Andrew Hughes is an economist specializing in transfer pricing, valuation, and risk management. He is based in Brussels.
In this article, the author discusses intercompany agreements and how they can affect other parts of an organization.
Following the OECD’s base erosion and profit-shifting project, more scrutiny has been placed on taxpayers’ intercompany agreements. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations do not provide much guidance or establish best practices for what those agreements should contain. This article discusses the increasing importance of intercompany agreements, outlines features that should be part of most agreements, and analyzes the impact that poorly drafted agreements can have on other parts of an organization.
Increasing Importance of Agreements
The U.S. Internal Revenue Code and the OECD transfer pricing guidelines discuss intercompany agreements in a somewhat similar manner. Under IRC section 482-1(d)(3)(ii)(B), when a written agreement exists, “the contractual terms, including the consequent allocation of risks, that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions.”
The crucial point of that sentence is that if an intercompany agreement is diligently put into place before the parties undertake a transaction, and if its terms are consistent with economic reality, the IRS should respect it. That suggests that for a taxpayer to expect the IRS to accept a contract as the starting point for analyzing an intercompany transaction, the contract should be concluded before the start of an underlying intercompany transaction.
Section 482 continues that what is most important is the actual conduct of the parties and that “if the contractual terms are inconsistent with the economic substance of the underlying transaction, the district director may disregard such terms and impute terms that are consistent with the economic substance of the transaction.” That leaves open a large area of risk because the IRS could misinterpret the intention, or current conditions, of a transaction, leaving the taxpayer in a precarious position to argue the actual circumstances. For example, a foreign parent company in a business with high seasonality could have a U.S. distributor related party with a specified level of entrepreneurship that is incurring higher-than-expected sales and marketing expenses relative to its sales volume for a short period. Absence of an intercompany contract that explains the true functions, assets, and risks undertaken by both parties could result in the taxpayer being left to argue against any assumptions the IRS might make about the transaction, including its failure to take into account seasonality or to consider the true intention of the transaction.
Like section 482, the OECD transfer pricing guidelines state that when associated enterprises have formalized a transaction through written contractual agreements, “those agreements provide the starting point for delineating the transaction between them and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract.” They also state that any contractual lack of clarity or specification of conditions can be found by referencing the parties’ actual functions, assets, and risks, as well as the characteristics of the transaction, the economic circumstances of the market, and business strategies pursued by both parties.
Also like the section 482 regulations, the OECD gives hierarchy to the transaction’s actual economic facts:
If the characteristics of the transaction that are economically relevant are inconsistent with the written contract between the associated enterprises, the actual transaction should generally be delineated for purposes of the transfer pricing analysis in accordance with the characteristics of the transaction reflected in the conduct of the parties.
Finally, the OECD concludes that when no written terms exist, the parties’ actual conduct will be taken into account in determining the economically relevant characteristics of a transaction. In that sense, the section 482 regulations and the OECD transfer pricing guidelines take a similar stance, in that an intercompany contract can serve as a starting point for analyzing the transaction but that the parties’ conduct will ultimately be the determining factor in the absence of a contract.
The OECD’s 2015 final BEPS action 13 report was the most recent catalyst for changes to intercompany agreements. Although those agreements are not strictly required based solely on the OECD transfer pricing guidelines or section 482 regulations, the local file transfer pricing documentation guidelines do require the submission of copies of all material intercompany agreements concluded by the local entity. For a master file, those guidelines require a list of important agreements among identified associated enterprises involving intangibles, including cost contribution arrangements, principal research service agreements, and license agreements.
The local file in particular has more burdensome requirements because the actual agreements should be submitted to tax authorities proactively. That has helped authorities scrutinize the terms and conditions of those agreements has drawn their attention to any transactions for which intercompany agreements have not been concluded. That means practitioners must ensure that additional documentation for all intercompany agreements is concluded and that the terms and conditions best reflect the actual conduct of the parties to the transaction.
Several countries have more stringent requirements. In Nigeria, intercompany agreements must be in place before a tax deduction is granted.1 In Australia, intercompany agreements are also required to support the deduction of charges.2 In China, remittance of service fees over $30,000 require tax clearance documentation and additional justification, including a formalized agreement between parties.3 Requirements vary by jurisdiction and add to the complexity of compliance monitoring for practitioners.
Although there are similarities in how the OECD transfer pricing guidelines and the section 482 regulations approach intercompany agreements, with a clear global call to proactively provide those agreements in local files or otherwise, overall there is a lack of guidance on what basic information should be included in the agreements.
