FAQs about Intercompany Agreements
Q: Can we put off implementing intercompany agreements until we need to deal with a tax challenge?
Doing this is a very bad idea, for three reasons.
First, tax administrations will expect to see a contractual assumption of risk before the risk occurs. Contractual arrangements put together after the fact will not be adequate.
Second, backdating may well be ineffective. The next Q&A on this page gives more detail on this.
Third, transfer pricing is not the only reason to put intercompany agreements in place. Other purposes include data protection or other regulatory compliance, or to protect and enforce intellectual property rights. Unless a group addresses the issue pro-actively, its tax function may be saddled with agreements which have been prepared without addressing the tax or transfer pricing implications, and which may be unhelpful for TP compliance purposes.
Q: Can we backdate intercompany agreements?
Even if backdating is possible from an accounting and legal perspective, it may still be ineffective. From a purely economic point of view, risk cannot be contractually allocated retrospectively.
This point is made clearly in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017: “The purported assumption of risk by associated enterprises when risk outcomes are certain is by definition not an assumption of risk, since there is no longer any risk.”
If a particular intragroup transaction is ongoing, then from a legal perspective it may be possible to sign an agreement which records the ongoing commercial terms, and which provides that the parties will treat those terms as having applied from a historic effective date. Such an agreement should still be dated when it is actually signed; giving a document a date which is earlier than the date when it was actually signed would almost certainly constitute fraud.
Tax and accounting advice would also be needed for an arrangement where ICAs are put in place with effective dates prior to the date the ICAs are signed. Where ICAs are put in place with historic effective dates, it will always be important to retain a file of documentary evidence that can be used to demonstrate that the relevant parties acted in accordance with the terms of the ICA (including with respect to risk allocation and pricing) during the period before the ICA was signed.
Q: Are intercompany agreements real agreements?
Some people believe that intercompany agreements are ‘artificial’. The argument goes that since ICAs are between group entities and would never be legally enforced or litigated, they do not need to be legally binding.
This is incorrect. The OECD’s Transfer Pricing Guidelines contain numerous references to contractual allocation of risk. And, clearly, ‘contractual allocation’ cannot take place without a legally binding contract.
The terms of ICAs can also make a significant difference to the position of creditors in corporate insolvency situations. The claims of creditors relate to individual legal entities, not to the group as a whole, and ICAs determine the rights and liabilities of those entities. Therefore, in cross-border insolvency proceedings, the terms of ICAs are closely scrutinised and may be the subject of disputes between groups of creditors with conflicting interests.
Directors of specific group entities need to understand the legal and economic risks that affect those entities they represent. They cannot solely rely on a consolidated, group-wide view.
There is one situation in which ICAs do not need to be fully legally binding: an arrangement between a company and its own branch or permanent establishment. Since there is only one legal entity involved in the arrangement, there cannot be a contract in the strict legal sense. However, best practice is to document the proposed allocation of functions, risk and reward between the ‘parent’ and its own branch. To make this consistent with other similar transactions across the group, it may be documented in the form of an ICA between the parent and the management team of the branch, with an acknowledgment of the true legal status of the branch and the document.
Q: Can we leave pricing clauses vague in intercompany agreements?
This used to be a common approach, but it is now globally recognised as being ineffective.
The thinking was that leaving pricing clauses vague or open would give corporates more flexibility when filing tax returns. However, the reality is that there can be no contractual allocation of risk without a legally binding contract.
Under many legal systems, a contract is invalid if it does not specify a price with legal certainty. Clauses which state that an intercompany price will be “such amount as the parties may agree from time to time,” or “an arm’s length price determined in accordance with the group’s transfer pricing policies” clearly do not meet the required standard.
Similarly, if a group’s TP policies state that particular entities are ‘guaranteed’ a minimum return (for example to reflect routine activities), this ‘guarantee’ needs to exist as a legal reality. The corresponding ICAs therefore need to specify how that return is calculated, in a form which is legally binding.
More fundamentally, if the pricing of an intercompany transaction is not clearly specified in an ICA, the directors of the legal entities involved are unlikely to have properly considered the arrangements. They are therefore exposed to liability for failing to comply with their legal duties.
Q: What impact do the terms of intercompany agreements have on the VAT/GST analysis of intragroup supplies?
As with many areas of compliance, ICAs define and delineate intragroup transactions. This includes the characterisation and terms of the supplies from a VAT/GST perspective.
