How intercompany agreements can help support your transfer pricing policy

Multinational enterprises should adopt a consistent intercompany agreement management practice to mitigate transfer pricing risks.

Intercompany agreements play a crucial role in evidencing and defending group transfer pricing policies. We discuss the role of intercompany agreements, which typically formalise transfer pricing arrangements in a binding and legally enforceable contract.

Intercompany agreements – a powerful instrument

In general, an agreement (including intercompany agreements) sets out the legally binding relationship among the contracting parties by providing a written document outlining the salient understanding of the business relationship, the allocation of risk as well as terms and obligations underlying the covered transaction. At the same time, it reflects the contractual basis for the underlying intercompany transaction, spells out the nature of good and services to be provided, terms of remuneration and termination clauses.

This makes the intercompany agreement a powerful instrument for compliance purposes and a key starting point for tax auditors to understand the transaction properly and evaluate its arm’s length nature during tax audits. This approach is set out in guidelines by the Organisation for Economic Co-operation and Development (OECD). Many jurisdictions worldwide follow the OECD guidelines on transfer pricing documentation and generally require intercompany agreements to be included in the transfer pricing documentation.

In a transfer pricing audit, tax authorities typically request the transfer pricing documentation including all relevant intercompany agreements as a starting point. This is expected and accordingly, not having intercompany agreements in place is viewed as immediate non-compliance and increases the likelihood of additional investigations by the tax authorities. By having in place a thorough intercompany agreement management process, taxpayers can effectively mitigate risks in tax audits with a comparatively small investment of time and cost.

Furthermore, tax auditors are increasingly looking for evidence that the information presented in the functional analysis section of transfer pricing documentation is reflective of the actual conduct of parties. Intercompany agreements, if appropriately implemented, are often considered as compelling evidence of the actual conduct of parties by tax auditors. The burden of proof in most instances resides with the taxpayer, so spending time upfront in putting together intercompany agreements is often time and effort well-spent.

Best practices to manage intercompany agreements

The requirements of a proper intercompany agreement obviously depend on the nature of the underlying transaction. An effective intercompany agreement management should consider the following best practices:

1.         Written form

By having a clear and coherent written agreement in place, the taxpayer provides evidence that transfer pricing arrangements have indisputably been implemented and helps to substantiate that the underlying transaction and its terms and conditions are in accordance with the arm’s length principle.

2.         Consistency

Intercompany agreements will clearly allocate functions performed, risk assumed, and assets used between the parties and transfer prices applied.

The OECD states in its transfer pricing guidelines that written agreements alone should not drive the economic outcome – the actual conduct of the parties in the covered transaction should. Many jurisdictions have also changed their transfer pricing laws in recent years and require that the legal form of intercompany transactions be reviewed against their actual substance.

Hence, any inconsistencies between the intercompany agreement and the actual circumstances of the transactions would be an immediate red flag for the tax auditors to dig deeper.  It is therefore important to ensure that at the drafting stage, the agreement is in line with the actual functions undertaken, risks borne, assets employed and reflect the actual economic substance of the underlying transaction.

3.         Regular review

The importance of regular review cannot be understated. On a regular basis, taxpayers should review whether the intercompany agreements are up to date and reflect the actual situation.

In unexpected situations such as the global COVID-19 pandemic, intercompany agreements should also be reviewed e.g., for whether it is possible to charge out the extraordinary cost incurred for serving stay-at-home notice and work-from-home requirements. The review should examine whether a force majeure clause moderates party’s obligations and allows parties to manage the impact of COVID-19 on intercompany transactions.

4.         Flexibility

Intercompany agreements should provide the contracting parties enough flexibility to handle any unforeseen changes. Amongst others, taxpayers should consider the following aspects:

►    Remuneration range

Limited risk distributors and routine service entities typically receive an arm’s length renumeration that corresponds with their functional and risk profile, which is also supported by benchmarking study results. Rather than presenting a fixed target renumeration (e.g., 4% mark-up on total costs), an intercompany agreement should present the targeted arm’s length range (e.g., 2% to 6% mark-up on total costs) to allow flexibility and avoid deviations from the contractual basis, which can trigger potential tax liabilities.

►    Termination clause

It should be anticipated that business environment is often not static, and its evolution may require parties to amend or terminate the intercompany agreement. Therefore, a well-structured agreement should consider a termination clause for such situations.

►    Year-end adjustments

Including appropriate contract clauses to cater for unforeseen circumstances such as pandemics would allow better flexibility for making year-end adjustments. Without such clauses, group headquarters may find it challenging to adjust the guaranteed profit for routine entities.

In some jurisdictions, year-end adjustments are only permitted if they are made based on a legal binding intercompany agreement in force at the beginning of the respective year.

5.         Tax implications

In addition to transfer pricing considerations, the direct and indirect tax implications should also be carefully considered when drafting intercompany agreements. To the extent possible, the intercompany agreement should have language to appropriately describe the anticipated tax treatment vis-à-vis the contracting parties, such as withholding tax and indirect tax obligations.

The role of intercompany agreements in operating models and intra-group transactions will increase in relevance. Tax authorities around the world will likely attach greater importance to intercompany agreements in auditing multinational enterprises. It is therefore critical that taxpayers establish an effective intercompany agreement management process that can track compliance and changes. For businesses that spans multiple jurisdictions, additional coordination will be required to take into consideration the legal frameworks, transfer pricing requirements and tax laws in the different jurisdictions.

With regulatory scrutiny and tax controversy expected to rise, it is time to review your intercompany agreements and implement a consistent and future-oriented intercompany agreement management process.

The co-authors of this article are Jonathan Belec and James Choo, Partner, International Tax and Transaction Services from Ernst & Young Solutions LLP.