Transfer pricing refers to the rules and methods used to price transactions between associated enterprises (related parties) under common ownership or control.
The Corporate Motivation for Profit Shifting
Multinational Enterprises (MNEs) operate across different tax jurisdictions. Because corporate tax rates vary significantly from country to country, an MNE has a financial incentive to manipulate the prices of internal trades. By overpricing or underpricing goods, services, or intellectual property transferred between its subsidiaries, the MNE can artificially shift taxable profits from high-tax countries to low-tax jurisdictions.
[Subsidiary A (High-Tax Country)] -- Sells raw materials at artificially LOW price --> [Subsidiary B (Low-Tax Country)]
Result: Low profit in High-Tax Country. High profit in Low-Tax Country. Total MNE tax bill drops.

The Arm’s Length Principle (ALP)
The globally accepted standard for adjusting transfer prices is the Arm’s Length Principle, codified in Article 9 of the OECD and UN Model Tax Conventions. The principle states that transactions between associated enterprises should be priced as if they were conducted between entirely independent, unrelated entities operating under free market conditions.
\(\text{Controlled\ Transaction\ Price}\approx \text{Uncontrolled\ Transaction\ Market\ Price}\)
Legal Definitions of Associated Enterprises
Two enterprises are deemed to be associated or related if:
  • One enterprise participates directly or indirectly in the management, control, or capital of the other (typically through holding a substantial shareholding, e.g., 25% to 50% or more depending on local status).
  • The same individuals or entities participate directly or indirectly in the management, control, or capital of both enterprises.

 
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