This table shows four ways that a contract can define the treatment of transfer pricing adjustments, and the VAT implications of each.
|How the contract defines transfer pricing adjustment||VAT treatment|
|Adjustment to reach guaranteed profit margin.||A profit adjustment is not a taxable transaction. No need to issue a debit or credit note, or any other documents for VAT purposes.|
|Adjustment is a profit split (eg in a joint venture).||As above.|
|Adjustment for previous supplies. Makes reference to a period during which transactions happened, with a list of invoice numbers and a breakdown of the adjustment to each supply||Supply of goods is a taxable transaction. A debit or credit note should be issued.|
|Adjustment is the billing of variances between the actual and budgeted cost of marketing or administrative expenses.||The taxable amount is adjusted. A debit or credit note should be issued.|
Q: How can we minimise the administrative burden of maintaining and updating intercompany agreements?
There are a number of practical approaches which can minimise the ongoing administrative burden of maintaining intercompany agreements, while also ensuring that they remain effective from a legal and a transfer pricing perspective.
Here are some examples:
- As far as possible, standardise the format and content of ICAs across the group. For example, use standard terms across all ICAs, or categories of intercompany transactions and ICAs
- Streamline the agreements and remove unnecessary and inappropriate provisions, making them as easy to read, understand and review as possible (including for non-lawyers)
- Avoid unnecessary termination or expiry dates, so that the ICAs are as ‘evergreen’ as possible (unless specific circumstances exist which require a fixed termination date)
- Think of ICAs as being framework agreements, and avoid being overly prescriptive about terms which may change, such as product names and service level
- Incorporate central policy documents by reference, such as policies for allocation keys
- Where appropriate, use multilateral agreements, rather than entity by entity bilateral ICAs
- Use electronic signatures where possible (you’ll find more on this below)
- Consider adopting a governance-type approach, whereby one party to the agreement (usually the parent or regional entrepreneur) can unilaterally notify the other parties of changes to the agreement, allowing the other parties an appropriate period within which to object to changes from time to time.
Q: Is functional analysis more important than intercompany agreements?
It is true that intercompany agreements are likely to be disregarded for transfer pricing purposes if they do not match the reality of how the group operates. Anyway, in that case they will probably be ineffective for legal purposes too, since they clearly do not reflect the ‘true’ agreement between the parties.
Legal agreements are the starting point for ‘delineating the transaction’ between related parties, as well as assessing the allocation of risk, which inevitably affects an arm’s length price. In many cases, an analysis of the functions performed by a particular entity within a group may be consistent with a number of different contractual structures, each with a very different risk profile.
For example, for an entity which acts as a procurement hub, one scenario could be that it merely provides facilitation services to other group entities. Another scenario would be that it acts as principal in purchasing goods or services from third parties, and sells them on to other members of the group. A functional analysis of the ‘procurement hub’ activity would therefore be incomplete without a clear understanding of a) the third party contracts involved, and b) the nature of the contractual relationship between the group entities, as implemented through appropriate intercompany agreements.
Q: How should groups prioritise which intercompany agreements to implement first?
For less complex group structures and for groups with less complex supply chains, it may be possible to implement ICAs covering all its material intragroup supplies in a single project, often completed within one month or less. In more complex cases, prioritising ICAs for particular supplies usually involves risk assessment and comparables analysis.
The following factors are often important:
- Known and expected tax audits or investigations (including high-risk jurisdictions)
- Supplies which are fundamental to the group’s value drivers
- Transaction types that are high-risk, high-volume and/or high-value
- Supplies to and from companies in low-tax and tax-free jurisdictions
- Supplies relating to other arrangements which are likely to be closely scrutinised by tax inspectors
Q: What are the main areas in which legal input is required for transfer pricing compliance?
These are four main areas where legal support will be needed.
Legal input into functional analysis (for Master File and Local Files, as applicable)
- Legal aspects of the description of the group’s business and functional model
- Legal ownership of assets (including intangibles)
- Identification of intangibles, including legal/beneficial ownership and the extent of legal protection and ring-fencing of IP
- Impact of regulatory issues
- Flow of contractual relationships, licensing and risk allocation, both internally within the group and externally with third party customers, suppliers and lenders
Identification of all ‘constituent entities’
- For local files and, if applicable, country-by-country reporting
Intercompany agreements (to be included in local files and referred to in master files, where applicable)
- Design of template ICAs
- Review of consistency with the group’s intellectual property ownership, protection and enforcement strategy
- Review of impact of regulatory issues
- Implementation of ICAs, including briefing notes for parent and subsidiary boards, plus board minutes and other corporate approvals for corporate governance purposes
- Documented policies for, among other things:
- the creation of further ICAs, as and when they are required
- the maintenance of current ICAs
- the avoidance of duplication and inconsistency as between ICAs
- ensuring that all relevant stakeholders are consulted in the ICA drafting process
- Documented policies and systems for the archiving and retrieval of signed ICAs, including access permissions, so that ICAs can be immediate recovered if a tax enquiry or audit occurs
Business restructurings, acquisitions and sales (including any intragroup functions, business or asset transfers, to align the group’s internal supply chain, assets and functions with its transfer pricing objectives)
- Legal, IP, asset ownership and commercial contract due diligence
- Legal input into design and planning of restructuring projects
- Drafting and implementation of legal documents and corporate approvals to implement restructuring projects
Q: What general principles should be followed when preparing and implementing intercompany agreements?
