Transfer pricing compliance requires more than just documentation reports kept on file. Transfer pricing policies must be implemented in legal reality through appropriate intercompany agreements (often referred to as “ICAs”). The key role that ICAs play in transfer pricing is clearly demonstrated in the policy statements of tax administrations and in recent transfer pricing litigation across the world.
IRS guidance issued in 2020 and renewed in later years confirms that “risk analysis should be consistent with intercompany agreements,” and “transfer pricing documentation should address … allocations of risk … and why the resulting pricing is consistent with the agreement.” Similarly, under the Organisation for Economic Co-operation and Development’s Transfer Pricing Guidelines, legal agreements constitute the starting point when “delineating the actual transaction”—which is an essential step before any benchmarking can be carried out. Several tax administrations go further by requiring agreements to be “clear and unambiguous,” implemented in advance, and, in some cases, registered with relevant authorities—failing which, deductions for the relevant expenses may be denied as a matter of course.
Although this is undoubtedly a specialist area, the task of implementing transfer pricing policies is not as complicated as it might sound. Multinational groups are not required to put in place agreements with obscure language and overly complex provisions. Nor is it usually necessary (or indeed appropriate) for ICAs to replicate the provisions found in third-party agreements.
Here are our top five action points for CFOs, tax directors, and other tax and transfer pricing professionals of multinational groups to help them avoid exposure to unnecessary double taxation, fines, or penalties caused by avoidable defects in their ICAs.
- Confirm that your intercompany transactions, particularly high-risk ones, are covered by ICAs
In previous decades, there was a view that it was better to avoid having agreements (or to keep them vague) on the basis that if you have no agreements, they can never be wrong.
Recent high-profile cases have shown that belief to be false. For example, the U.S. case of Aspro, Inc. v. IRC (2022) and the judgment of the Spanish National Court (No. 5537/2021) both concerned the denial of deductions for management charges between related parties. In the Aspro case, the taxpayer failed to provide any written agreements or other contemporaneous documentation supporting the existence of a service relationship. In the Spanish case, the taxpayer claimed that the relevant agreement had been lost. In both cases, the taxpayers attempted to present expert evidence regarding the services claimed to have been provided, but this evidence was rejected by both courts.
The following is a list of common intercompany transactions for which having an ICA is particularly important:
- Provision of management services, e.g., executive functions on behalf of affiliates;
- Provision of support services, e.g., corporate, regional, or other;
- License of intellectual property, e.g., know-how, brand names, or customer lists;
- Sale of assets, e.g., equipment, intangible property (IP), or machinery; and
- Financial transactions, e.g., term loans or revolving credit facilities.
These transactions are often placed under increased scrutiny by tax authorities that will expect clear and robust documentation regarding the parameters of the transaction. Because risk cannot be allocated retrospectively (in the same way that you cannot bet on a race after the winner is announced), ICAs should be put in place in advance of the relevant transactions. And if there are gaps in relation to the current year or previous years, you should fix them as soon as possible. - Check your existing ICAs for alignment
When tax authorities are looking for grounds to challenge tax positions, inconsistencies between ICAs and transfer pricing policies are an easy win for them.
Your review should focus on alignment in four key areas:
- Functions (which entity is doing what in regard to supply of services, supply of goods, contribution of intellectual property, and so on);
- Allocation of risks between group entities (market risks, credit risks, inventory risks, research and development risks, foreign exchange risks, etc);
- Ownership of intangible assets, including any improvements to existing IP; and
- Financial terms (such as how the intercompany charges are calculated, any markups applied, any true up/true down mechanisms, due dates for payment, and any late payment interest).
- Make sure that the needs of all internal stakeholders are taken into account
ICAs are not only relevant for transfer pricing. They also play a critical role in determining the treatment of intercompany charges for other purposes, such as customs duties, withholding taxes, sales taxes, and currency control. In essence, agreements provide a “single source of truth,” which sets the foundations for multiple purposes.
Therefore, it’s important to identify all the relevant internal stakeholders and make sure their needs are considered. Sometimes this may require balancing conflicting internal interests and choosing an approach that best protects the group’s welfare.
- Don’t forget financial transactions
Although mentioned previously, financial transactions are critical to have documented, so it’s worth going into more detail. Intercompany financial transactions between related parties can include an array of financial arrangements, including intercompany loans, cash pooling and revolving credit facilities, factoring arrangements, and guarantee fees.
The interest rates, factor rates, and guarantee fees offered by commercial lenders vary widely, depending on the creditworthiness of the parties involved and the legal terms of the arrangement: the security provided, the transaction terms, the currency, whether the rate is fixed or floating, and so on.
The same principles apply to the pricing of intercompany financial transactions—it’s impossible to benchmark interest rates, factors, and fees unless you have defined the legal terms of the arrangement. This means that ICAs are just as important for financial transactions as they are for other transaction types.
- Put in place ongoing systems to make sure your agreements are kept up to date and are available in a central online archive
Very few groups are static. Over the course of a year, a group may acquire new entities, dispose of or remove entities, modify its operations, or create new business lines. In addition, changes to the economic environment are almost inevitable, and transfer prices may need to be re-benchmarked.
ICAs (like transfer pricing policies) are of little use if they are not kept current. Therefore, it’s essential to build processes into your annual compliance calendar to review whether there have been any changes in your group (and whether there are likely to be any changes affecting the forthcoming period) that may need to be reflected in updates to your agreements.
When a tax authority examination occurs, your group will see the value of having ICAs that are clearly aligned with transfer pricing policies. This can save the group from unnecessary double taxation, fines, and penalties, as well as from protracted inquiries or disputes. A centrally managed archive (often “owned” by the tax function) is an important part of your defense.
If you have any questions regarding the above information or would like to discuss in more detail, please reach out to a professional at FORVIS or LCN Legal or submit the Contact Us form below.
This article is co-authored by Paul Sutton of LCN Legal.