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:
Organization for Economic Development and Cooperation (OECD) Observer article
Professional Pricing Society article
JurisConsults International Group article
Arthur Consulting Group article