Functional Analysis: The Main Foundation of Arms Length Principle Application in Transfer Pricing

In the world of international taxation, there is often a misconception that transfer pricing is a rigid mathematical formula that will always yield one "correct" number. However, the reality is far more complex. All major guidelines in the world—from the OECD, UN, to tax authorities in Southeast Asia—agree on one fundamental premise: Transfer pricing is not an exact science.

This concept is not a weakness, but an inherent characteristic of the application of the Arm’s Length Principle. This article will dissect why this uncertainty occurs, how various jurisdictions handle it through the concept of "Arm's Length Range", and its implications for tax compliance.

The Nature of Uncertainty in Transfer Pricing

Why can't transfer pricing be exact? The answer lies in the attempt to mimic market forces. When independent parties transact, prices are determined by thousands of dynamic market variables. When Taxpayers or tax authorities try to replicate these conditions for affiliated transactions, it is impossible to find comparable data that is 100% identical in every aspect.

Global View

The OECD asserts that transfer pricing is not an exact science, but rather requires the exercise of judgment from both the tax administration and the taxpayer. Similarly, the UN Manual states that the application of the arm's length principle is often difficult because independent enterprises may not undertake the same transactions as affiliated enterprises, so direct evidence is difficult to find.

Regional View

Tax authorities in Southeast Asia adopt a similar view:

• Singapore (IRAS): Explicitly states in its guidelines that "Transfer pricing is not an exact science". Therefore, IRAS does not expect taxpayers to rigidly comply with a specific set of rules, but encourages a pragmatic approach.
• Malaysia (IRBM): Affirms that transfer pricing is not an exact science and even the application of the most appropriate method may produce a range of equally reliable results, not a single figure.

Consequences: From "Single Price" to "Arm's Length Range"

Due to this inherent uncertainty, looking for a single "correct" price figure is often unrealistic. Instead, tax authorities around the world accept the concept of the Arm’s Length Range. This is a statistical acknowledgment that in a free market, there can be various fair prices for the same transaction, depending on specific facts and conditions.

OECD and UN Approach

The OECD states that because transfer pricing is not an exact science, there will be many occasions when the application of the most appropriate method produces a range of figures (range of figures), where all those figures are relatively equally reliable. The UN Manual also recognizes that comparability analysis often produces a range of financial indicators (prices or margins), not a single figure.

Variations in Application in Indonesia, Malaysia, and Singapore

Although the basic concept is the same, the technical way of determining this range differs in each country, reflecting their respective policies in handling data uncertainty:

Malaysia (IRBM Guidelines 2024)

Malaysia defines the range as the value between the 37.5th percentile and the 62.5th percentile. If outside the range, adjustment is made to the Median or a point above the median that better reflects the facts.

Singapore (IRAS Guidelines 8th Edition)

A more flexible approach. IRAS suggests the Interquartile Range for wide price ranges, but if all points in the Full Range (e.g., in the CUP method) are proven to be equally reliable, then the full range is acceptable.

The Role of "Judgment" and Fact Analysis

Because there is no exact formula, the quality of transfer pricing analysis relies heavily on the quality of judgment used in analyzing facts.

OECD emphasizes the search for a reasonable estimate (reasonable estimate). In Indonesia, PER-22/PJ/2013 affirms that case resolution depends heavily on facts on the ground, not just theoretical assumptions. In Singapore, IRAS states a logical and coherent basis is needed to show transfer prices are fair.

Data Limitations and Adjustments

Malaysia explicitly acknowledges the difficulty of finding good quality comparables so "imperfect comparables" (imperfect comparables) are sometimes accepted with adjustments. The UN Manual highlights the challenges of developing countries where public data is often unavailable, so the use of foreign databases may be necessary.

The fact that transfer pricing is not an exact science is not an excuse to be careless. Quite the opposite, this demands higher documentation standards.

The best defense is a robust Transfer Pricing Documentation (TP Doc) to tell the "story" behind the numbers. As in Singapore, well-documented reasonable efforts (reasonable efforts) will be considered a form of compliance.

The key is transparency, consistency, and logical rationale.

References

1. OECD. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing, Paris.
2. United Nations. (2021). Practical Manual on Transfer Pricing for Developing Countries (2021).
3. Ministry of Finance of the Republic of Indonesia. (2023). Regulation of the Minister of Finance of the Republic of Indonesia Number 172 of 2023 concerning the Application of the Principle of Fairness and Business Prevalence in Transactions Influenced by a Special Relationship.
4. Directorate General of Taxes. (2013). Regulation of the Director General of Taxes Number PER-22/PJ/2013 concerning Guidelines for Audit of Taxpayers Having a Special Relationship.
5. Inland Revenue Board of Malaysia. (2024). Malaysia Transfer Pricing Guidelines 2024.
6. Inland Revenue Authority of Singapore. (2025). IRAS Transfer Pricing Guidelines (Eighth Edition) (2025).
7. IRAS Singapore. (2025). IRAS Transfer Pricing Guidelines (Eighth Edition).