The following general principles should apply whenever intercompany agreements are created or updated, whether for transfer pricing, regulatory or other commercial or strategic purposes.
1 – Brevity
Each intercompany agreement should be as short as reasonably possible. Long and overly complex agreements are unlikely to be read and understood by all the relevant stakeholders. They are also less likely to match the way the group actually operates or is capable of operating in connection with intragroup supplies. This problem often occurs when groups use third-party commercial contracts as a starting point for intercompany agreements.
2 – Simple language
As far as possible, intercompany agreements should be written in simple language. This makes them easier to read, understand and translate. Quoting statutes and regulations should be avoided if at all possible.
3 – Grouping commercial terms
The key commercial terms should be grouped in one place, rather than being distributed across definitions, schedules and appendices. Again, this allows readers to understand the effect of the agreement more quickly. Often standard terms can be used across the full suite of a group’s ICAs – but not always.
4 – Consistency with transfer pricing policies
This includes the pricing structure, the basis for allocating costs and risks across multiple service recipients, and (where appropriate) the exclusion of charges for shareholder services and costs, which do not directly benefit the relevant recipient entity.
5 – Consistency with legal relationships
Each intercompany agreement should be consistent with the legal relationships regarding the ownership and use of assets (including intangibles), the flow of supplies and related contractual relationships with third parties, and the allocation of risk reflected in those relationships.
6 – Corporate benefit
The directors of each participating group company should be able to properly approve the arrangements described. That means that they must promote the interests of that specific entity. This includes taking account of the relevant company’s financial resources and its ability to assume risk and satisfy its liabilities, including all contingent liabilities, on an ongoing basis.
7 – Legally binding
Intercompany agreements should contain the elements necessary for them to be legally binding under all applicable laws.
An exception is an ‘agreement’ between a parent company and its own branch or permanent establishment. As there is only one party, this will not constitute a legal agreement, but rather a memorandum of understanding of the applicable commercial terms, agreed to by the board of the parent and the managers of the branch.
8 – Briefing notes for directors
Directors of participating entities should be briefed on the reasons for putting in place the agreements and the likely implications of the proposed terms.
9 – Stakeholder review
The proposed intercompany agreements should be reviewed by all relevant stakeholders. This is to ensure that the agreements reflect the needs of the group as a whole, as well as the reality of intragroup transactions and recharges.
Q: How long should intercompany agreements be?
This depends on the type of transaction involved, the complexity of the arrangements, the applicable pricing methods, and the payment mechanics. The aim is always to document the key terms as simply as possible.
Usually, intercompany agreements should be no more than 5-10 pages in length. Longer agreements may look impressive, but they are usually less robust, because they are less likely to be read and understood by key stakeholders, less likely to reflect the operations of the group and the relevant parties, and therefore less likely to be fit for purpose.
Q: Why do we need briefing notes for local boards and signatories of intercompany agreements?
The process of putting in place intercompany agreements should support good corporate governance. “Tax told us to sign” is unlikely to be a helpful answer, either for subsidiary boards, individual signatories or for the group as a whole.
Boards of parent and subsidiary companies should receive a high-level briefing on the issues they are being asked to consider and the terms of the ICAs.
This is something that we routinely cover as part of our work with multinational groups and transfer pricing advisers.
Q: Can we use electronic signatures to implement intercompany agreements?
Yes. Most jurisdictions recognise electronic signatures as a legitimate method of executing many legal agreements, including ICAs, and multinational groups very often use them.
The European Directive on Electronic Signatures has been implemented in most EU countries. It ensures that electronic signatures are recognised when certain conditions are met. In the US, the law permits the use of electronic signatures in many situations, and preempts many US State laws that would otherwise limit the use of electronic signatures.
Q: How should a group’s in-house legal function be involved?
Many of LCN Legal’s clients have experienced in-house legal, compliance and company secretarial teams. Those teams should be fully consulted in the design, implementation and maintenance of intercompany agreements.
Whenever we run workshops for multinational groups, we recommend that people from all three teams attend, along with those from tax, TP, finance, and other relevant functions. When everyone shares a common understanding and appreciation of key aspects of TP compliance, it is more likely that agreements will be implemented effectively.
Clearly, it is up to in-house legal teams to decide whether they want to deal with the detail themselves, or to prioritise other things. Teams that are not familiar with the intricacies of transfer pricing compliance often outsource that role to specialists such as LCN Legal. They might also ask us to review their templates, systems and processes, to give assurance that they deal appropriately with the issues involved and ensure robust TP compliance for their group.