Key Features to Include in Agreements
This section serves as a guide for practitioners in thinking about key features and terms that should be included in nearly any standard intercompany arrangement, such as:
Identifying all parties to the transaction.
Describing the transaction taking place with specific details on the characteristics of the transaction, what is in scope, and what is out of scope.
Specifying the terms of the contract, including the effective date, end date, and any terms for extension. Practitioners should consider how likely it is that a transaction would be concluded between third parties without an end date or that would allow for tacit renewal into perpetuity.
Outlining conditions under which the parties would be able to terminate the contract or the contract might automatically terminate.
Specifying the jurisdiction of the parties and the specific territories where any services will take place. For example, a distribution agreement should indicate the markets that the distributor will have access to, and a license agreement should indicate the jurisdictions where the licensee can exploit the intellectual property.
Defining payment terms for the transaction, including when payment is to be made; the price of the transaction; the currency in which the transaction will be made; whether any discounts will apply for volume; and, assuming that the price is not on a fixed-fee basis, a description of the payment base (for example, cost or sales basis) that includes what components constitute that base and how calculations are made. For example, if remuneration is made based on a percentage of sales, the contract should describe which sales channels, customers, or jurisdictions the agreement is for, and whether items that could affect the base, such as returns and rebates, are in scope.
Setting the parties’ minimum expectations for service delivery or quality and how they will be held accountable for failure to meet those expectations, which would also include any applicable product warrantees or guarantees. Third-party providers will often include key performance indicators and penalties to hold parties accountable for quality expectations.4
Detailing the legal ownership of preexisting IP that might be involved in the transaction in addition to ownership of any intangibles that might be developed during the transaction. Even if the transaction at hand is not explicitly a license of IP, there is a good chance it exploits some kind of marketing intangible, know-how, or business processes. Best practice is to detail IP and its ownership even if it is secondary to the transaction itself.
Including change-of-control clauses in case the organization wants to annul the arrangement as part of or as a result of a merger, acquisition, or restructuring. Those kinds of clauses are common in third-party contracts and can be considered a prudent risk management tactic should the circumstances necessitate them.
Considering the incorporation of insurance and limit-of-liability clauses. In the routine performance of functions in a third-party context, a third party will accept only a limited amount of responsibility and will often defer on insurance responsibility as much as possible. For example, a third party providing payment processing services for an e-commerce merchant would not accept all the financial risk of the payment processing company experiencing significant downtime or business interruption. It would thus be unreasonable to expect the payment processing service provider to compensate the e-commerce merchant for all of its lost sales during service interruption. It would also be ideal to state the amount of time each party has to declare damages or invoke a liability clause against the other.
Outlining data privacy conditions to proactively manage risks, especially in a relationship with a related party operating in a jurisdiction with strict data privacy rules and penalties, and especially for IT or HR service providers and distributors.
Including force majeure clauses to dictate how and if related parties could stop their contractual commitments if drastic events occur, especially given the context of the COVID-19 crisis.
Although the conditions listed should not be construed as exhaustive, prudent practitioners should at least consider all of the them in writing intercompany contracts and determine what terms and conditions unrelated parties would include under similar circumstances.
Nontax Effects of Suboptimal Agreements
As most practitioners have heard, tax is often not the driver for major business decisions. Thus, transfer pricing professionals can find themselves involved too late in the process to raise risks and will be left with making the best of a nonoptimal situation from a tax perspective. However, they can add value to their business partners and affiliates by identifying adverse risks in intercompany agreements that can affect other areas of a multinational organization.
Strategic Risk
Intercompany agreements that are not concluded at arm’s length can affect a company’s strategy, specifically regarding its competitors. In a monopolistic or highly regulated industry, intercompany agreements could be the starting point for a regulatory or governmental organization to determine at which price services, goods, funding, or IP should exchange hands for new competition. That risk is specifically inherent in highly regulated industries and markets with barriers to entry. For example, the European Commission’s competition unit promotes consumer choice, efficient service, and intranational competition, and it has targeted specific industries for liberalization. The commission is generally considered to have liberalized the EU markets for air transportation and telecommunications, and has turned to EU energy, transportation, water, and postal companies.5 It will call on organizations controlling key assets or IP to provide equal access to competitors under conditions similar to those they might provide related parties.
Take, for example, a national railway group that owns exclusive access to a maintenance center. Those kinds of facilities are often in dense cities and are heavy capital investments, creating a natural barrier to entry for any competitor wanting to operate on that line. In the past, only related-party companies would be able to access the facility, but as market liberalization occurs, groups are required to give access to competitors for terms and conditions that they offer to all companies — that is, their related parties. It is easy to imagine other scenarios that apply across other sectors, such as energy and telecommunications, whereby the allocation of scare resources and infrastructure in an intercompany arrangement could be referenced by external regulators for new entrants looking to enter the market.
