Aligning with the Arm’s Length Principle: Key Themes and Challenges in Transfer Pricing Disputes

This article is part of a series that builds on my previous article: Lessons on the Arm’s Length Principle, Economic Substance, Documentation, and Comparability Challenges – For proper context, read that article first.
The following articles are also related:
The Arm’s Length Principle (ALP) lies at the core of global transfer pricing rules, designed to ensure that intercompany transactions between related entities are priced as if the parties were independent. However, applying this principle in practice is anything but straightforward.
As demonstrated by the disputes in Refinitiv, Glencore Energy UK Ltd, and GE Canada, aligning with the ALP often raises complex questions about economic substance, market conditions, and appropriate methodologies. This article delves into the common themes that emerge when aligning with the ALP, highlighting the critical challenges and lessons for multinational enterprises (MNEs).
A Principle Built on Independence
The ALP is fundamentally about replicating market-driven pricing between independent entities. This seemingly simple concept becomes significantly more complex when applied to the intricate structures of multinational groups. In each of the three cases, tax authorities questioned whether the transactions in question adhered to the ALP, focusing on whether the arrangements were consistent with those that unrelated parties would have agreed upon.
For example, in the Refinitiv case, the UK entities’ significant contributions to intangible assets were scrutinised. HMRC argued that the cost-plus method used in the APA failed to capture the full economic value generated in the UK and proposed a profit-split methodology instead. This case illustrates how disagreements can arise over pricing and the choice of methods—a recurring theme in transfer pricing disputes.
In Glencore, the focus shifted to commodity pricing, where the inherent volatility of markets and the lack of precise comparables posed significant challenges. The dispute revolved around whether the pricing mechanism adequately reflected the market risks borne by each party. Meanwhile, GE Canada’s dispute centred on financial guarantees, with the tax authorities questioning whether the fees paid for explicit guarantees were appropriate given the implicit support already provided by the parent entity.
Economic Substance as a Guiding Principle
While the ALP emphasizes pricing consistency, tax authorities increasingly look beyond formal agreements to assess the economic substance of intercompany transactions. This shift reflects a growing recognition that legal arrangements must align with the actual conduct and risks undertaken by the parties involved.
In the Refinitiv case, the UK entities played a pivotal role in the development and enhancement of intangible assets. However, the APA’s cost-plus methodology allocated a smaller share of profits to these entities, creating a mismatch between the economic substance of their contributions and the financial rewards they received. HMRC’s challenge highlighted the need for transfer pricing arrangements to reflect real-world contributions, not just contractual terms.
Similarly, Glencore’s dispute underscored the importance of aligning pricing mechanisms with the economic realities of commodity trading. The case revealed how discrepancies between contractual terms and actual risk allocation could open the door for tax authorities to question the arm’s length nature of the arrangement. This theme was also evident in GE Canada, where the court examined whether the guarantee fees were reflective of the genuine benefits derived by the subsidiary.
The Benchmarking Challenge
Identifying appropriate comparables is one of the most significant hurdles in aligning with the ALP. Tax authorities and MNEs often disagree on the reliability and relevance of benchmarking data, especially in industries with unique or volatile market conditions.
Refinitiv faced difficulties in benchmarking intangible asset contributions due to the absence of clear comparables in the market. This lack of precedent complicated the application of the ALP and left room for differing interpretations. In Glencore’s case, the inherent volatility of commodity markets exacerbated the challenge, making it difficult to establish reliable benchmarks for pricing transactions. GE Canada’s dispute added another layer of complexity, as the pricing of financial guarantees required specialized credit rating analyses that were open to interpretation.
These cases demonstrate that benchmarking is not a one-size-fits-all exercise. The unique characteristics of each industry and transaction type must be carefully considered to ensure that comparability analyses are both defensible and reflective of market realities.
The Importance of Methodology
Choosing the right transfer pricing methodology is critical to aligning with the ALP, yet this choice is often contested in disputes. The Refinitiv case exemplified how a methodology that was suitable in one context (cost-plus) became inadequate as the business evolved, leading to disagreements over the appropriate approach. HMRC’s decision to adopt a profit-split method reflected its view that the UK entities’ intangible contributions warranted a larger share of profits.
In Glencore, the pricing mechanism for commodity transactions came under scrutiny for not adequately reflecting market risks. The case highlighted the importance of tailoring methodologies to the specific risks and rewards associated with the transaction. For GE Canada, the court’s focus on guarantee fees revealed the nuanced considerations involved in financial transactions, where implicit and explicit support must both be accounted for.
A Dynamic Approach to Compliance
The common thread across these cases is the dynamic nature of aligning with the ALP. Static agreements or methodologies often fail to keep pace with evolving business models and market conditions, leaving MNEs vulnerable to challenges. Tax authorities are increasingly sophisticated in their analyses, going beyond traditional metrics to examine the substance, comparability, and economic rationale of intercompany transactions.
For MNEs, the key takeaway is that aligning with the ALP requires more than just compliance with existing rules. It demands a proactive approach that anticipates potential disputes, invests in robust documentation, and adapts methodologies to reflect changing circumstances. By doing so, businesses can not only meet their compliance obligations but also build a defensible position that withstands the scrutiny of tax authorities worldwide.