Arm's-Length Principle
What would a product cost if transacted by unrelated parties?
The "arm's-length principle" of transfer pricing states that the amount charged by one related party to another for a given product must be the same as if the parties were not related. An arm's-length price for a transaction is therefore what the price of that transaction would be on the open market. For commodities, determining the arm's-length price can sometimes be as simple a matter as looking up comparable pricing from non-related party transactions, but when dealing with proprietary goods and services or intangibles, arriving at an arm's length price can be a much more complicated matter. US transfer pricing law requires that the best method rule be used to determine which transfer pricing methodology is most appropriate for determining the arm's-length price of a given transaction.
The official definition of the arm's length standard as it applies in the United States can be found in Section 482-1 (b) of the transfer pricing regulations:
(b) Arm's length standard--(1) In general. In determining the true
taxable income of a controlled taxpayer, the standard to be applied in
every case is that of a taxpayer dealing at arm's length with an
uncontrolled taxpayer. A controlled transaction meets the arm's length
standard if the results of the transaction are consistent with the
results that would have been realized if uncontrolled taxpayers had
engaged in the same transaction under the same circumstances (arm's
length result). However, because identical transactions can rarely be
located, whether a transaction produces an arm's length result generally
will be determined by reference to the results of comparable
transactions under comparable circumstances. See Sec. 1.482-1(d)(2)
(Standard of comparability). Evaluation of whether a controlled
transaction produces an arm's length result is made pursuant to a method
selected under the best method rule described in Sec. 1.482-1(c).
(2) Arm's length methods--(i) Methods. Sections 1.482-2 through
1.482-6 provide specific methods to be used to evaluate whether
transactions between or among members of the controlled group satisfy
the arm's length standard, and if they do not, to determine the arm's
length result.
(ii) Selection of category of method applicable to transaction. The
methods listed in Sec. 1.482-2 apply to different types of transactions,
such as transfers of property, services, loans or advances, and rentals.
Accordingly, the method or methods most appropriate to the calculation
of arm's length results for controlled transactions must be selected,
and different methods may be applied to interrelated transactions if
such transactions are most reliably evaluated on a separate basis. For
example, if services are provided in connection with the transfer of
property, it may be appropriate to separately apply the methods
applicable to services and property in order to determine an arm's
length result. But see Sec. 1.482-1(f)(2)(i) (Aggregation of
transactions). In addition, other applicable provisions of the Code may
affect the characterization of a transaction, and therefore affect the
methods applicable under section 482. See for example section 467.
Here is a pdf of the complete regulations: 26 CFR 1.482.
Here are some articles that discuss the arm's-length principle:
