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How should TNMM / CPM arrangements be implemented in ICAs?

Intercompany Agreements

8 June 2021

Some TP methods – specifically, the cost plus method – imply a specific drafting structure for pricing clauses in intercompany agreements (ICAs).

Others do not. Take for example, the Transactional Net Margin Method (TNMM), aka the Comparable Profits Method (CPM). This method may suggest a drafting approach based on the relevant profit or margin, or may instead merely be a way of testing the result after the event.

This ambiguity often causes confusion.

Confusion can leave MNEs in a situation where their TP policies for material transaction types have not been legally implemented at all. Which in turn means that TP documentation purporting to describe how those policies have been implemented, risks being a sham.

It is not uncommon to find intercompany agreements which do not specify price at all, and instead leave it to the parties to agree prices on a case by case basis. This approach is sometimes used in commercial agreements between unconnected third parties, where the agreement merely provides a framework within with orders may be placed. However, such ‘agreements to agree’ are generally not recommended in the context of intercompany agreements, for a number of reasons.

Firstly, and most fundamentally, an agreement which does not set a price in an objectively ascertainable way fails to provide ‘audit-ready’ support for the intercompany charges which were actually applied in the relevant periods.

Secondly, if the pricing of a set of transactions for transfer pricing purposes relies on a level of return being guaranteed (for example, for an intragroup distributor), then there is no guarantee unless the level of return has actually been specified with legal certainty and forms part of a legally binding agreement. Although agreements to agree can be legally binding in some jurisdictions, many legal systems do not recognise them as creating legally binding obligations.

Thirdly, the decision by a party to an agreement as to whether to contractually assume a set of risks should clearly evaluated against the anticipated return. If no clear contractual framework for pricing is provided, the allocation of risk is not placed in context. In other words, the agreement looks fake because it is incomplete.

Fourthly, from a subsidiary governance perspective, leaving prices to be agreed on in individual orders or transactions would require the board of directors (or equivalent governing body or delegated authority) of each legal entity participating in the arrangement to make a decision on each occasion. This is rarely practicable. If the pricing of such individual transactions were to be determined centrally (for example, by a central finance function), this would amount to an abrogation of responsibility by the relevant boards and would not be a tenable approach.

These factors mean that in general, the approach for the legal implementation of TNMM / CPM arrangements through ICAs is the same as for any other transaction type:

  1. Clearly identify the nature of the transaction(s) involved, in a way which is consistent with the legal context (including contractual flows with third parties).
  2. Allocate risk appropriately on a forward-looking basis, so that the backward-looking statements that you want to be able to make in after-the-event TP filings are factually true.
  3. Provide appropriately for the ownership of IP and other intangible assets as between the parties.
  4. Specify the contractual price with legal certainty, in a way which is consistent with the TP policies and which the legal duties and responsibilities of directors.

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Article by
Paul Sutton
LCN Legal Co-Founder

Free Guide: Effective Intercompany Agreements for TP Compliance