Intercompany agreements have varying levels of specificity. However, these contracts often implicitly assume business as usual, and may not address fundamental business disruptions. For example, who is responsible when suppliers are not able to operate due to government shutdowns? What happens to unsold inventory when customers are not allowed to come into stores? What happens when there is significant bad debt?
Intercompany contracts remain a fundamental part of transfer pricing compliance; whether or not it’s a time of crisis, they should be consistent with the conduct of the relevant parties involved. Since the activities performed and risks assumed by related party entities may be changing to accommodate business needs during this uncertain time, it is imperative for taxpayers to consider whether any of the terms in their intercompany contracts should be amended (to the extent allowed by law). This article will provide a framework to consider and questions to ask related to intercompany agreements.
Intercompany Agreements: Questions & Considerations
The U.S. Treasury Regulations specify contractual terms that should be considered when comparing controlled and uncontrolled intercompany transactions. These terms are also important to consider when drafting (or updating) an intercompany contract, and include:
- Form of payment
- Sales volumes
- Warranties
- Rights to updates
- Term and termination
- Collateral transactions
- Credit/payment terms
These terms are among those that should specifically be evaluated to ensure that form and substance are aligned, particularly in light of the current economic volatility. With regard to intercompany transactions, for example, are related party entities still making timely payments? Do they require less units than contracted for? Are ancillary services no longer being provided? Do they still have the financial capacity to offer credit terms? Has the arrangement ceased entirely? It is important that written contracts reflect any of these potential new operating realities. Of course, if terms are renegotiated, taxpayers still need to demonstrate that they are consistent with the arm’s length standard.
Taxpayers should also be particularly aware of whether their intercompany agreements contemplate how risks are shared amongst entities under extraordinary circumstances.
The Treasury Regulations are clear that the terms of a transaction will be respected if they are consistent with the economic substance of the transaction. In evaluating economic substance, the actual conduct of the parties is most heavily weighted. To the extent that form and substance are inconsistent, new terms will be imputed based on conduct.
Similarly, the lack of a written agreement will also lead to imputed terms based on the conduct of the parties. Therefore, also consider whether new intercompany agreements need to be put in place. Based on changes to workforce, supply chain, etc., have any new transactions been implemented? Are contract manufacturers selling directly to any new entities? Are any entities providing global supply chain management services that they previously had not? Imputed terms may not be ideal, so even a short-term contract that covers this period of economic uncertainty may be worth having in place when the dust settles.
Based on the above, it is also important to consider whether the taxpayer truly has a change to an existing agreement, or if it has a completely new arrangement. Under the OECD Guidelines, it is clear that the terms of a transaction may change over time. However, the Guidelines go on to state that “the circumstances surrounding the change should be examined to determine whether the change indicates that the original transaction has been replaced through a new transaction with effect from the date of the change, or whether the change reflects the intentions of the parties in the original transaction.”
This distinction, especially as it relates to timing, is important. Per the U.S. Treasury Regulations as well as the OECD Guidelines, an allocation of risk between controlled taxpayers after the outcome of such risk is reasonably knowable lacks economic substance. When a risk is known, there is no longer any risk to be assumed. As such, any modifications to intercompany agreements should be made as timely as possible for the terms to be respected.
Whether amending terms in an existing intercompany contract or drafting terms for a new one, consider the taxpayer’s agreements with third-parties and whether there have been any recent amendments to them. To the extent that payment terms have been extended, prices have been renegotiated, etc., these modifications may provide market evidence for the arm’s length nature of the terms the taxpayer seeks to include (and therefore support) in its intercompany agreements.
Additionally, consider whether to add terms that will address extraordinary events in the future, whether through force majeure or other provisions.
Lastly, some intercompany agreements are more explicit than others, particularly as it relates to payment terms. Therefore, whether amending an existing agreement or drafting a new one, if it states that compensation is based upon a fixed mark-up or margin, this might be a good time to consider whether more general phrasing such as “an arm’s length price” would be more appropriate.
In general, the framework and questions outlined above should serve as a reminder that best practices should be followed now more than ever to demonstrate arm’s length behavior. As always, support new or existing agreement terms with a functional and risk analysis (i.e. through the conduct of the parties) and be on the lookout for examples of market evidence. While much in the economy has changed, the basic principles of transfer pricing have not.
Any opinions expressed in this article are those of the authors, and not necessarily those of Valentiam Group.
Topics: Transfer pricing, COVID-19
