OECD and IRS guidance on intercompany agreements and the legal implementation of transfer pricing

The OECD and the IRS have stated clearly what they expect from transfer pricing agreements and other documentation. It is all set out in detail in the OECD’s Transfer Pricing Guidelines. The IRS Guidance on Transfer Pricing Best Practices is also clear, saying: “Risk analysis should be consistent with intercompany agreements,” and “The transfer pricing documentation should address … allocations of risk, how the risk allocations compare to the comparable companies used, and why the resulting pricing is consistent with the agreement.”

In this section we’ll look at two important questions for multinational groups:

What practical impact do intercompany agreements have on arm’s length pricing for transfer pricing purposes?

At what point in the TP lifecycle do ICAs need to be put in place?

What practical impact do intercompany agreements have on arm’s length pricing for transfer pricing purposes?

A single clause in an intercompany agreement can make a significant difference in this area.

Consider this example from the OECD’s Transfer Pricing Guidelines. It relates to a ‘buy back’ clause, in which a related party distributor of goods receives a contractual undertaking from the supplier that the supplier will repurchase any unsold stock. Inventory risk would usually be borne by the distributor if it holds stock, but the buy-back clause transfers that risk to the supplier.

In the particular example in the OECD’s Guidelines, if the intercompany agreement does not include a buy back clause, the return for the distributor increases by 20%. The table below shows this in detail:

From the OECD Transfer Pricing Guidelines 2017, p 427.

At what point in the TP lifecycle do intercompany agreements need to be put in place?

Many people believe that intercompany agreements should be reviewed as part of the year-end process, while assembling the formal transfer pricing documentation for the year in question. This is incorrect.

The OECD’s Transfer Pricing Guidelines are very clear that retrospective contractual allocation of risk after the event does not work. This is because the relevant economic outcomes are already known, and the concept of ‘risk’ is only meaningful when there is uncertainty about the future. The Guidelines state: “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.”

A group therefore needs to establish its transfer pricing policies, and implement appropriate ICAs, at the start of each financial year, before any relevant transactions take place.

This is particularly important for transactions in which allocation of risk is a key factor. Examples of these include the appointment of limited risk intragroup distributors; many arrangements regarding profit splits; and the licensing of intellectual property or other intangible assets.