Organization for Economic Cooperation and Development (hereinafter referred to as OECD) states in Article 9 of ‘OECD Model Tax Convention’ that ‘two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly’. Generally speaking, transactions between two affiliated enterprises should be the same as those between independent enterprises, and the transaction prices should be determined by referring to the transactions with an independent third party. Where the profits are not obtained due to the unreasonable prices, tax authority will make adjustment to the prices in compliance with arm’s length principle between independent enterprises.

At present, the arm's length principle has been widely recognized by countries all over the world and has become the basic principle guiding countries to deal with transfer pricing issues.

China has formulated systematic regulations on the definition and function of the arm's length principle, the detailed terms are as follows:

(1)   Article 41 of the Enterprise Income Tax Law states: The business transactions between enterprises and their affiliated enterprises that reduce the taxable income or income of such enterprises and their affiliated enterprises not in compliance with arm’s length principle, tax authority has the right to make adjustments in accordance with reasonable methods.

(2)   Article 111 of Implementation Regulations of the Enterprise Income Tax Law states: the arm’s length principal stated in article 41 of the Enterprise Income Tax Law refers to the principle that unrelated parties to a transaction conduct business in accordance with fair transaction price and regular business practices.
 
(3)   Article 16 of the Measures for the Administration of Adjustments under Special Tax Investigation and Mutual Consultation Procedures states: A tax authority shall, on the basis of comparability analysis, select reasonable transfer pricing methods to analyze and evaluate the affiliated transactions of an enterprise. Transfer pricing methods shall include the comparable uncontrolled price method (“CUPM”), the resale price method (“RPM”), the cost-plus method (“CPM”), the transactional net margin method (“TNMM”), the profit split method (“PSM”), and other methods in compliance with the arm's length principle.

Company A sells a certain product to a third-party company B. In a fair market competition environment, the product unit selling price agreed by both parties is 1,000 yuan. In that case, if the transaction conditions are not changed, when company A sells the same product to its related enterprise C, the unit price should also 1,000 yuan in compliance with the arm’s length principle.

If company A sells the same product to company C at unit price of 500 yuan which is obviously low and unreasonable. As a result, China tax authority shall choose and use appropriate transfer pricing measures on the basis of comparability analysis to make adjustment to the affiliated transaction which violated the arm’s length principle.