Intercompany agreements first then TP analysis, or the other way around? The IRS has the answer

If you’re a transfer pricing professional, you’re probably already aware that the IRS publishes guidance on best practice regarding TP documentation, in the form of its FAQs.

These FAQs were first created in response to a 2018 report of the Large Business & International Division (LB&I) Subgroup of Internal Revenue Service Advisory Council (IRSAC), which referred to the perception that the quality of transfer pricing documentation had declined.

The FAQs were updated in 2022, and in Q/A4 they have this to say about intercompany agreements (my italics):

“Risk analysis should be consistent with intercompany agreements. Every business faces risks. From a transfer pricing perspective, risks must be identified and then allocated between the controlled parties. Intercompany agreements and the assignment of rights and responsibilities between the parties generally establish how risks are allocated. For example, under an intercompany agreement, a distributor may have the right to return all unsold inventory to the related supplier, thus shifting some risk to the supplier. The transfer pricing documentation should address such allocations of risk, how the risk allocations compare to the comparable companies used, and why the resulting pricing is consistent with the agreement. If an adjustment is made to the comparable companies based on risk allocations, the quantification of the risk and method for computing the adjustment should be clearly explained.”

Clearly, the FAQs state that TP documentation needs to explain how pricing is consistent with intercompany agreements, and not the other way round. In other words, agreements first, then TP analysis. This is in contrast to the attitude of some TP and tax professionals. For evidence of this, just look at cases such as Coca-Cola, SingTel and Aspro, where intercompany agreements were an afterthought at best.

A different approach

At LCN Legal, we advocate an approach to intercompany agreements which starts with the end in mind – in other words, ensuring that the group has a portfolio of tax audit-ready agreements which are aligned with its TP policies, and which can be produced at short notice to respond to tax enquiries and audits.

We frequently provide training sessions for TP teams in advisory firms and in corporate groups. Generally lasting about an hour, they address issues such as:

• The 4 key areas of alignment between intercompany agreements and TP policies
• Common mistakes and misconceptions
• Contractual ‘levers’ regarding risk allocation
• Drafting of pricing clauses for specific transaction types, including target margin arrangements
• Practical approaches to minimise the ongoing administration needed to keep agreements up to date

If you’d like to arrange one of these sessions for your team, please feel free to reach out. I will be very happy to help.