Tax AdvisoryNovember 24, 2023by fiecon

The Significance of Intercompany Agreements (ICAs) in Transfer Pricing Compliance

Income Tax Return Deduction Refund Concept

Intercompany agreements, or ICAs, are legal contracts entered into between businesses with similar interests. These agreements lay the groundwork for the legal structure that governs the provision of services, products, intangible assets, and financial assistance inside a corporate group. Management services, administrative and other back-office services (e.g., finance, tax, legal, and HR services), marketing services, R&D services, sales agency and commissionaire arrangements are among the transactions covered by ICAs. Appointment of limited risk distributors (on a target margin basis, for example), Appointment of full risk distributors, Contract manufacturing and toll manufacturing, Intellectual property licenses and intra-group franchisees Profit divides on transactions, Arrangements for cost sharing / cost contribution Arrangements for shared services, Intercompany debt in security (e.g., term loans, revolving credit, and overdraft facilities), loan facilities (e.g. term loans, revolving credit and overdraft facilities), Intercompany debt in security form (e.g. loan notes), Guarantees and other forms of security or financial support, Cash pooling and finally Secondment of staff and other mobility arrangements.

ICA Case Law

Transfer pricing compliance is a critical aspect of multinational enterprises, and the absence of well-documented intercompany agreements can have far-reaching consequences. This article delves into the impact of the lack of intercompany agreements and the importance of having one in place, using the recent legal case of Aspro, Inc. v. Commissioner (USA, 2022) as a prime illustration.

The Aspro case serves as a compelling example of the repercussions that can arise from the failure to establish intercompany agreements and provide corresponding documentation to substantiate management charges.

Over an extended period, Aspro, Inc. distributed annual payments to its shareholders, designating them as management fees rather than dividends. Crucially, no written agreements were in place, and no supplementary documentation was provided to support the existence of a bona fide service relationship between the involved parties.

The Internal Revenue Service (IRS) responded by disallowing the deductions claimed by Aspro for the entire relevant period spanning 2012 to 2014. Subsequently, the United States Court of Appeals ruled in favour of the IRS, underscoring the significance of robust intercompany agreements and supporting documentation in transfer pricing matters. The key takeaways on this case include;

  • Documentation Deficiency: The lack of written intercompany agreements and supporting documentation left Aspro vulnerable to challenges from tax authorities.
  • Substantiation of Transactions: The absence of documentation supporting the service relationship between Aspro and its shareholders led to adverse consequences.
  • IRS Disallowance: The IRS disallowed the claimed deductions, emphasizing the need for meticulous documentation to withstand scrutiny.
  • Legal Precedent: The decision by the US Court of Appeals in favour of the IRS establishes a legal precedent, reinforcing the importance of comprehensive intercompany agreements in transfer pricing compliance.

Tax Authority Expectations

If TP measures are not executed – both legally and administratively – they give no protection against tax concerns. As a result, tax authorities’ requirements for TP compliance include the following:

  • The transfer pricing documentation should address risk allocations, how the risk allocations compare to comparable companies used, and why the resulting pricing is consistent with the agreement.
  • Risk analysis should be consistent with intercompany agreements.
  • Ex ante contractual risk assumption should provide unequivocal evidence of a commitment to assume risk prior to risk outcomes materializing. Such data is a critical component of the tax administration’s transfer pricing consideration of risks in commercial or financial relationships, because, in fact, a tax administration audit may take place years after the making of such up-front decisions by the associated enterprises and when outcomes are known.

Intercompany agreements thus play an important role in identifying regulated transactions, documenting risk allocation, proving ownership of intangibles, and determining price (including any post-year-end true-up or true-down arrangements).

In practice, ICAs are frequently one of the first documents requested by tax authorities during a transfer pricing investigation or audit. Gaps in intercompany agreements, as well as disparities between intercompany agreements and TP documents, are easy for tax authorities to spot and are frequently the subject of their investigations.

As a result, the importance of ICAs in TP is reflected in the following fundamental points;

  • ICAs are the starting point for tax administrations to delineate transactions as part of TP analysis, as contemplated by the OECD’s Transfer Pricing Guidelines (the same principles apply under the rules in many countries, including Kenya)
  • In terms of formal compliance with base erosion and profit shifting (BEPS), the OECD’s Transfer Pricing Guidelines require that master files include a “list of important agreements relating to intangibles,” and that local files include copies of “all intercompany agreements entered into with the relevant local entities.

Multifaceted Functions of Intercompany Agreements (ICAs)

ICAs are required for more than just transfer price compliance. They also play an important role in risk and compliance management in other functional areas which include;

  • The analysis of VAT charges
  • Customs compliance
  • Regulatory compliance (e.g. in the financial services and insurance sectors)
  • Enforcement of intellectual property rights against third parties
  • Managing personal liability risks for directors
  • Supporting the external and internal audit of group entities
  • Exchange control and cross-border funds flows (for some countries such as China, ICAs are part of the mandatory documentation required for any transfer of funds out of the country)
  • Demonstrating ‘substance’, especially as regards control functions exercised in offshore jurisdictions such as the Cayman Islands, Mauritius, Jersey, Guernsey and the Isle of Man
  • Ringfencing assets from legal risks
  • Preparing the group for sale, IPO or fundraising (since TP is often regarded as one of the most significant tax risks facing cross-border businesses, and ICAs are a key means of managing those risks).

Audit Ready ICAs Key Attributes

ICAs must be all of the following in order to be considered ‘effective’ for transfer pricing purposes;

  • Aligned with the allocation of functions, risks and rewards described in the TP policies
  • Legally binding
  • Correctly signed and dated on behalf of all the participating entities
  • Kept updated on a regular basis, so that they continue to provide an appropriate legal framework for the group’s TP policies, corporate structure and operations as they evolve
  • Appropriately archived, so that they can be accessed quickly when required.

In conclusion, the requirement is therefore to have a set of ‘audit-ready’ signed agreements, which can be produced at short notice, when needed to respond to tax enquiries, audits and investigations.

Author: Eddie Opiyo