In highly regulated or monopolistic markets, intercompany arrangements (and thus agreements) will become the starting point for determining pricing for competitors, acting as a sort of comparable uncontrolled price for competition to gain access to the market.6 Intercompany agreements that are not arm’s length will have the effect of either allowing a competitor to gain access to the same services, assets, or goods as affiliate companies for similar pricing, terms, and risk allocation, or bringing intercompany agreements under scrutiny and challenge by authorities that will now have access to them.
Liability and Insurance Risk
Intercompany agreements that are not concluded at arm’s length can also create insurance risks. Clauses that may be forgotten in an intercompany context are those regarding liability limits. Often, risk can be created when liability is contractually shifted to a related party that is not responsible for the damage.
As discussed, a party that is routinely remunerated for relatively routine functions will normally not bear unlimited risk in a third-party context. When damage is claimed by one related party against another, there is the risk that the third-party insurer will not agree to cover the risk because it would in turn ultimately be liable for the contractual shift of risk, regardless of who was responsible for the damage.
Imagine a parent company that is a global manufacturer and distributor of widgets. It contracts with related party A to perform manufacturing services in return for a limited markup. It also requires the contract manufacturer to provide similar services to related party B. However, the intercompany agreement between A and B states that the contract manufacturer (A) is held liable for any product defects or business interruption losses that ensue, regardless of responsibility. If a related party provides design specifications that are not structurally sound, leading to a large product defect and ensuing business interruption loss for related parties, A’s insurer will scrutinize the intercompany agreement and question A’s acceptance of unlimited risk regardless of responsibility. Even if A is part of a group insurance program (which is not always the case), large delays in processing the claim and receiving payout will arise while the insurer addresses complex questions of contractual allocation of intercompany risk.
Although that situation might seem easily avoidable because a contract manufacturer by its very nature should not accept unlimited liability for risk, in practice, parent companies sometimes force affiliates to enter into intercompany relationships that are less than optimal — and without input from the transfer pricing or insurance department. If a practitioner sees that kind of risk in an intercompany agreement, best practice would be to alert the group to the potential tax risk and try to amend the agreement to be more in line with arm’s-length terms. He should also liaise with the insurance department up front to flag the risk to the insurer to try to gain a certificate of coverage and, if unsuccessful, flag the risk for the insurer in the next renewal to try to gain upfront certainty of coverage.
Data Privacy Risk
Nearly all agreements between third parties include standard data privacy clauses. Those clauses are especially important for the provision of back-office services such as HR, payment processing, or IT because all those services involve processing employee or client data or other sensitive information. Data privacy clauses are key in distribution and marketing relationships as well, because a distributor or marketing service provider will be handling client lists or collecting data with payment information.
Clauses clearly outlining the responsibilities of both parties should be incorporated into intercompany agreements. Tax practitioners should confer with a company’s data privacy consultant because allocation of this risk cannot always be contractually shifted to another party. What standards will be followed, what data will be collected and how long it will be stored, and who is responsible in the event of a data privacy breach should all be detailed to outline the responsibility between related parties to avoid any tax questions that may follow should a data privacy risk arise.
Conclusion
The last several years have brought significant increases in the level of scrutiny into and compliance requirements for intercompany contracts. Although previously only an afterthought, intercompany agreements are now an important part of a practitioner’s transfer pricing workload. Although the OECD transfer pricing guidelines and IRC section 482 regulations remain silent on best practices for how to think through terms of an intercompany agreement, there are potential implications in those agreements that can affect other parts of a multinational organization. Transfer pricing practitioners can add value to their organizations by acting as active risk managers and considering the broader effects that related-party agreements can have across all departments.
FOOTNOTES
1 “Intercompany Agreements for U.S.-Based Multinational Enterprises,” LexisNexis (Dec. 30, 2014).
2 “Intercompany Agreements,” Thomson Reuters OneSource.
3 Peter Guang Chen, “Intercompany Payments Between Multinational Corporations and Their Affiliated Companies in China,” Charles River Associates — Insights: Transfer Pricing (2012).
4 In the author’s experience, this aspect is often overlooked. Practitioners often face internal challenges in being able to hold a related party (especially a parent) accountable for penalties in intercompany contracts.
5 European Commission, “Competition: Liberalisation” (Sept. 2015).
6 Technically, that is a comparable controlled price; however, regulators in monopolized industries will likely use those observations as starting points because there will not be observable prices in the open market.
END FOOTNOTES