Your thoughts on ‘putting the cart before the horse’

We recently wrote a blog post about the factors that should dictate a group's contracting model ('Putting the cart before the horse?'). It was inspired by the following extract from a TP report by a Big Four firm (my italics):

“The Group utilises a centre-led operating model, whereby client contracts are entered into by either the local entity or the central UK entity. The determination of where a contract is signed should reflect the economic substance relating to the contract, and the central UK entity should not be entering into contracts substantially agreed by other companies. Intercompany agreements should be in place to support the recharge and governance processes, including acting on behalf and covering the actual economic circumstances.

In the context of the Group’s operating model, where prospective clients and negotiations are undertaken in the US and Switzerland, the contracts should be executed, and negotiations documented by the local entities (US and Switzerland); thereby aligning the economic substance to that respective jurisdiction. Where negotiations and work are undertaken within the UK or in any other countries (most commonly where there is no local presence), the UK should be assigned as the contracting entity to reflect the economic substance for that contract.”

Four people got in touch with us to share their thoughts. All were broadly in agreement, and offered further practical insight or analysis. Here are their comments in full:

Response 1

I think of it this way: the group is free to structure its contracts with customers to satisfy whatever legitimate business objectives it may have (but not, for example, to game the TP rules); it must then prepare its intercompany TP agreements to reflect the economic substance of the activities, rights, and duties of the group companies that support the customer contract structure.

Response 2

The first paragraph seems to be based on an assumption that the place where the contract is signed must follow the economic substance. I am not aware of any TP rules that have this effect.

The second paragraph seems to be based on an assumption that the place where the contract is executed, and negotiations are documented, determines where the economic substance is. I say this because it says those actions will align the economic substance with the jurisdiction. The first part is certainly wrong. The name of the contracting party is, in itself, virtually irrelevant to economic substance.

The party that carries out the negotiations may well be an important determinant (since negotiating the contract is usually a key success factor in a consultancy business). To be picky, it is the action of negotiating that is important. Documenting this accurately may help to make clear that this is where substance lies, though the act of documenting cannot change the substance.

As you say, though, commercial factors should normally dictate who should sign the contract. If they are not determinative it may make sense to take into account transfer pricing, though not in the expectation that this will change the economic substance. It may make sense to align the contract execution with the economic substance (rather than vice versa), because this will avoid inconsistencies that then need to be considered in the TP analysis. This would keep the analysis simpler. Perhaps they were also conscious that the IRS has not, in practice, fully accepted that economic substance trumps legal form, so as this group has US operations it is better to make sure that legal form is aligned with economic substance.

That may be what they really mean, but have said in a confusing way.

Response 3

Your reaction echoes my own thoughts from my time negotiating/structuring IT consultancy and software (customisation) projects.

Where multiple entities were involved in delivery, then either an umbrella contract would be used allowing local-to-local billing (where multiple customer entities), or the main commercial entity of the provider (usually a UK entity for a UK MNC would be used) with the right to sub-contract to other group companies.

This meant one set of legal agreements; a very familiar legal jurisdiction to manage risks and regulatory requirements; etc. Commercially though, the customer would often want the performance guarantee of the main consultancy company (implicitly a group guarantee). This removed the issue of the creditworthiness of the local subsidiary which, as a service provider, would tend to be asset-light and unable to, say, support a 15% cost overrun on a very big contract, or be sure to be around if issues only arose later.

Even where a project was being delivered locally, that local entity would often still need to “borrow” individual consultants from another entity/country and require TP arrangements to address. I think for these reasons IBM has effectively selling/customer management entities but then a global pool of consultants to deliver customer projects.

At worse where no real commercial involvement, the contracting entity would require a small turn for contract and invoicing administration and the implicit performance guarantee (which probably reflects the underlying substance anyway).

Response 4

I see in practice (me being “back office”) – that unfortunately the “business” when negotiating contracts even with third parties are not capable of what was agreed orally to process this via contracts in writing. They think that writing the contract is the job of “legal department” despite the fact that “legal” was not in a meeting and does not know what was agreed…

So if I translate this into “related party” agreements – “why you are complicating we are MNE”. Which comes down to what you wrote in your book, which I really like:

Legal entity perspective vs line of business and functional management

Many corporate groups are managed by reference to business functions and lines of business, and their reporting structures therefore do not directly reflect the legal structure of the group. However, if the decision-making process is not consistent with the legal structure, this can create potential liability exposure for officers.

Ultimately, a ‘group’ has no legal existence, and the only way that a corporate group can interact with third parties is through legal entities and individuals which have the legal capacity to hold assets and to sue and be sued. The more a corporate group carries on its operations through subsidiary entities, the more significant subsidiary governance becomes.

I hope that these responses give you some further insight and food for thought on this very interesting issue. And – to be completely honest – I was very gratified to see our book being quoted! I'd just like to take this chance to remind you that we'll updating that soon; we've already received lots of excellent suggestions about content for the new version, but it's not too late to share your views if you want to.

Thanks very much, as always, to anyone who takes the time to give us their thoughts on any issue. It is very much appreciated.