The Arm’s Length Principle: Foundation of Transfer Pricing

The Arm’s Length Principle: Foundation of Transfer Pricing

• 27 October 2025
• Transfer-Pricing
• Nthabiseng Kobe

In a global economy, multinational groups routinely move goods, services, financing, and intangibles across borders. When related parties transact, the natural tension of independent dealing may be absent — raising a key question for both taxpayers and tax authorities: how should profits be allocated fairly between jurisdictions? The answer is the arm’s length principle, the organising idea behind South Africa’s approach to transfer pricing.

Understanding the Arm’s Length Principle

At its simplest, the arm’s length principle requires related parties to price their dealings as independent parties would under comparable circumstances. A South African subsidiary that purchases from its foreign parent should pay no more, and no less, than an unrelated South African company would pay an unrelated foreign supplier for a comparable product on comparable terms.

Internationally, this standard appears in Article 9 of the OECD Model Tax Convention, which allows tax authorities to adjust a taxpayer’s profits when the conditions in controlled transactions differ from those between independent enterprises. Because many jurisdictions draw from this model, there is a broadly consistent way of testing related party prices across borders.

The South African Context

South Africa’s rules are contained in Section 31 of the Income Tax Act 58 of 1962. The policy objective is to protect the domestic tax base as cross-border commerce expands. Section 31 empowers SARS to adjust consideration in affected transactions between connected persons or associated enterprises where prices are not at arm’s length.

Since the 2012 move to self-assessment, taxpayers are expected to determine and reflect arm’s length outcomes in their returns, which places a premium on careful analysis and contemporaneous records. Although issued in 1999, SARS Practice Note 7 continues to guide local practice and aligns South Africa with the OECD Transfer Pricing Guidelines where the Act or Interpretation Notes are silent.

Why Comparability Matters

Applying the arm’s length principle is not a matter of looking up a single number. It is an exercise in comparability: whether the transaction under review can be reliably compared to dealings between independent parties and, if not, whether reasonable adjustments can bridge the differences.

In practice, comparability depends on what is being transferred, the functions performed by each party, the assets used and risks borne, the contractual terms that govern the deal, the economic circumstances in which the parties operate, and the strategies that might reasonably influence pricing. Perfect comparables are rare; sound professional judgment, transparent reasoning, and clear documentation often matter as much as the data itself.

Methods and Practical Application

South Africa recognises the suite of OECD-endorsed methods. Together, they provide a toolkit rather than a rigid hierarchy. Where high-quality, like-for-like pricing is available, the comparable uncontrolled price (CUP) method offers the most direct test. Commercial reality often calls for a different lens: a distributor’s gross margin may be more meaningful than a unit price, in which case a resale price method can be appropriate. A manufacturer’s or service provider’s mark-up can be tested using a cost-plus perspective.

Where transactional data is limited, but operating outcomes are observable, the transactional net margin method (TNMM) can provide a practical benchmark. In highly integrated situations, especially where unique intangibles are involved and the parties’ contributions are intertwined, a profit split can align outcomes with value creation. The choice of method should follow the facts — the nature of the transaction, each party’s functional profile, and the quality of available data.

Documentation and Defensibility

The substantive rule sits in Section 31, but the day-to-day defence of a transfer pricing position is built on contemporaneous documentation. Effective files do more than meet a procedural expectation: they show that the arm’s length outcome was considered before the return was filed, record the reasoning behind method selection and comparability choices, and provide a consistent reference point as facts evolve over time.

A practical way to think about compliance is as a sequence: confirm association, define the affected transaction with precision, select the most appropriate method, test comparability and make adjustments where necessary, and record the rationale and results in a way that another professional could follow. When an audit comes, clarity and completeness often decide whether a debate is short and technical or long and costly.

Clarifier: Connected Person and Associated Enterprise

Connected person and associated enterprise are related concepts but not identical. “Connected person” reflects longstanding domestic rules on relatedness for tax purposes, whereas “associated enterprise” is a newer concept in South Africa, aligning with international transfer pricing practice and applying from years of assessment beginning on or after 1 January 2023.

For Section 31, the practical takeaway is simple: test whether the relationship meets the associated enterprise standard, even where the connected person definition may also apply. Being clear about which test applies helps avoid scope errors when assessing affected transactions and preparing documentation.

Illustrating the Principle in Practice: A Case of Intra-Group Loans

Consider a South African borrower receiving funding from its foreign parent. The analysis has two parts:

1. Debt level: Determine whether the amount of debt itself is something independent parties would accept, given the borrower’s forecast cash flows, capital structure, and industry norms. If the borrower is thinly capitalised compared to peers, an independent lender might reduce the quantum of debt or require equity first.
2. Pricing: Price the debt on terms that comparable borrowers could obtain in the open market. The interest rate and fees should reflect market pricing for a borrower with similar credit characteristics, tenor, and security.

In practice, this means a clear debt capacity analysis and a transparent explanation of how the reference rate, margin, and any fees were selected. When both the amount and pricing reflect what independent parties would accept, the loan is more likely to meet the arm’s length standard.

Bringing the Principle to Life

The arm’s length principle is ultimately about aligning profit with real economic activity. In South Africa’s self-assessment environment, understanding how the standard operates in law and how it is applied in practice is essential.

It helps you price management services in line with functions performed and risks assumed, informs judgments about the appropriate level and cost of group financing, and frames a distributor’s margin in light of its risk profile. Most importantly, it equips you to explain those outcomes in a way that stands up to scrutiny. When the analysis is careful and the story is well told, the principle becomes more than compliance — it becomes a disciplined way to manage cross-border tax risk.

Conclusion

In a well-regulated transfer pricing environment, enterprises should enable the adoption and integration of the arm’s length principle by ensuring sufficient internal capacity to apply it through the applicable methods described above. Enterprises that understand the principle and invest in the skills to manage transfer pricing compliance effectively can reduce the risk of adverse audit findings and costly adjustments.

For readers who want to explore the topic further, they can register for the upcoming webinar on transfer pricing, which will provide deeper insights, practical examples, and guidance on applying the arm’s length principle.

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