One of the perennial challenges in the legal implementation of transfer pricing policies is reconciling differing perspectives: those of functional analysis on the one hand, and legal rights and obligations on the other.
A classic example is routine returns for distribution and production functions, as in the recent Coca-Cola case. As the US Tax Court stated in that case, ‘understanding the rights and obligations of entities within the Coca-Cola System requires an examination of both written contracts and the parties’ course of dealing.’
However, one of the Court’s key findings was that, although the group used a certain formula to allocate profits between the relevant entities, ‘it never incorporated any aspect of that formula into its written supply point agreements.’ (You can find a link to the case report here.)
From a TP perspective, routine distribution functions are often described as the provision of routine services by the distributors to the principal.
From a legal perspective, the principal supply is in the opposite direction: for example, the sale of goods, license of software, or provision of services for resale to customers. And the payments between the parties may be in either direction, depending on the third party revenue actually achieved by the ‘routine entity’ in the relevant period, and whether that results in an amount which is more or less than the targeted / guaranteed margin.
It may be tempting to create agreements which follow the TP perspective alone, and merely describe the provision of routine services. But ultimately this would be counterproductive, because it would misrepresent the transactions which actually exist, and which need to be documented for non-TP reasons (such as VAT/GST, customs, regulatory compliance, personal duties of directors etc).
Substance can only be based on reality, and not on a convenience or fiction.
It’s perfectly possible (and essential) to create and maintain legal agreements which accurately describe and delineate the actual transactions, but which are also consistent with the TP analysis of functions and value chain.
As always, it requires a cross-functional approach and a global perspective, and accurately describing the basis on which intercompany charges are being made.
N.B. You can find the latest version of our Guide to Maintaining Effective Intercompany Agreements for Transfer Pricing Compliance here.