How to create an intercompany agreement that works

This article appears in the February issue of our International Corporate Structures Newsletter.

Whenever you are putting in place an intercompany agreement for a particular intra group supply, you need to decide what the terms should be. Or rather, you need to submit a proposal to the boards of the participating companies, for them to consider. Very often, the transfer pricing analysis will address the subject matter of the supply (for example, the types of services to be provided) and of course the pricing, but it won’t express a view on other essential terms such as duration, scope of warranties, exclusivity and so on.

Many of these terms are “invisible” – in other words, they cannot necessarily be observed in the actions of people or the movement of physical objects, cash or even accounting entries. So how should those contractual provisions be determined?

The starting point is to remember why you are doing this in the first place. Why you are bothering to create a written agreement or memorandum of terms, for a relationship between related entities. And of course, the objective is not just to write something “for tax”, “for transfer pricing” or “for the regulators”, but to create a record of a genuine consensual arrangement which is grounded in commercial reality and responsible corporate governance. This is the ‘quid pro quo’ of a group being made up of separate limited liability companies, rather than a single trading company with branches.

Here’s what can be considered to be the ultimate test for any proposed term or set of arrangements to be documented: put yourself in the hypothetical position of being a director of one of the participating entities. And imagine that you hold no other directorships or other positions within the group. Imagine that the holding company of the group is a publicly listed company, or is owned by a private equity fund – meaning that the directors of the parent company may be unlikely to have ultimate control over the group, and therefore any concepts of personal loyalty on their part should probably be discounted as well-intentioned but unreliable.

By virtue of your hypothetical position as director, you are personally accountable for your decisions. Willful blindness is not a defense. Nor the position of allowing a situation to exist, without having formally approved it. You owe a personal duty to take into account the interests of your company’s creditors and employees. If the company were to go into insolvent liquidation, the liquidator would have a statutory duty to investigate your personal conduct as director in the period leading up to the insolvency, and to pursue personal liability claims against you if appropriate.

In the light of this background, the answers to a number of questions become clearer. Questions such as:

• Should you agree to a loan being repayable on demand, if your company has no liquid assets?
• Should an agreement under which your company provides services be terminable by the service recipient on one month’s notice, if your company depends on that revenue to pay overheads or to service debt?
• Should your company give full warranties for the provision of intra-group services, if those services depend on an external provider, and your company effectively acts only as a conduit?

This test should be applied from the perspective of each of the participating companies. It will not necessarily dictate one specific solution, because a range of different scenarios and business models may be possible. But it should help avoid creating intercompany agreements which are unsustainable and which undermine the group’s governance, both from a tax perspective and from a corporate perspective.