Why CFOs must have robust intercompany agreements

Paul Sutton, founder of LCN Legal, explains why intercompany agreements are so crucial between corporate entities

The value of intercompany agreements (ICA), like many types of contractual arrangement, often only becomes apparent when something goes wrong.

Businesses frequently take the view that the relationship between corporate entities within a group is unlikely to come under scrutiny and so neglect to invest in clear, legally robust intercompany agreements.

Even when such agreements do exist, they are often badly drafted, incomprehensible and out-of-date, and don’t reflect the commercial reality of how the group operates.

CFOs of international groups should ensure that legally binding intercompany agreements are in place and any Transfer Pricing risks minimised. Failing to do so is akin to giving tax authorities access to the group’s bank accounts so they can withdraw what they consider fair.

Intercompany agreements are legal agreements between related parties. They define the legal terms on which services, products and financial support are provided within a group.

ICAs can cover a wide range of issues, including head and back office services, revenue and cost sharing, intellectual property licences, and so on.

It has long been accepted that ICAs are a fundamental part of Transfer Pricing compliance and with the implementation of the OECD’s BEPS guidance by an increasing number of countries each year, this importance is only increasing for multinational enterprises and financial institutions.

The OECD had this to say on the matter in 2010: “Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it. Accordingly, it would be a good practice for associated enterprises to document in writing their decisions to allocate or transfer significant risks before the transactions with respect to which the risks to be borne or transferred occur…”

While the tax reasons for properly drafted intercompany agreements are compelling enough (in many years HMRC nets well over a billion pounds in additional tax from Transfer Pricing enquiries), there are non-tax drivers, too.

ICAs can be an important tool for regulatory compliance; ring-fencing assets and liabilities from risk; improving the corporate governance of companies throughout the group; reducing personal liability risks for directors; supporting the external and internal audit of group entities and ensuring that intellectual property rights can be enforced and monetised appropriately.

On the other hand, the consequences of not having ICAs can be serious. Fundamentally, groups which do not have appropriate, signed ICAs in place are on the back foot in discussions with local tax authorities about their Transfer Pricing compliance.

This is because they are unable to present a clear statement as to what intra-group supplies are being made and for what price, how relevant assets are held and how risks are allocated between group companies.

In certain jurisdictions, corporates are routinely subject to fines and penalties, simply for failing to produce signed ICAs when requested.

Other problems include expenses potentially being disallowed, post year-end ‘true up’ type adjustments being subject to challenge and local tax authorities attempting to re-characterise a transaction as something other than that claimed by the taxpayer.

It is important to achieve the governance and Transfer Pricing benefits of having robust legal documentation for intra group supplies.

For intra group supply, the relevant intercompany agreements obviously need to be consistent with the group’s Transfer Pricing policies in terms of the nature, the terms and the pricing of the supply.

They also need to be consistent with the reality of how the arrangements are operated and managed in practice.

Complicated change control or reporting provisions which have been imported from an arms’ length commercial contract will do nothing to enhance a group’s Transfer Pricing position if they are not followed in practice.

The terms of the intercompany agreements must be consistent with the legal and beneficial ownership of any relevant assets and the commercial reality of intra group transactions. For example, an intra-group agreement where a company purports to grant a license over intellectual property which it does not actually own, may be likely to create confusion and misleading accounting entries, rather than promoting the group’s Transfer Pricing and other commercial objectives.

The legal agreements should reflect an arrangement that the directors of each participating company can properly approve as promoting the interests of that company. This means that some proposed arrangements can be problematic – such as arrangements which would involve a particular entity incurring ongoing losses; being exposed to liabilities or cashflow demands which it does not have the financial resources to meet or ‘giving away’ assets or value, especially if it is to a parent undertaking.

Finally, the intercompany agreements must be capable of being legally binding, which means that the key terms of the arrangement must have ‘legal certainty’.

This principally applies to the description of what is being supplied and the price of the supply, so that those provisions must be objectively ascertainable from the terms of the agreement.

We see a lot of intercompany agreements where there is no price stated or the price is set by some vague reference to comparable turnover or net profits of the subsidiary. This approach can raise issues around legal certainty and Transfer Pricing compliance.

Other common mistakes include agreements being too complicated, not matching ownership and flow of IP, not adequately reflecting group structures, failing to guard against inappropriate termination provisions and overlooking the importance of making provisions for allocation of cost between multiple service recipients.

Putting in place and regularly updating intercompany agreements can seem like a complex and costly process.

Failing to do so, however, is usually a false economy.

Intercompany agreements do not have to be complicated – in fact they need to be simple so that stakeholders fully understand them. But, like anything else, they need to be properly planned and implemented.

There are real savings in taking a proactive approach to BEBS compliance, group Transfer Pricing policies and related intercompany agreements.

 

Paul Sutton is the founder of LCN Legal and was previously a partner at Pinsent Masons.

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