14 legal mistakes to avoid when implementing transfer pricing policies

Common errors which create unnecessary risks of adverse TP adjustments

At LCN Legal, we generally try to focus on the positive. That said, there’s much to be learned from looking at commonly made mistakes – particularly those that can make it much harder for a group to defend its TP positions when required.

With that in mind, here are fourteen common errors relating to intercompany agreements (ICAs) that can create serious problems for groups and their TP advisers.

1. No ICAs. Without agreements in place, the taxpayer has lost the opportunity to define and substantiate the transaction – and any benchmarking or economic analysis will necessarily be flawed because there’s no clarity about what is being benchmarked.

2. ICAs not contemporaneous with or preceding the controlled transactions. Yes, if a group has gaps in its agreements, the sooner those gaps are fixed the better. And sometimes this means creating agreements which purport to have retroactive effect. But the fact remains that ‘backdated’ agreements are an obvious red flag for tax administrations, and undermine the taxpayer’s documentation. And from a substance perspective, they do not comply with the arm’s length principle.

3. Price setting policies not implemented in ‘clear and unambiguous’ contractual provisions which support the calculation of invoiced amounts. The old received wisdom of ‘keep agreements vague so that they can never be wrong’ no longer works (if it ever did), and results in sham agreements which are clearly not agreements in any genuine sense.

4. Nature of payments not defined. Related party transactions often involve a bundle of different elements which may be charged for separately – such as the price for goods, fees for services, royalties for use of intangibles etc. Those elements may be treated differently for withholding tax, customs and other purposes. One of the important roles which agreements play is to define and characterise the nature of payments, and failure to do creates uncertainty and risk. It’s equally problematic if the characterisation of payments in agreements is then contradicted by invoice narratives.

5. ‘Guaranteed’ returns not reflected in legally binding provisions. Transfer pricing documentation sometimes states that particular entities are ‘guaranteed’ a certain return. We might see this in limited risk distribution arrangements, for example. Any such statements need to be objectively verifiable by reference to the contractual terms in place.

6. True up / true down mechanisms not implemented in legally binding provisions. This may appear to be an administrative matter only, but in fact such provisions are often central to delineating the transaction.

7. Currency of payments not defined. Unless the currency of payments is clearly specified in the relevant agreement, it’s not clear which party bears the currency risks. Such risks can be very significant, especially in times of volatile exchange rates.

8. Risk allocation incorrectly implemented. Examples include product liability, IP infringement, inventory, credit risk. (We’ll be publishing a podcast episode on this subject soon.)

9. Ownership of intangibles incorrectly analysed / implemented (including treatment of prior IP and improvements).

10. Profit split arrangements incorrectly implemented. For example, failure to define the nature of the arrangement (split of actual vs anticipated profits), the nature of the parties’ respective contributions, the definition of the residual profits to be split, profit splitting factors, weighting, timing, and more.

11. Cost sharing / cost contribution agreements that fail to comply with US Treasury requirements as regards form, content and timing (within 60 days after costs first incurred)

12. Loan terms not defined. (Maturity date, interest rate, interest setting periods, interest payment dates, covenants, security, ranking, ability to prepay, acceleration of repayment provisions...)

13. Agreements not updated to reflect important changes, such as in group structure, TP policies, benchmarking, selection of TP method, operations and so on. This is one of the key lessons from the US Tax Court’s decision in Coca-Cola: agreements have little value if they do not reflect the structure of the group and its transfer pricing policies as they evolve.

14. Terms of ICAs changed or ignored without written justification. When updating TP policies it is essential to update the relevant agreements, and also to document the reasons for the change from the perspectives of the legal entities involved.

After reading this list, you might understandably feel that the bar for transfer pricing compliance has been raised significantly. That’s probably a correct assessment.

From a practical perspective, this makes it all the more important to do four things:

• Simplify intercompany transactions as much as possible, making sure that there is a clear commercial rationale for those transactions from a legal entity perspective
• Standardise and streamline intercompany agreements as far as possible
• Create and maintain a comprehensive online archive of signed and dated agreements, together with briefing notes or other suitable documentation to explain the commercial rationale
• Set up ongoing systems and processes so that agreements are reviewed on a regular basis (usually at least annually) and any changes in the group’s structure or operations are captured.

Article by Paul Sutton

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