflects what independent parties would have done, then both sides of the transaction must reach the same conclusion or at least a consistent one. You cannot have arm’s length pricing that results in one jurisdiction taxing income that another jurisdiction has already taxed in the hands of the related party. That outcome is not arm’s length at all. It is double taxation.
This is why revenue authorities must genuinely accept that the related party in another jurisdiction will also want and indeed has the right to be at arm’s length.
The foreign affiliate is not a passive recipient of whatever residual profit survives after the home country has taken its fill. It is an independent economic factor, contributing functions, assets, and risks that must be remunerated appropriately under the very same standard that the auditing authority claims to apply. A tax authority that demands arm’s length treatment for its own resident entity cannot simultaneously dismiss the arm’s length claims of the entity on the other side of the transaction. To do so is to invoke the principle selectively, stripping it of its neutrality and coherence.
Symmetry in theory, asymmetry in practice
In theory, the two-sided nature of transfer pricing is well recognised. The OECD’s Transfer Pricing Guidelines explicitly address corresponding adjustments and compensating adjustments.
A corresponding adjustment is a secondary adjustment made by the tax authority of the counterparty jurisdiction to eliminate economic double taxation arising from a primary transfer pricing adjustment in another country. A compensating adjustment is a voluntary adjustment made by the taxpayer, typically in its tax return, to bring its results in line with the arm’s length principle before or without a tax authority adjustment. A corresponding adjustment is a relief mechanism whereas as compensating adjustment is compliance mechanism. Compensating adjustment achieves arm’s length outcome proactively and reduces audit risk. A corresponding adjustment is done post an audit and often involves Mutual Agreement Procedures (MAP).
The Mutual Agreement Procedure (MAP) under bilateral tax treaties provides a mechanism for competent authorities to resolve disputes and eliminate double taxation. The Advance Pricing Agreement (APA) process allows taxpayers to agree a transfer pricing methodology with one or more tax authorities in advance, achieving certainty on both sides of the coin simultaneously.
Yet in practice, the symmetry frequently breaks down. Corresponding adjustments are not automatic; they depend on the goodwill and cooperation of the other jurisdiction’s tax authority. MAP proceedings can take years and are not always available or effective. Bilateral APAs, while powerful, are resource-intensive and accessible mainly to large multinationals.
The result is a landscape in which taxpayers can find themselves caught between two revenue authorities, each insisting on an arm’s length outcome that is incompatible with the other’s. Both authorities may be technically correct within their own analytical frameworks using different comparables, different methods, different assumptions about risk allocation and yet the combined effect for the taxpayer is taxation on more than one hundred cents of every dollar of profit. This is neither arm’s length nor equitable.
Accepting the full implications of the standard
For transfer pricing to function as intended, revenue authorities must internalise a broader view of the arm’s length standard one that encompasses both sides of the transaction from the outset. This means analysing, (at the start of any audit or risk review), the consequences of the corresponding position for the related party if a transaction is adjusted. The important question to be asked is whether the adjusted position is sustainable in the other jurisdiction?
This means engaging proactively with treaty partners rather than treating bilateral resolution as an afterthought. Authorities should seriously consider the transfer pricing documentation filed by taxpayers, which when prepared in accordance with the OECD’s three-tiered approach of master file, local file, and country-by-country report. This documentation is specifically designed to present a coherent, group-wide picture of value creation and profit allocation.
Most importantly, it means acknowledging that arm’s length is not a floor for domestic revenue. It is a standard that constrains revenue authorities as much as it constrains taxpayers. An adjustment that pushes beyond arm’s length does not protect the tax base. It distorts it and invites the very double taxation that the international tax framework was designed to prevent.
Conclusion: Both sides must hold the coin
Transfer pricing disputes will never be eliminated entirely. The valuation of intercompany transactions, particularly for unique intangibles and complex financial arrangements, involves genuine uncertainty. Reasonable people may disagree. But the disputes that arise from a failure to recognise the two-sided nature of the standard are avoidable, and they are the most corrosive because they undermine the legitimacy of the arm’s length principle itself.
When a revenue authority insists on arm’s length treatment for its own taxpayer, it simultaneously commits to accepting arm’s length treatment for the taxpayer on the other side. The coin cannot be spent by one authority alone. Both sides must hold it, and both sides must honour what it represents. A standard of neutrality, consistency, and mutual respect between jurisdictions that is the only workable foundation for a fair international tax system.
Transfer pricing, properly understood, is not a weapon in the arsenal of tax authorities. It is a shared standard, and its integrity depends on all parties. Taxpayers and revenue authorities alike treating both sides of every transaction with equal rigour and equal respect.
(The author is a Partner, Head of Tax at Deloitte Sri Lanka and Maldives)