One of the main concerns for tax administrations is taxing multinational groups with respect to cross-border operations carried out through their related parties. The Arm’s Length principle has been instrumental in this regard, as it requires that intercompany transactions replicate the bargaining dynamics that would occur with independent third parties. This approach seeks to ensure that business groups are taxed in the places where they generate value, although its practical application can present significant challenges.

Over more than 90 years of global application, the Arm’s Length system has not been free from criticism. It has been pointed out that its implementation can be complex, requiring a system of technical rules that is not always simple and that may disadvantage countries with less developed tax administrations. In addition, in some cases, the system may be subject to manipulation or aggressive interpretations, which can lead to mispricing practices that erode the tax base of administrations.

In response to these limitations, a Formulaic apportionment system has been proposed, which allocates the taxable base of a multinational group among the jurisdictions where it operates, using variables such as sales, assets, and employees. This system is considered more stable and predictable, and some argue that it would significantly reduce the controversies generated by the application of the arm’s length principle. However, it also faces challenges, such as the lack of consensus on allocation metrics and the risk of new forms of tax disputes.

In this scenario, what are the pros and cons of each system from an economic theory perspective? Here are our considerations:

Arm’s Length Regime vs. Formulaic Proposal 

1. Real functions, arm’s length, and Formulaic: the hierarchical structure

The Arm’s Length principle is based on a preference rule: first, it seeks to use observed prices in comparable transactions. This implies a higher level of precision, since it directly reflects the market price of the good or service. Only when there is insufficient comparable data does the method resort to margins or financial indicators, which are indeed more general and resemble the type of approximation proposed by the Formulaic regime, but with greater detail and therefore a closer approximation to the real functions performed by the companies analyzed.

The Formulaic regime, in contrast, seeks to synthesize the analysis in a general allocation formula, which means that, by definition, its functions are more aggregated than those employed under arm’s length.

Formally, we can express the hierarchy of functions as follows:

•  Real functions, specific to the company analyzed.

•  Arm’s length functions, which seek to approximate real functions in greater detail.

• Formulaic functions, necessarily more general than arm’s length.

It implies that:

And, in turn.

Thus, the structure is hierarchical and nested: the Formulaic regime always oversimplifies what Arm’s Length can capture with greater detail.

2. The problem of systematic bias

In the Formulaic regime, for each set a standard return would be defined based on measures of central tendency.

This return is defined as

This generates an inevitable bias:

If the subset of the Arm’s Length function corresponding to the real function is at the high end of the return distribution within the Formulaic set, then the return is underestimated.

If it is at the low end, it is overestimated.

In practice, higher-risk and more complex activities are usually at the higher ranges, while routine activities are at the lower ones. Therefore, the bias is systematically regressive: it penalizes those who perform relatively higher-value activities within each Formulaic set and rewards those who perform lower-value activities.

3. The role of ranges and dispersion as information

The Arm’s Length regime is not limited to assigning a single value, but uses Arm’s Length ranges for each function   typically defined by the first and third quartiles of comparable observations:

The risk associated with the function is expressed in the length of the interquartile range:

• A large   value indicates high dispersion and greater risk.

•  A small  value indicates more stable conditions and lower risk.

In contrast, the Formulaic regime replaces the interquartile range with a standard return for each aggregated function 

Equivalent to assuming zero dispersion.

Thus, the Formulaic proposal eliminates the information contained in dispersion, which is not noise but a reflection of real market risk conditions.

4. Economic consequences: efficiency, incentives, and global productivity

Let  be the expected return of functions located in a jurisdiction  and  the return assigned under the formula. The mismatch is:

•  ,the jurisdiction received less than it should have.

•  ,the jurisdiction receives more than it should have.

Investment in institutional and productive infrastructure—understood broadly: including physical infrastructure (roads, ports, energy, telecommunications) and also institutional (legal services, legal certainty, property protection, regulatory frameworks)—depends directly on the expected profitability of attracting relatively high-return activities.

If the Formulaic regime systematically under-rewards jurisdictions that generate relatively higher returns, then investment will be lower than under an arm’s length regime.

5.  Critical considerationsIt could be argued that the Arm’s Length approach does not always identify specific real functions, but even in those cases, it comes closer to them than the Formulaic regime, whose declared purpose is simplification. The Formulaic regime may seem simpler but creates regressive incentives.The bias of the formula creates a moral hazard problem:
   • • Jurisdictions that try to attract relatively high-return activities receive less than they should.
   • • Jurisdictions with relatively low-return activities receive more than they should.

   The incentive is perverse: the most productive jurisdictions reduce their standards and investments, while the least productive unfairly benefit.

   The result is an inefficient global allocation of resources, which affects:

   1. The optimal location of capital and talent.
   2. Global productivity, by reducing the provision of institutional and productive infrastructure.
   3. International trade, by incentivizing fiscal and regulatory strategies that prioritize the formula over economic reality.

   Another criticism is that the Formulaic regime would reduce administrative costs for jurisdictions. However, this goal can be achieved more efficiently through advanced technologies (e.g., artificial intelligence applied to comparables analysis), whose development depends precisely on encouraging higher value-added activities. A regime that penalizes these activities undermines the possibility of creating the tools that would solve the cost problem.

    

    

    6. Conclusion

   The Formulaic regime, by its aggregated nature, generates a systematic bias compared to the arm’s length approach. By relying on general averages, it tends to underestimate the returns of highly valuable activities and overestimate those of lesser value. This can lead to inefficient resource allocation and discourage institutional investment. The Arm’s Length approach, though complex, remains the method closest to reflecting the economic reality of intercompany transactions.

   The transfer pricing regime in Mexico is about to turn 30 years old. From the incorporation of the arm’s length principle to the development of specific regimes for key sectors, such as the maquiladora, and the implementation of detailed documentation requirements, the country has established itself as an active player in this field. This is not surprising, considering that more than 30,000 multinational companies operate in the country, according to data from the Ministry of Economy.

   The construction of an efficient regime, supported by specialized transfer pricing teams with the technical expertise necessary to tax business groups under international standards, has generated significant revenues. In the last year alone, such revenues exceeded 19 billion pesos. This success demonstrates that the arm’s length system not only works, but also contributes to the country’s economic development, as well as to that of other nations that have invested in its implementation.

   In this context, it would be more reasonable to focus efforts on improving the arm’s length system before considering the adoption of a Formulaic regime whose practical application has not been tested and could prove counterproductive. A Formulaic allocation system, although seemingly simpler and more predictable, would not only be less accurate in reflecting value creation in intercompany operations, but would also imply a surrender of the country’s tax sovereignty. Therefore, the way forward is to strengthen the current regime, not to replace it.

   Some key improvements for the arm’s length system include:

   • • Requiring independence between tax advisors and transfer pricing advisors to avoid conflicts of interest.
   • • Reviewing the rules for applying transfer pricing methods, ensuring greater clarity and consistency.
   • • Formalizing procedures for the analysis and reporting of information in high-risk operations, such as those involving intangibles, services, and financial transactions.

   In conclusion, the arm’s length standard is not only crucial today, but should continue to be consolidated as a key element for the development of emerging countries. Although complex, it has proven its effectiveness, adaptability, and contribution to economic development. Improving its design and strengthening its enforceability should be the priority steps, rather than considering alternatives that could compromise the objectives of equity and tax collection.

    

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