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IntroductionThe arms length principle ALP states that the transfer price betweentwo associated enterprises should be the price that would be paid forsimilar goods in similar circumstances by unrelated parties dealing atarms length with each other reference The concept of an armslength transaction is to ensure that both parties in the deal are actingin their own self interest and are not subject to any pressure or duressfrom the other partyTo prevent profit shifting by manipulation oftransfer prices tax authorities typically apply the arms lengthprinciple in corporate taxation and use comparable market prices tocorrectly assess the value of intra company trade and royalty incomeof multinationals But so far there is no single institution has theauthority to set the standard of international transfer pricing taxationBurns and Ross 1981 Some country follows the arms lengthprinciple but there is no agreement on what constitute an armslength priceTransfer pricing and the arms length principleTransfer pricing is the pricing of transactions between related partiesfor example sister companies within the same commonly controlled groupof companies The transactions could include the purchase and sale ofgoods or tangible and intangible assets the provision of services theprovision of financing and also cost allocation or cost sharingarrangements Transfer prices are often used to record intra-firmtransactions among various divisions within the firm On one hand theygenerate information for measuring divisional performance and providethe basis for management accounting On the other hand they affect thefirms overall tax liability when divisions operate in multiple taxjurisdictions When some divisions of a firm face competition researchhas further shown that transfer prices can also serve strategic purposesAlles and Datar 1998 Zhao 2000 Arya and Mittendorf 2008 Typicalreasoning for the strategic use of transfer pricing relies on the firmsability to exercise price discrimination by charging transfer price toits own affiliate that is different from what the firm would chargeunrelated buyers the firm is able to improve the affiliatescompetitive posture against the unrelated competitors MNCs run theirbusiness on an international basis and a sale
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