One of the preliminary processes in confirming the arm’s length value of a transaction between related parties is the analysis of its contractual terms. Unlike transactions between independent third parties, related parties may lack the incentives to reflect in their contractual terms the negotiation dynamics that would have been followed with third parties. Furthermore, even if arm’s length terms are established, in practice, they may be replaced by different terms.
Another possible scenario is that the transaction is incorrectly classified, and an inappropriate contractual form is assigned to the operation. Additionally, there may be activities that are not legally or financially recorded, to the detriment of one of the contracting parties.
For these reasons, and in accordance with the recommendations of the BEPS plan under actions 8-10, it is necessary to review the contractual terms governing intercompany transactions and assess their consistency with the characteristics of the operation, the functions performed, the assets used, and the risks assumed by the participants in the transaction. This includes not only evaluating the relevance of the risk concerning the transaction but also analyzing the economic capacity and control of the contracting parties over the assumed risks. The objective is to prevent a potential recharacterization of the transaction or, ultimately, the disregard of the agreed contractual terms, which could have a direct impact on the taxable base of the transaction participants.
As a recommendation, it is important to consider that each intercompany transaction involves the absorption of functions, assets, and risks by a related entity, and these activities should be documented through the appropriate contractual form. Suppose that, in the absence of structure, personnel, or resources to perform the purchasing function, there is a need to outsource the activity to a related party. Depending on the activities performed, the transaction may need to be characterized as a “purchasing agency,” for example. In this case, the contract governing the transaction should detail the objective of the transaction, the activities to be performed by the agent, the risks incurred by both the agent and its counterparty (where such risks should be allocated as independent third parties would), as well as the agreed remuneration, in arm’s length terms.
Another function typically absorbed by related parties residing abroad is information technology services. In such cases, the terms of the service would need to be documented, possibly through a “Service Level Agreement,” where, once again, the service objectives, characteristics, frequency, risks, and remuneration should be agreed upon in arm’s length terms. It is also essential to consider that for any intercompany contract, the failure to quantify the direct costs incurred by the service provider and, therefore, the use of allocation keys would trigger the need to structure the contract as a “cost contribution agreement,” in accordance with the provisions of the miscellaneous rule 3.3.1.27 for 2018 and Chapter VIII of the OECD Transfer Pricing Guidelines for 2017.
The above are examples of contractual forms aligned with intercompany transactions in compliance with the new BEPS regulatory framework. We remain at your disposal for any clarification regarding your intercompany contracts.
Example (Contractual Terms that Differ from the Economic Reality of the Transaction, Paragraph 1.44 of the 2017 Transfer Pricing Guidelines)
Company P is the parent company of a multinational group based in country P. Company S, located in country S, is a wholly owned subsidiary of Company P and acts as an agent for P-brand products in the market of country S. The agency agreement between Company P and Company S does not reference any additional marketing activities in country S that the parties should carry out.
Upon analyzing the economically relevant characteristics of the transaction, and in particular the functions performed, it is identified that Company S launched a media campaign in country S to position the P brand—an activity different from those typically performed by an agent. This campaign represents a significant investment for Company S. Based on the evidence of the parties’ economic behavior, it can be concluded that the contract does not fully reflect the actual agreement between the parties. Consequently, the transfer pricing analysis should not be limited to the contractually agreed terms but should also consider the parties’ actual conduct, including the terms under which Company S decided to execute the advertising campaign for the benefit of Company P.
